Author: Daniel Krawise
Source: https://nakamotoinstitute.org/mempool/crashes-and-hyperinflation/
introduction
John Maynard Keynes famously said, "The market can remain irrational longer than your lifetime." But the reverse is also true: the market can suddenly become rational, much shorter than you expect. When people begin to accept irrationality as the norm, a sudden surge of rationality can catch them off guard. Crashes and hyperinflation can be seen as the consequence of a society gradually becoming complacent in its irrationality. A crash occurs when people invest too much in specific businesses, leaving little to correct mistakes. Hyperinflation is on its way when people begin to accept low levels of inflation as normal.
Understanding these phenomena will be crucial to understanding when people tend to hold cash and when they prefer to buy investment products; the impact of these decisions on the economy; and how the expansion of the money supply affects the incentives for these decisions. This is the subject of this article, and below are my definitions of the concepts to be discussed.
Money : Money is an abstract concept used to refer to the most liquid commodity (regardless of what it actually is). The advantage of having money, from an investor's perspective, lies in its ease of sale in the market—this is precisely what "highest liquidity" means. It also means that if something particularly good comes up for sale, those holding cash will be the first to acquire it.
Cash : Different things become money in different eras. Because I want to discuss the process by which a commodity loses its monetary status, I use " cash " to refer to a commodity that is currently money —but may cease to be money in the future. When this happens, the monetary status will shift to some other commodity, and cash will become worthless paper or worthless numbers on a computer. Money is an abstract concept, but cash is a concrete commodity.
Savings : The cash portion of an investor's portfolio.
Investment products : Goods other than cash, purchased because of the anticipated future benefits, not for immediate consumption. This could be because they provide income, such as bonds or stocks with dividends, or because you expect their price to eventually rise. I don't differentiate between different types of investment products because the distinctions between them are not important to the issues I'm discussing. Even if I use a company's stock as an example, I could easily substitute it with bonds, commodity futures, sports cards, and so on. When I say "stock market," I mean the entirety of investment products, not just the stock market in a narrow sense.
This article aims to compare cash with other investment products and explain why some people prefer one over another, which is why it doesn't consider cash an investment product. However, in a sense, cash can be considered an investment product—some people buy it because they expect it to become more valuable in the future. If they anticipate a stock market crash, they might convert their cash to cash first, hoping to buy stocks again at a lower price after the crash. Others might hold only cash and no other investment products because cash has an immediate benefit (current value), namely its liquidity. This will be discussed in more detail below.
Inflation : In this article, inflation refers to an increase in the money supply, not a rise in prices. The rationale for this definition is that if an investor knows the money supply is increasing, they will expect their cash to become less valuable (compared to the scenario where the supply doesn't increase). This will be true even if there is no obvious price increase at present. Generally, investors learn to react to the reasons that lead to their expectations of price changes, because if they wait for prices to actually change before reacting, they have already missed the opportunity.
This article presents an idealized economic system—in which there are objective answers to what constitutes money and what does not; and where money is managed by issuers in an extremely simple way: issuing more money. Real-world economies are far more complex, but my argument is that understanding the real world involves unveiling it and identifying its idealized models (I will not defend this here). I do not believe that the operating model of national currency in the real world is fundamentally different from what I am describing here.
I recently wrote an article discussing money supply growth, titled " Unrelated to Technology, Just About Money ." This article can be considered a sequel to that one, but it can also be read independently. That article mainly discussed the positive feedback loop between money adoption and its value; that is, the more people use a commodity as money, the more useful it becomes as money, resulting in greater liquidity. This article discusses how money interacts with the rest of the economy after it matures, and why mismanagement by issuers can lead to its failure.
The value of money
The first thing that confused many people about Bitcoin was: how could it possibly have value? It's just a string of numbers on a computer! I'm not saying that people who thought Bitcoin had no value were stupid; in fact, their only shortsightedness was not asking the same question about all forms of currency. At that time, people were already paying real dollars for numbers on computers (gold in World of Warcraft, upgrades in Farmville), and most of those "real dollars" were also just numbers on computers. Therefore, Bitcoin as a form of currency has never been anything special.
Why don't we throw a one-dollar bill on the ground and shout, "It's just a piece of paper! How could I have ever thought it had any value?" This seems unlikely, yet no single currency has existed throughout history. I will argue that money plays an important role in investment, and the benefits gained by those who successfully invest in currencies explain why people want to hold them.
First, I want to simply dispel a common misconception: that the value of money comes from its use as a medium of exchange. Money is useful as a medium of exchange, but this is because it has value, not the other way around. This can be demonstrated by the fact that you can use money as a medium of exchange without increasing the demand for it at all. If you always spend money immediately after you earn it, then you are using it as a medium of exchange; however, you discard it so quickly that you immediately eliminate the need for it.
For the value of money to increase, people must all want to hold more units of money at the same time, or they must all want to hold it for a longer period. In other words, the value of money actually comes from people's demand for it as savings. Some people live paycheck to paycheck and only have enough money to meet their immediate needs. Others have large savings, but their spending rate is roughly equal to their income rate. Still others spend more/less than they earn, thus increasing/decreasing their savings. The value of money can be understood from the reasons why people want to save large (or small) amounts; and changes in the value of money, whether fast or slow, can be understood from the reasons why people's valuation of savings changes.
Savings function
Here are the most practical benefits of holding cash. People with cash can remain indecisive about what they want to buy until the last minute. They are better prepared for unexpected expenses and opportunities, and therefore don't need to plan. What's a disaster for those without savings can be treated as a normal expense for those with savings. Most people, given enough income, will buy insurance for their car, house, and health. But if someone has substantial savings, they won't need as much help from others.
People with savings are also better equipped to help those in distress. If people need help, they are not only able to show kindness but also to reap benefits in return. Businesses have specific, recurring expenses that, if uncollected, lead to bankruptcy. For example, salaries must be paid on due dates. There are also always risks that prevent businesses from generating sufficient revenue at times. Holding extra cash hedges these risks; alternatively, cash can be used to purchase more capital or attempt to expand future production capacity. Maintaining the right balance is difficult in a constantly changing and uncertain environment, so even very sound businesses sometimes urgently need cash. At such times, the company's stock price may fall because the risk of insolvency increases. They may be willing to borrow from lenders at very favorable interest rates. Investors with cash on hand can help such valuable businesses survive by covering urgent expenses in exchange for the opportunity to buy shares at a favorable price or earn substantial interest from bonds.
However, such opportunities don't come every day. Only those with cash on hand can seize them. When someone has cash, they are not locked up and are prepared for the opportunity. Conversely, a large portion of an investment's potential returns depends on the ability to choose when to sell. The price of an investment may continue to fall, even if, in the longer term, an investor can sell and profit. If an investor can hold an investment long enough to wait for a good selling opportunity, the chances of it bringing returns are much greater. Furthermore, while stocks may seem readily marketable on ordinary days, there are times when the prices of most investments (except cash) fall simultaneously. In such cases, quickly selling investments may not be possible, therefore, holding cash from the outset is far better.
Therefore, the benefit of cash to its owner is that it is ready to take advantage of good trading opportunities; and cash holders provide corresponding benefits to the economy by being ready to go where help is needed. Cash holders also benefit the economy by deciding which distressed businesses are worth saving and providing the necessary cash.
Of course, cash itself cannot repair a troubled business; it can only be used to purchase necessary resources. For example, it can be used to pay employee salaries, keeping the business running until new revenue arrives. Therefore, the presence of cash holders in an economy can be seen as a preservation of a portion of the economy's productive capacity in order to correct mistakes.
The problem of overinvestment
Cash holders can live leisurely without investing. It's a mistake to condemn such people for being idle. The ability to live leisurely is also the ability to be readily available—to whatever people need most. People need this service because no one is perfect and it's impossible to be completely error-free, so everyone in the economy depends on others, and we are all affected by the mistakes of others.
Even before committing to anything, one cannot solve every possible problem. Ultimately, there is a limit; once committed to something, one cannot take on more. Therefore, if a large amount of money is held in cash, the economy has a high tolerance for failure; conversely, if only a small amount of money is held in cash, the economy has far less tolerance. Thus, the problem with overinvestment is that it reduces tolerance for failure. If everyone decides to immediately invest their money in production, theoretically more goals can be achieved simultaneously, but the risk of failure is also much greater. If large amounts of cash holders remain on the sidelines, there will be less risk-taking, but the probability of success will be much higher.
Because an error within one company can affect companies that depend on it, when people overinvest, not only is the risk of making mistakes greater, but the consequences are also much more severe. For example, suppose two companies, A and B, both make short-term mistakes that need correction. In a healthy economy, perhaps one will go bankrupt, but the other will be saved; however, in an overinvested economy, both will go bankrupt. Now, suppose company C can tolerate either A or B failing to deliver, but cannot tolerate both failing to deliver. Now, C is also on the verge of bankruptcy.
Therefore, it's entirely possible that in an over-invested economy, a small mistake can trigger a major catastrophe because no one is prepared to correct it, no matter how minor. That's what economic crises are. When too many people are involved and not enough are watching, everyone in the economy has to keep pace with the rest. In a healthy economy, everyone has more room to mess things up.
Maintaining the status of currency
Now I can talk about why the monetary status of commodities can be maintained in the long run, even though in reality it's almost a shared illusion. Why don't people wake up one day and throw their money in the street? In my previous article, I explained that the growth of money is a gradual process—a commodity gradually gains monetary status as one investor after another treats it as money.
You might think that this process could also be reversed—investors losing confidence in their own currencies and then continuously dumping them, one after another. To explain the long-term maintenance of a currency's status, we need a theory to explain why some people would buy cash that others want to dump.
Let's assume an investor is genuinely worried that their cash will become worthless. This person tends to hold investments rather than cash, while others prefer to hold cash. Or, conversely, let's assume this person is a stock market fanatic who can't understand the value of cash, so they sell everything and invest their entire fortune in the stock market. Either way, the result is the same. When they sell cash and buy investments, they very slightly increase the price of stocks relative to the cash supply. Consequently, they also very slightly increase the risk of cash losing its monetary status and the risk of a stock market crash.
Another investor might respond to this stock market maniac's actions by assessing whether the risk of cash losing its monetary status or the risk of a stock market crash is greater. If he judges the risk of a stock market crash to be greater, he will sell stocks and obtain additional cash, thus performing the opposite of the first investor. If he judges the risk of cash losing its monetary status to be greater, he will follow the first investor's lead and also sell his cash.
A long-established and widely accepted currency might be perceived as safe because investors have ample firsthand experience of others relying on cash as a safe haven. Therefore, they will tend to (correctly) view the stock market as riskier than cash. On the other hand, if there is reason to believe that other investors are losing information about the currency they hold, it is also possible that other investors prefer the risk of the stock market to the risk of the currency. If enough people do this, then the currency could lose its monetary status, just as they initially feared.
Therefore, the long-term maintenance of money's status can be explained by the fact that more people are more eager to reduce their exposure to investment risks than to the risk of cash losing its monetary status. Thus, there even exists a natural price for money. This differs from ordinary prices, which are the proportion of two goods exchanged. But you can think of the price of money as the proportion of the total money supply to (some measure of) the value of all investment goods in the economy. (In the real world, there are many different figures to represent this price because people may disagree on how to properly measure these two—the total money supply and the value of all investment goods).
Change the money supply
This section discusses how changes in the money supply affect investors' incentives to hold cash and purchase investment products. Deflation refers to a decrease in the aggregate money supply, while inflation is an increase. The most important thing about changes in the aggregate money supply is that they occur in specific places and are the result of specific actions. Whenever there is deflation, there are people causing it; whenever there is inflation, there are people causing it. In other words, money doesn't appear or disappear by chance—it's always held by specific individuals.
Deflation is true charity because those who cause deflation earn money through work or investment and then destroy it without asking for anything in return. Therefore, people rarely do this. Inflation, on the other hand, is something to worry about because those who cause inflation acquire money out of thin air. This means that if such behavior goes unpunished, everyone will do it. Those who can print money have a huge advantage over those who can only accumulate money through careful spending, because they can simply print it when they need it; they can immediately take advantage of good trading opportunities without having to work and accumulate cash first. Therefore, the ability of someone to print money makes others less inclined to hold cash. Instead, they are incentivized to invest.
Clearly, the person who creates inflation hasn't created more resources to match the new money they've created. They've simply driven people away from saving and into investing. Prices rise because everyone is buying. No one stays ready to correct the mistake. Investors can't because their savings have dwindled. The person who creates inflation can't either because prices have risen, and production is no longer as easy to carry out. Therefore, while the person who creates inflation may appear to the rest of the economy as an investor with a large amount of cash, the economy doesn't benefit from this. It's over-investment.
No longer a refuge
In an unstable market, if a mistake continues to spread like dominoes, causing investors to flee back to cash, the investment market collapses. For cash to lose its monetary status, the risk of inflation must consistently outweigh the risk of the stock market, even as more and more investors rush into the stock market. This scenario is possible, but it might sound strange because such a devaluation of currency has no other source than a lone investor who has infected others with his paranoia.
However, with the "correct" inflation plan, those who create inflation can cause this situation. The faster inflation rises, the more investors prefer riskier investments and the less safe cash becomes. An economy can still function without an established form of money, or with an alternative, but inflation exceeding a certain rate is unsustainable. All that's needed is for those creating inflation to push it to such a high level that stopping cash saving becomes the preferred option.
As inflation rises, investors become more risk-averse, diminishing the function of holding cash—even before it's replaced by something else. Instead, the economy must change from the outset to reduce the probability of error. Businesses must become more self-sufficient, less reliant on long-term profits. In other words, the economy needs to become more primitive.
If the economy can compensate for inflation at a rate that keeps pace with the rate at which inflators can spend their newly created money, then the inflator will find that, in order to maintain the same level of consumption, they must allow the money supply to expand faster and faster. If they do not want to reduce their consumption, then they will continue to push up the inflation rate until it becomes unsustainable. That is when people begin to regard cash as worthless paper, as meaningless numbers, rather than as a store of value.
in conclusion
This article may be the final installment of a trilogy. The first two parts are " Reciprocal Altruism in Monetary Theory " and " It's Not About Technology, It's About Money ." The first part attempts to explain the use of money as a game. The second part concerns the growth of money. This final part is about the death of money.
Because any commodity can be used as money, it's best to understand money as an action rather than a thing. Money is often a useless commodity; it's easily counted but difficult to reproduce. Money rarely has a demand for consumption. Even gold, with its important uses in industry and jewelry, is usually just stored away. Therefore, the characteristics of the specific commodity being used are not the reason money is useful. It is how people treat it that makes it useful.
People treat money as something that is readily available and flexible, in other words, something that is universally accepted. This is not an inherent property of any commodity. It is an attribute established by tradition. Every time people accept money, they are reinforcing this tradition. At that moment, they are also investing in it, because there is no guarantee that this tradition will remain strong and unshaken when they need to spend the money. But as long as people continue to invest in this way, this tradition will continue.
While those who accumulate money may not necessarily feel this way, it makes sense to view money as a form of altruism (biologists call this form "reciprocal altruism"). In reciprocal altruism, an animal does something that consumes itself but immediately benefits another animal. This animal can afford this cost because it is part of an altruistic group, so it ultimately benefits from the altruism of another animal.
A necessary condition for maintaining reciprocal altruism within a group is that non-altruists can be identified and excluded. Otherwise, a group of lazy people will live off altruists until altruism becomes unsustainable. In a monetary economy, this condition is achieved when people cannot have negative balances. People must first be altruists (earn money) before they can become beneficiaries (spend money).
At first glance, understanding money through altruism seems strange, since people often assume the pursuit of wealth is self-interested. However, biologically speaking, there is no true altruism, or rather, even if there were, it would be quickly exhausted to death. So there is only superficial altruism. The theory of reciprocal altruism tells us that it is possible for an animal to exhibit altruism in the short term and then receive help from other animals when it is unable to help itself. If an alien suddenly landed on Earth and encountered a miser, it might also assume the miser was altruistic, because the miser seemed to be working desperately only because of others' demands, without receiving anything of value in return. Only after the alien saw others also trying to accumulate money would it understand the miser's self-interest.
Because money is a social activity, its value depends on the society in which it is used, not on the physical properties of the commodity itself. Because the number of people using a currency can increase or decrease, and because this group can want more or less currency, a currency can become more or less useful depending on an individual's understanding of the society in which they live. In other words, an individual may find that their society has become more or less altruistic, and thus, the currency becomes more or less valuable.
This network effect explains how money initially grew from a commodity that might have had very little value. Because the earliest investors in a currency would be rewarded far more than later investors, they were incentivized to take the extra risk and get in early when it seemed worthless. In doing so, they immediately made it more useful, as they created initial demand that others could rely on. As money grew, the most far-sighted investors pulled it from its initial state to the center of the economy.
The death of currency follows the same process: the most farsighted investors flee first, followed by more and more, until cash no longer has any monetary value. Theoretically, this process could occur alone, but it is expected to be due to the arrival of a more superior competitor in the market, or to an inflationary monetary policy that renders it utterly useless.
This network effect explains why money can grow and contract, but it doesn't explain why money reaches an equilibrium state. It also doesn't explain why people hold more cash than they need immediately. The reason is that cash has an investment function, so investors need to hold large amounts of cash. The equilibrium price of money is a point where investors no longer want to hold more cash and instead prefer to hold more stocks (or bonds, or other investments).
This is how I understand money. Now, for the good of society, let's earn as much Bitcoin as possible!
Advanced Reading
- "Money, Bank Credit, and the Business Cycle," by Jesús Huerta de Soto
- "Man, Money, and the State" by Murray Rothbard
- The Austrian School Theory of Business Cycles
- "The Theory of Money and Credit" by Ludwig von Mises
