Part 1: Understanding Crypto Currencies and Blockchain for Newbies (5-7 minute read)

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Note: This is only part 1 of the series “Understanding crypto currencies and blockchain for newbies”. I intend to make a part 2 as well where I’ll dive into the details of crypto currencies and what is blockchain. But before I do that I felt it was necessary to do a recap on what currency or money really means. Without clearly understanding how currency works, it might not make sense why crypto currencies exist or how do they work and what advantages and disadvantages do they hold.

Below is a 5-7 minute read. I have intentionally kept it brief but if you want more details on something, please refer to the references section at the end of the article or just leave a comment and I’ll try to answer as best as I can.

Let us now dive into part 1 of this series.

Before any form of currency existed, people used to exchange goods or services for other goods or services they needed. For example, assume that person A has plenty of rice while person B has plenty of fish. Person A is ready to let go of 2 kilograms of rice in exchange for 1 kilogram of fish from person B. This way of exchanging goods or services is also called a bartering system.

bartering system

Figure 1. Bartering system

Source: https://historyplex.com/barter-services-history-of-barter-system

The bartering system has its own disadvantages[1] – there is a need for people to be willing to buy the product that you want to sell. If I want to exchange fish for rice, first I need to be able to find someone who has rice and wants fish. Another major problem of the barter system is the difficulty in storing and transporting the goods to exchange. For all these and several other reasons, it was important to have some form of a common currency that could solve these problems.

According to sources[2] [3], the earliest known form of currency can be dated back to almost 5,000 years. It was called “The Mesopotamian shekel”, which, in physical form, consisted of how heavy a precious metal like gold or silver weighed. Similar forms of coinage were discovered in Europe, Asia, Africa, and other parts of the world suggesting that coinage system was indeed considered as a medium of commodity money to buy goods and services. These kind of currencies are called Representative Money that are backed by a physical commodity like gold. An example of Representative Money was the US dollar until 1971 when President Nixon decided to abandon the gold standard[4] according to which 1 ounce of gold was then worth US $35. Representative Money is not affected by inflation and the governments could only print enough money for the amount of gold they had in reserve.

Representative Money has its own disadvantages that are beyond the scope of this article. Fiat Money[5] is what replaced Representative Money and all the countries in the world now use Fiat Money. Fiat Money does not hold any value by itself. Instead, it holds value since the government of a country puts a value to it and backs it up. This also means that Fiat Money is susceptible to inflation and might lose its value in case of an unstable government or if the economy of a country collapses.

An interesting question that I used to think about is this – why can’t the government just print as much money as it wants in exchange for goods or just to give it to the poor people? The answer isn’t straightforward but in simplistic terms, a government can and should print only so much money as it needs. If there is more than needed money printed then the cost of all the goods and services will also go up, which effectively means that the value of the currency would go down. The demand and supply need to be in balance otherwise the over supply of currency can lead to hyperinflation – something that happened to Zimbabwe in 2007 that ultimately made them change their currency to the US dollar[6].

fiat currency

Figure 2. Fiat Money only has value because the governments assign a value to it

Source: https://www.investopedia.com/articles/investing/092413/how-currency-works.asp

Another interesting question is who controls this Fiat Money and decides how much to print? In the USA, it is the responsibility of the Federal Reserve to take care of it. Similar organizations in other countries like the RBI in India decide how much currency to print and regulate its flow. This is based on lots of factors like the interest rates, fiscal deficits, exports, etc. that are beyond the scope of this article.

So, next time you hold a $100 bill, think about what you really own. What is the actual value of the piece of paper that you have in your hand and what can you buy with it today vs. 10 years from now? Some food for thought 🙂

References:

  1. de MIRAMON, J., 1983. Advantages and Disadvantages of Countertrade. J. Comp. Bus. & Cap. Market L., 5, p.347.
  2. Chapurukha Kusimba, smithsonian.com 2017. “Making Cents of Currency’s Ancient Rise”. https://www.smithsonianmag.com/history/making-cents-currencys-ancient-rise-180963776/. [Online; accessed 11-Nov-2019].
  3. worldhistory.biz, 2015. “Mesopotamian Money and Weights”. https://www.worldhistory.biz/ancient-history/71590-mesopotamian-money-and-weights.html. [Online; accessed 11-Nov-2019].
  4. history.com, 2019. “FDR takes United States off gold standard”. https://www.history.com/this-day-in-history/fdr-takes-united-states-off-gold-standard. [Online; accessed 11-Nov-2019].
  5. Jason Hall 2017. “Fiat Currency: What It Is and Why It’s Better Than a Gold Standard”. https://www.fool.com/investing/general/2015/12/06/fiat-currency-what-it-is-and-why-its-better-than-a.aspx. [Online; accessed 11-Nov-2019].
  6. Tejvan Pettinger 2017. “Hyper Inflation in Zimbabwe”. https://www.economicshelp.org/blog/390/inflation/hyper-inflation-in-zimbabwe/. [Online; accessed 11-Nov-2019].

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