What Crypto Should Learn From Monetary History

Mr. Market

November 14, 2022

The crypto movement aspires to decouple money from state power. If money enables transactions between private actors, where the state is involved only insofar as it guarantees money, then why can’t we simply replace the state with a decentralized system supported by cryptography and raw compute power? Yet this idea is hardly original to the crypto movement. In the 18th century, advocates of what would later be described as the “real bills” doctrine envisioned a self-sustaining, self-correcting system in which banks would provide all the money society needed through short term loans collateralized by “real” economic activity. The crypto movement, in its current hour of distress, could benefit from a brief history in the transformation of this most elegant world of “real bills” to the very monstrosity of state-backed modern banking that it confronts and aspires to overthrow today.

The Elegant World of Real Bills

To illustrate, let’s say Merchant A sells grapes to Merchant B for 10 dollars, where Merchant B intends to turn those grapes into wine which B will later sell for 12 dollars. However, it takes time for Merchant B to turn grapes into wine and wine into money. So rather than give Merchant A money for his grapes, Merchant B hands him an IOU, known as a “bill,” that promises payment in 90 days. But Merchant A needs money now to pay workers and invest in his vineyard. How can the system give Merchant B time to turn grapes into wine without sacrificing Merchant A’s ability to expand grape production? How can the system, in a word, provide enough money to fund more economic activity today, which will only be realized as money in the future?

The “real bills” advocates envisioned that this would be done through a private banking system. In such a system, Merchant A brings his bill (Merchant B’s IOU) to a bank, which buys the bill for a small discount and provides Merchant A with a bank deposit that’s the equivalent of, let’s say, 9 dollars. In 90 days, Merchant B pays Merchant A 10 dollars which Merchant A then uses toward repaying the bank. The bank receives the 10 dollars and has now made a modest profit (of 1 dollar). Because the bank is lending on a relatively short time horizon (90 days) against “real” economic activity (the processing of grapes into wine), the bank takes limited risk. Thus, the economy benefits from an “extra” 10 dollars, which gives Merchant B time to turn grapes into wine while simultaneously enabling Merchant A to produce more grapes—all without the state having to determine how much money to print. In this system, money supply would naturally expand or contract in line with the needs of “real” economic activity, that is, activity tied to the production of real goods and services. The bankers’ jobs were to ensure that they were lending against “real” economic activity i.e. real bills. Money and the economic activity enabled by money would thus be decoupled from the state.

But this system had one very important quirk. Instead of giving 10 dollars of cash (or gold) to Merchant A, the bank would have credited Merchant A with a deposit at the bank with this deposit serving as money. For the most part, Merchant A would have been able to transact with his suppliers by exchanging deposits, and thus would not have needed to draw down actual cash or gold from the bank account. Hence, the bank would have needed to hold only only a fraction—let’s say 20%—of its deposits in cash (or gold). Thus, a bank theoretically on the hook for 100 dollars of deposits could have only held 20 dollars of cash (or gold). The “missing” 80 dollars would have been held in IOUs collected from parties like Merchant A. And as long as those IOUs paid off in a reasonable time, the bank would always have had enough cash on hand to redeem its depositors over time. This marked the rise of the “fractional reserve” system of banking, in which banks served not just as vaults to hold money, but actually created money through purchasing IOUs.