Our Layered Money System is a House of Cards
But is it built on a strong foundation?
I’ve recently finished reading Nik Bhatia’s fantastic book, Layered Money.
The book breaks down the US monetary system evolution through the lens of ‘layered money’.
Layered money — the idea that most money in circulation represents a claim on another form of money. Most money is a balance sheet liability rather than an item of intrinsic value.
If this doesn’t make sense at first, don’t worry! Let’s unpack it using an example.
Metal (not the music genre)
Back in the day (many many days ago…), gold and silver were used as currencies because they featured the core components of money:
- a store of value — maintains a constant value over time
- a medium of exchange — can be used exchanged for goods and services in the economy; and
- a unit of account — a tool to quantify the value of goods and services
Anything can perform the function of money if it has these features. I think we often mischaracterise money by defining it as an item with ‘intrinsic value’ (as I’ve done above). Even with precious metals, arguably they have no ‘intrinsic value’. They only have value if we ascribe value to them.
But back to precious metals. Metals like gold and silver were too bulky to carry around day-to-day, and there was a considerable risk of theft.
To reduce risks for the transacting parties, the Medici Banking Family (back in the 16th century), introduced bills of exchange, paper instruments promising to pay the bearer a specified sum of money.
We begin this layered approach by thinking about the difference between a gold coin and a piece of paper that says, “The Medici banking family will pay one gold coin to the bearer on demand.”
The gold coin is a first-layer money and the form of final settlement. The piece of paper only exists because of the gold it represents; it’s a second-layer money, created as a liability on somebody’s balance sheet.
All second-layer monies are IOUs (I-owe-you) or promises to pay first-layer money.
Although this eliminated risks associated with the two parties trading goods/services, it introduced a third-party issuer (the Medici family) as a new ‘trusted’ counterparty.
We begin to see the appeal of layered money. By abstracting currency away from its base form (gold in this case), one can reduce risk between contracting parties and simultaneously increase the velocity of money in the economy.
Counterparties. You get a Party, I get a Party
Layered money is nice. It allows businesses to engage in value-accretive projects without concerning themselves with month-long payment settlement.
The issue is that each new layer of money introduces new counterparty risk — the risk that a third party does not fulfil their promise to pay.
Moving forward a few centuries, we now have a system where money is no longer tied to precious metals. It is tied directly to the US Government’s solvency and trustworthiness.
In 1971, the United States suspended gold convertibility for the dollar; the suspension initially was supposed to be temporary, but the dollar never returned to any linkage with the commodity.
Two years later, the modern era of free-floating currencies began, officially ending the Bretton Woods agreement.
Gold transitioned to the informal role of neutral money, still held today by governments and central banks around the world as first-layer, counterparty-free money.
The conclusion of the Bretton Woods accord was a fundamental turning point in the monetary system. Second-layer US. Dollars are now tied to US Treasuries issued by the government rather than gold.
Back to the point I made above, there’s nothing inherently wrong with using US Treasuries as the base layer for money.
Money is whatever we ascribe value to, and usually requires the three properties listed above.
Interestingly, Treasuries are a form of credit issued by the US Government — a form of government debt.
The US Government promises to pay back the value of the bond at maturity, and pays out a nominal interest rate in return for the loan.
This interest rate is often referred to as the ‘risk free’ rate of money. U.S. Treasuries are now the first layer of money, and the US Dollar is the global reserve currency facilitating most global trade.
‘First-layer’ of money now has inherent counterparty risk. Our entire financial system relies upon US Government creditworthiness, and proper management of the US Dollar by the Federal Reserve.
Gold, the original first-layer money, was verifiably scarce and immutable. By eliminating gold from the layered money system, we eliminated a counterparty-free form of money.
However, the US Dollar system now looks a little like this.
Again, don’t worry if this looks complicated. The core idea is that the US Dollar system relies upon first layer money which is subject to government and central bank control.
Money Printer Cannot Brrrr Forever
In The Bitcoin Standard, another fantastic book, Saifedean Ammous explains that effective monetary systems require low levels of new issuance. Put simply, it must be difficult to create new money.
This is the reason that precious metals, large stones, and sea shells were all used as monetary instruments in the past. It was difficult to issue new supply of the currency, and so the existing supply was able to maintain its value.
The US Government made a decisive move in 2020 to flood the economy with new money to prevent an economic contagion (excuse the pun) in the aftermath of a spreading COVID virus. This, in itself, was necessary.
But the money printer was left running for way too long, driving significant inflation. Here’s a look at the M2 Money Supply, which captures liquid cash and other savings deposits.
Almost 35% of all circulating US Dollars was printed over the last two years!!
My point here is that the US Dollars system relies upon trust that the US Government is a creditworthy entity able to manage its money supply and repay its debts.
Time and time again, they’re failing at this mission.
This is not to say that the US Dollar will not remain the global reserve currency for the foreseeable future.
But viable alternatives are beginning to spawn, which could mark the beginning of the end for government-issued fiat currencies.
Currencies issued using blockchain technology can programmatically limit issuance of new money, thereby ensuring the scarcity of first layer money.
This is important not because it allows first-layer cryptocurrency money to become a medium of exchange, but because it reintroduces a verifiably scarce first layer of money!
This allows for preservation of the three features of money: store of value (value isn’t inflated away), medium of exchange (can reliably be used to transact with other goods/services), and a unit of account (the price of goods/services stays somewhat consistent).
Robust first-layer money with zero counterparty risk is worth striving for. For all we know, the US Government may begin to use cryptocurrencies like Bitcoin in its reserves to back second-layer Dollars.
If nothing more, cryptocurrencies will pose a competitive threat to fiat currencies. Never before have fiat currencies truly been challenged as a medium of exchange (within domestic economies). We have only seen situations where countries are forced to abandon failing local currencies due to monetary mismanagement (e.g. Ecuador, El Salvador, Zimbabwe).
The competitive dynamic introduced by crypto may force central banks to act more carefully in their monetary policy, or entirely abstract monetary policy away from centralised government entities. By this, I mean that policy decisions may be made algorithmically based on on-chain, real-time metrics.
Realistically, established blockchain-native currencies will be better suited to such a system, but the US Dollar should not be ruled out entirely.
Central banks will need to act quickly and decisively to explore faster, real-time data sources to construct more fluid, flexible policy.
In this day and age, we can’t rely on monthly economic data to adjust monetary policy.
Layered money provides a powerful framework to unpack the fundamental issues with our global US Dollar system, and envision a path forward.
We must seek to re-establish scarce first-layer money with a transparent and highly-responsive monetary policy.
