February 25, 2020

The Future of Money: National Currencies' Race to the Bottom

A four-part series on the future of money. In the first part, the focus is on how the world was cut off from gold and has consequently been faced with an ever-accelerating battle of devaluation between national currencies.

Money – the magical power it has on people is almost universally. But whether we earn it, spend it or save it, we hardly ever think about the following questions: What is money, why does it exist and what will money look like in the future? Why should we? Our money works. Day in, day out we use it without much effort. So what’s the problem?

Well. Let me explain. As August Friedrich von Hayek pointed out, we humans constantly use things we don't know anything about. It's this very fact that makes us such a successful species. It's no different with money. That we don’t have to think about money but can still use it successfully, is a big win and a witness to how well our market and knowledge society functions.

In the course of Bitcoin's meteoric rise, however, questions about money suddenly seem to become more relevant. Is the institution of money undergoing great chance? As the history of money shows, money has never been a dormant, unchangeable thing. Money and its nature have always been in a state of flux. Therefore, even with money, what we take for granted today may no longer be valid tomorrow. It is simply not a problem until it is a problem. 

Money at a Crossroads

The assumption that the essence of money has probably never been more in flux today than ever before could be due to the following facts: technological change, the Faustian overextension of our financial order, old insights from monetary theory or entrepreneurial discovery processes are shaking up the current dogmas of money. Precisely because uncertainty about the future of money seems to be felt by an increasing amount within the general public, it is worth taking an objective and sober look at the current processes, trends, and dynamics.

Today we associate money primarily with national currencies: Dollar, Euro or Swiss Franc. These national currencies are issued by the respective state, or more precisely by its constitutionally authorized national or central bank. These monies are also commonly referred to as fiat currencies. The term "fiat" is of Latin origin, meaning "it will be", and is intended to refer to the fact that national currencies were created from nothing ("ex nihilo", also Latin) and would have no intrinsic value.

The extent to which this description is correct is the subject of heated debate. According to Chartalists, money would get its value from the state’s monopoly on money and taxes. In their view, the state is the origin of money and determines what exists as money. Other economists point to the necessity of a functioning economy, whose diverse production structure makes a medium of exchange necessary. This group sees money’s intrinsic value coming from the productivity of an economic area. Still, others consider a money’s backing to be the determining factor. Historically, paper currencies were backed by gold. In August 1971, gold backing the Dollar was abolished with the closing of the so-called gold window. Currencies no longer referenced to commodity money. Ultimately, where money really gets its value from is still being debated, even after hundreds of years.

Battle of Devaluation

With the abolition of the gold backing, the latter argument has lost its argumentative appeal. State currencies continue to exist without any link to commodity money while the modern monetary order has not crashed, but has moved to a system of free exchange rates. Whereas the yellow precious metal had previously served as an anchor of value and price, henceforth a battle of national currencies was unleashed. This battle turned out to be quite costly. The different exchange rates of individual currency pairs led to an increase in currency risks. The latter increased transaction costs for international trade, which continue to weigh heavily on global trade to this day. It’s global inefficient barter on a national currency level.

Merchants, companies and politicians reacted to this situation. Within the political sphere, the US dollar developed into the global unit of account for oil and other commodities due to the US hegemony as the strongest economic power around the globe. To this day, the US dollar continues to function as an international reserve currency. In this way, the Greenback facilitates global trade, but due to its importance it also let the US exploit what is called the "privilège exorbitant". The sheer dominance of the dollar and the advantages for US markets are impressive

The entrepreneurial response has been to create derivatives and more and more hedge funds. The former are financial products whose primary objective is the contractual hedging of risks over time and space. The latter, hedge funds, are entities that trade in these financial products. They are actively managed investment funds. It is therefore hardly surprising today that hedging transactions to minimize exchange rate risks account for a considerable proportion of total financial transactions.

The importance of these instruments and entities is particularly evident in the case of internationally active companies. Their income and costs often arise in geographically diverse currency areas. Derivatives help to reduce currency risks here. For example, the organizer of the Wimbledon tennis tournament receives payments in dollars for broadcasting rights in the United States. However, almost all costs for the tournament are incurred in pounds. This makes the organizer dependent on the pound-dollar exchange rate. For a given price, this risk can be reduced with derivatives by the tournament organizer committing to sell its dollars at a predetermined exchange rate for pounds at a certain point in the future.

 The ever-increasing number of derivatives used today is ultimately a consequence of the costly effects of this diversity of national currencies. Anyone wishing to send money across national borders today pays hefty fees. The reason: the reality of different currency areas requires the involvement of banking and financial institutions. Countless banks, partner banks and financial service providers from different countries are involved and want their “fair” share. So ultimately, our current international monetary order resembles a global barter trade based on numerous fiat monies.  Legacy systems and regulatory requirements make their efficient and rapid transfer difficult.

The various fintech companies of today are therefore also to be seen as an entrepreneurial reaction to this state of affairs. The most popular and successful among them are those who want to remove artificial barriers in international payment transactions resulting from this global barter. What banks have barely managed to do is now made possible by upstarter companies such as TransferWise or Revolut. Sending and receiving national currencies is not only becoming faster but also cheaper.

But fintechs do go beyond payment. Encouraged by the success of high-flyers such as TransferWise or Revolut, they are now venturing into other areas of the money business. Whether "commission-free" securities trading by Robinhood, innovative insurance solutions by Lemonade, digital retirement planning by Viac or Descartes Finance, new types of financial services aggregation by Altoo and a reinvention of private banking by Yapeal – fintechs have only just started.

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