Why does the pound sterling in your pocket have value? What about the US Dollar? The Euro, or any currency? Why can you take a currency to a store and expect it to accept it – in paper, metal or an electronic form – in exchange for goods like clothes, shoes, rings and what have you? And don’t you think “it is because it is backed by gold”. Those days are long gone. Currencies are not backed purely by a force of habit or blind faith.
Let’s bring it back to the pound because as one example will make it easier to explain.
Ultimately, the pound is worth something because the UK government states that it has value. That’s it.
Effectively, the pound is backed by the strength of the UK’s economy and institutions, and in the ability of the government to tax the population. This modern form of currency strength is called fiat money, or fiat currency. If you didn’t know before, now you do!
What has been just outlined sounds reasonable, right? What’s the risk?
The risk is that across history, plenty of governments have collapsed, and their currencies have gone with them. Even those countries which are still successful today have had plenty of hairy moments.
There were several instances of currency crises including the hyperinflation in the Weimar Republic, in the early 1990s. For instance, there was the Latin American Crisis of 1994 which affected Mexico and other Latin American nations which were alleviated by an emergency loan from the US.
Then there is the Asian Crisis of 1997 which caused a series of domino effects. There was also the 1998 Russian Ruble Crisis, the 1998-2002 Argentine great depression, the 2013-present (at the time of writing) crisis in Venezuela and the 2018 Turkish currency and debt crisis.
(All these crises are more complicated than explained, so I linked an article to both.)
In fact, some economists would argue that the Eurozone Crisis of 2007-2008 was a currency crisis of sorts. Actually, when you think about it, when Britain was kicked out of the Exchange Rate Mechanism (ERM) system upon the reunification of East Germany and West Germany, this was also a currency crisis of sorts. (Also known as the day George Soros broke the Bank of England! It is known as Black Wednesday.)
What if there was a form of money that did not rely on the backing of anyone entity? This is the core idea behind Bitcoin – and the digital currencies that followed. Those who love Bitcoin, and the idea of cryptocurrency in general, romanticise the concept because it embodies the principles of a free market.
Before we move onto the next section, a quick history lesson, which many crypto manics are not even aware of. The idea is that many businesses could have failed and the system could be more efficient had the government not intervened via modern capitalism. (Hint: old school Keynesianism was the saviour of capitalism, by not allowing the invisible hand to let “inefficient companies” die out, so to speak.)