Where Does Money Come From? (S1E3) Transcript Samantha [0:07]: Hi, I’m Samantha Yap, and I help blockchain and cryptocurrency companies tell their stories. I’m really passionate about demystifying emerging technologies and making it easy to understand for everyone.  I’m embarking on a journey to discover the history of money, in order to better understand where money is heading today. In this series we’ll explore why Bitcoin, digital currencies and decentralised finance may play an important role in our future.  Come join me on The Story of Money, by YAP Cast. Samantha [00:44]: So we agree that there's no one clear definition of money and there is a movement to reinvent money today with Bitcoin, but before we get to that I want to first look at who gets to decide what money is today and how much of it there is. After all, governments might not be too happy about cryptocurrencies, because essentially, governments still decide what money is today. However, the picture isn’t quite that simple. Let’s go back to the Yapese. Who decided what money was? As far as we know, they had a central bank of sorts. The tribal leader, who would authorise trips to mine more stones and keep the larger ones, was effectively in charge of controlling the amount in circulation. In theory, the tribal leader could therefore manage the value of stones by limiting how many there were. But in practice, he seemingly lacked the authority or respect to be able to decree what money was. He could only authorise trips which enabled the creation of money, but his authority over the actual stone was limited, and that authority was eventually undermined. When David O’Keefe, the Irish adventurer, built a more sophisticated and efficient supply chain with bigger boats and more miners, he ended up flooding the market with stones. He therefore did two things: He usurped from the tribal leaders the control on who issued currency, and he also caused inflation by making stones more plentiful.  He also, possibly indirectly, caused something else. Eventually, the mining stopped, forever freezing the number of ‘Stones’ in circulation. That would, at least in theory, have prevented any further inflation, but it probably also led to the demise of the stones’ role as a currency. So what could we learn from this? Governments consider money to be their sole prerogative, although sometimes this is farmed out to a supposedly independent agency. Ultimately though, the government is considered to be the sole arbiter of a currency’s value, because theoretically, it is they that would honour the value written on the dollar bill or coin, but there are limits. Like the tribal leaders of Yap, governments have authority, but that authority is based on the credibility of the underlying token - the stone. The stone is a limited resource. Similarly, governments need to ensure the credibility of their role of ‘seigniorage’, which means the authority to print money or mint coins. This is one reason why governments create central banks, ostensibly at arms length. So how has this worked over the years, and what might crypto change, or be changing? To help me answer this question, I’ve had the privilege of speaking with Professor Cathy Mulligan, Co-Director of the Imperial College Centre for Cryptocurrency Research and Director of DCentral Lab from the University of Lisbon. DCentral Lab looks at all things crypto and blockchain. Samantha  [03:45]: Welcome to the show, Cathy. Cathy  [03:47]: Thanks for having me Samantha, lovely to be here. Samantha  [03:48]: Earlier in the show, we touch on the Yap islands and stone money, and back in the day the tribes determined the supply of access to the stone money, whether it's maintaining the flow of people mining these stones, and also providing access to travel to it. In a sense it’s evolved: Today governments and central banks manage where money comes from. Cathy, if you can help us paint a picture or take us back, who decides what money is? Cathy [04:32]: That's a really interesting question, Samantha, and really pertinent for our world today. So for me, the best way to think about money is actually as a form of social contract. We have agreed that there are these institutions in the world that will define for us what money actually is. So we have a way across the world today to agree that a US dollar or a bill that says ‘Great British Pound’ has value and is money because a set of institutions will tell us that it does. And what that implies, of course, is the other side of that equation is we've all agreed to trust them, that it is the US dollar and that it is the Great British Pound. So it's a social contract between citizenry and their government for me. Samantha  [04:58]: So we basically trust what the governments say, which is interesting when you put it that way. So how do they decide how much money there needs to be in the world, or in the country?  Cathy  [05:09]: Okay, that's a really, really, tough question and actually it really depends which country you are in. So one of the most interesting things I found out when I started studying cryptocurrencies is that there's no universal definition of money across the world. Our contextual understanding of money in Britain, or in Portugal or in the United States may have subtle nuances, and that's why there's a lot of discussion around how cryptocurrencies, in fact, should be regulated because there is no uniform definition of money. But when we think about money, and I tend to take this from a simplistic perspective because I think that is easier for people to grasp, there are very complex groups of people: So there's something called the MPC, The Monetary Policy Council in the United Kingdom that assists the Bank of England to understand how the monetary supply is working and how much money should be in the economy, or what the interest rate should be - should they raise them? Should they lower them? They were also, for example, deeply involved in the financial decisions around how the Bank of England should respond to COVID and all of those kinds of examples. But let's take a step back from that and think about something, because I think most people don't necessarily understand that most of the money we have in the economy is not actually created by printing presses. We have this image in our head of printing presses spewing out dollar bills or whatever it is from the movies, but actually banks create money by providing loans. Now I know that sounds a bit weird, but think about it this way - your bank account is often considered money even though it's not actually cash. That's because you can buy things with your bank account using your debit card. So if you think about it this way, how does new money get created? Well, if you borrow a 100 dollars let's say, or 100 pounds, the bank is going to credit you 100 pounds, and that is new money being created in the economy. And as you pay that off, the electronic money is deleted and therefore it no longer exists. So in that instance, banks are really creating the majority of the money in an economy through loans. I know that seems really counterintuitive, but that's really how it works. The other thing to remember is, of course, that there are lots of different types of money in an economy. So for example, in the British economy, you have notes and coins which now make up a very small part of that. I think about 3% of the money in Britain is now notes and coins, then you have Federal Reserves or the reserves, and also bank deposits, which actually make up about 75% of money in Britain. Samantha  [07:40]: Wow, thanks for breaking that down, because I think you make a good point. People have this image where how much money we have in this country is all representative of coins and notes but really, it's all just digits on a bank account for us. Cathy  [07:52]: So what is interesting, however, is the fact that the flows of money are actually maintained by the central bank. So there's a difference between the commercial banking system in which you and I engage with, and the central banking system, which is the system of banking for the government. So there's really two different types of banking systems in a country. And I think that's the critical piece to understand, in particular when it comes to thinking through cryptocurrencies and those kinds of things. Samantha  [08:19]: You're saying that in terms of the supply, the central bank or the governments decide what the supply of money is based on the MPC? What are the other factors at play? Cathy [08:28]: Most, or at least most economies that I'm aware of, tend to not be too totalitarian about the way that they control money in the economy. They will look at inflation and decide what to do. So we've seen the outgoing head of the Bank of England warning about inflation, but other people are saying don't worry about inflation. There's always different ways to interpret it. But I would say that they are relatively hands-off, whereas other nations who have different types of monetary systems or different political systems may have a much more hands-on control over their monetary policy and actually control over money in the economy. What I will say though, is that a central bank and the people who control the flow of money in an economy, what they do is they're ‘the lender of last resort', and you’ve probably heard this phrase used for the banking system. So their job is to ensure the stability of the financial system in a particular country, to ensure that we all continue to trust the commercial banking system which sits around it. So if you were looking at the financial industry back in 2008 at the beginning of the global financial crisis, what you could see was the central banks were acting as the lender of last resort trying to prevent the commercial banking system and indeed some of the institutional banks from completely collapsing, because of the systemic financial risk that that would have caused across the entire economy. The central bank functions towards the commercial banking system - it basically controls the banks. Samantha  [10:01]: Interesting on the ‘lender of last resort’. So you're saying that the government, to maintain stability, they lend more money? Cathy  [10:08]: Yeah. So in 2008 there was a run on lots of banks. We saw something most of us thought we would never see in our life. I remember it was a long time ago now, I was finishing my PhD, I think, I was walking down the street and there were queues outside the bank, and literally queues for about nearly half a kilometre outside of the bank. There was a run on the accounts from Northern Rock, so the citizens got very worried that they weren't going to have their money, and they were trying to take it out of the bank. And what happens in those situations is, behind the scenes, the Bank of England will be attempting to ensure that as many banks as possible don't go bankrupt because that obviously has a massive impact on the overall economy and can cause a crisis of trust in money. Samantha  [10:50]: That's interesting because you're saying that they were lining up to take money out of the bank, and they're essentially lining up to take cash out, physical cash? Cathy  [10:58]: Physical cash because the ones and zeros can vanish very quickly. Samantha  [11:00]: Right. We touched a bit on stone money and then along the way it was barter and then there were precious metals like gold, and then we ended up today, where we use paper money. So you're saying back in 2008, people were lining up to take cash out again, and now we're going into this cashless society and a world with digital currency. How does that change the game? Cathy  [11:22]: Well, that's a very, very good question and it's a very difficult question for a lot of the Central Banks, in particular when they're thinking about Central Bank Digital Currencies or any of those kinds of situations, because what happens if you suddenly get a run on the banks in a digitally enabled world? So, what you could do with a CBDC is, consumers could say "Actually, it seems a lot more sensible to me to take all of my money out of the bank and just buy CBDCs". Samantha  [11:50]: Just to take a step back a little bit, you mentioned CBDCs - what are CBDCs, if you could explain it? Cathy  [11:52] Yeah, very simply, a CBDC is what we would call a fiat currency, so a British Pound, lets say, is a fiat currency of a nation, put onto a digital technology such as cryptocurrencies. It could be other types of digital technology that it could be built on, and instead of issuing notes as the country does today, they could instead just issue electric coins and electric notes using the digital technologies. Samantha  [12:20]: Central Bank-Backed Digital Currencies. Actually, back to the analogy of people lining up to take cash, if a similar situation happened today, would it look like us taking digital versions of money? Cathy  [12:25]: Exactly. That's exactly what it would look like. I think the other thing to really think about as well is, the Global Financial Crisis is when Bitcoin got released and if you look at the original papers and the original discussions at the time, it was very much in response to the fact that there was this Global Financial Crisis and people felt they couldn't trust the banks. If we have a digital world today, and we all have digital CBDCs or we are able to purchase them, then it basically looks like a digital run on the bank. The issue in that instance is far worse because digitally we can do things a lot quicker. So we can have incredible efficiency improvement in that queue, whereas physically we had to queue up before for half a kilometre - you don't have to do that anymore, you just digitally remove the money. Digital technologies give you great efficiency, most people talk about efficiency as a very good thing, but if you end up in a negative feedback loop, and a very efficient negative feedback loop, you can cause massive problems very, very quickly. So these are some of the issues that need to be thought through. Samantha  [13:36]: You touched on how Bitcoin was created during the 2008 Global Financial Crisis and Bitcoin is not run by any central authority, it's purely decentralised, but Central Bank-Backed Digital Currencies are still, in a sense, managed by governments, right? Cathy  [13:53]: So if we talk just briefly about cryptocurrencies and about the history of money, there's one period of history in the history of money that I think everyone forgets to think through. And I think it's also very relevant to some of the digital currencies we're talking about today. There was, actually, in American history, an era called the “Private Money Era”, and that was the era when people themselves would issue their own banknotes, or towns or companies would issue their own banknotes. So that's called private money. And one of the biggest changes in the monetary system in America, about 100 odd years ago now, is that they created one national currency because there were a lot of issues around private money. What you're actually doing with the cryptocurrency is creating a form of private money because it is decentralised, it is not controlled by anybody, and it is outside of the control of a central bank. What CBDC's are doing is taking the technology of something like a cryptocurrency and saying, "We will now ensure that this is backed up by the reserves of the country in question". So the CBDC is a liability of the central bank, and the government has to maintain reserves and the deposits to back that coin up, rather than private money. On the cryptocurrency markets we see wild fluctuations (of course we do), and what the people who are proponents of CBDCs are saying is that we can stop the fluctuations if we align it to the government, and the government maintains reserves. So it's really combining our existing financial system with the central bank, creating trust, together with the technology base of a cryptocurrency. Samantha  [15:42]: That's a good distinction and that is a really great explanation. So there's a separation between the cryptocurrencies that are decentralized like Bitcoin or Ethereum compared to CBDCs. Are governments not so happy with Bitcoin and Ethereum and the other cryptocurrencies? What do you think? Cathy  [16:00]: Depending on who you ask, again. We've just seen El Salvador has accepted it as legal tender, and it could be relatively good for their economy. I would say what we see is cautious interest from other countries. So for example, the FCA, the Bank of England, they've done lots of studies on this stuff and they're starting to do some trials around it. The FCA for example, in the United Kingdom, warns that these are quite unstable investment vehicles. I think anyone who watches the market can agree with that. The thing to remember, of course, is that the difference between the private money, and the government-backed money is that in your bank account, in the United Kingdom, at least, the Bank of England guarantees up to 80,000 pounds of my deposits. Whereas in that private money system there's no guarantee at all. So there's lots of subtle differences. And so governments, I think, are cautiously interested, because the other thing that's happening separate from cryptocurrencies, separate from all the digital currency discussions, is that we're seeing lots of geopolitical interactions around money. The United States dollar has acted as the reserve currency of the world for many, many years. And the power of that is starting to slip, and many people are becoming quite worried about that. We can see that there are geopolitical interactions with China trying to make the Renminbi the replacement for the reserve currency, the US dollar. Other actors in that space, for example, the Bank of International Settlements and some other people from the Bank of England have been looking at how you could use cryptocurrencies to help mitigate that. So, for example: Could you use a digital currency that enables you to create a basket of currencies as the global reserve currency, rather than having one single reserve currency? There's lots of different discussions in this space, but what we're seeing is a complex interaction of geopolitics, technology and economics, all coming together. And that's why it's so exciting to research in this space, it changes literally every day. Samantha  [18:07]: Yeah, thanks for that overview. I was actually gonna ask about the different countries and you rightly touched on China and the US, because they're all thinking of also launching their own digital dollar. What are the concerns that can come out of this? I think some people are concerned about mass surveillance. If CBDCs become a thing, and China and the US can track where everyone's money is being spent and used, is it a concern? What other concerns are there? Cathy [18:33]: Yeah, there's lots of concern about these kinds of technologies and combining them with our financial system in this way. There could obviously be privacy implications, there could also be cyber security implications, and there could also be obvious implications around the use of these kinds of CBDCs, as we've discussed before, creating a run on the commercial banking system. So, the relationship between a central bank and the commercial banking system still needs to be resolved if we're all using CBDCs. And there's lots of different ways you can cut that, and lots of different ways you could think about implementing it. So I think there's quite a lot of reasons to think carefully through how you would implement it. But on the other side there's just as many reasons to think about doing it. For example, CBDC's could actually reduce the transaction costs of managing and transferring money in the economy. Currently they're extremely high. So, let's say if you're a government and you want to pay your unemployment benefits to your citizens. Currently that money has to go through the commercial banking system, and the commercial banking system will charge you a lot of money to make those transactions. If you have CBDCs, suddenly, for the government to pay unemployment benefits becomes a lot cheaper. So removing transaction costs is really interesting. But the other reason that many countries are thinking about it is what we're seeing as the evolution of money. You were talking about the Yap islands and we've seen an evolution through gold, private money, fiat currencies, through to all of the things we're seeing today - we're moving towards what you've already referred to as a cashless society. If we move into a cashless society, the central banks really need to think very carefully about how they can actually control monetary flow, and this is one of those technologies that could enable them to continue to control the flow of money within the economy in a digital form. It is, however, massively complicated so it needs careful thought. Samantha  [20:28]: And that's a great point to wrap up on. Thank you so much, Cathy, for joining YAP Cast. Cathy  [20:32]: Pleasure. Thank you for having me. Samantha [20:34]: What I learned from Cathy is that there is no clear universal definition of what money is. Something that surprises me, but explains why our response to cryptocurrencies has been so varied. How do you have control over something if it is not clear what it is you already have? Part of that lack of definition, Cathy told us, comes from us not really understanding what money is and who creates it. She explained it beautifully: It’s banks, in essence, which create money. But there are two systems, one for banks and governments, and one for us ordinary people. And that second one really works for people who already have money. The rest, those of us without much money or any money at all are out of luck when it comes to loans. In short, money works great for those who have it, and for those who don’t - well, it doesn’t. That leaves a problem big enough to demand a solution - can social good come out of the technologies like cryptocurrencies to make money less unfair? We are in a world where money is evolving, so expect lots more experimentation as we try to figure out what kind of system we’d like to see, perhaps one that doesn’t look anything like what we understand as money today. Samantha [21:46]: If you’d like to watch my full length conversation with Professor Cathy Mulligan, head to the YAP Cast Youtube channel. I’m Samantha Yap, thanks for listening to The Story Of Money, by YAP Cast.