Currency as an information system
On cryptocurrencies, why currency is information, and why it feels alienating.
The last of a short series on currency systems.
In my post on fiat currency, I noted how governments maintain currency as digital 1’s and 0’s. Currency is fundamentally digital today, with the key properties of unforgeability and value being enforced by the state1.
The pieces of paper associated with some of the money supply are not necessary for a functional currency system. Money can be made from pure information, so long as someone is there to prevent forgery.
Example of a pure-information currency
Digital currencies rely on the government to keep track of how much money everyone has. To maintain viability as a currency, the government checks that nobody is duplicating or stealing money at scale.
It turns out it’s possible to do this without a government enforcer.
Imagine you live in a small town. Everyone knows everyone, and rather than use currency, people keep track of what they owe each other. Kind of like when people know who’s buying the next round.
When you buy a few beers, you say “put it on my tab” and both you and the bartender know the exact dollar amount you owe. When the bartender needs a haircut, they transfer some of your debt to the barber. When the barber needs some yard work done, you help out in order to buy back your own debt and remain in good standing.
Nobody can “forge” these I.O.U’s because everyone has an excellent memory, almost everyone is honest, and gossip gets around fast. Debt is quantifiable because the townsfolk are so precise. Debt is valuable because people are in fact willing to trade labor and resources for it. So it satisfies all the properties we need from a currency.
The key is to make sure every (reasonable) person agrees how much money everyone has. Cryptocurrencies do the same thing: create consensus about how much money is in each “wallet”.
How cryptocurrencies work
In the real world, people aren’t as trustworthy as the townsfolk. Cryptocurrencies need a mechanism that prevents people from confabulating more money. If someone says “hey, turns out all the imaginary digital dollars are in my account now” you need a way to refute them.
The way this actually works is pretty complicated, but here’s a summary:
People privately create their own special digital signature to authorize transactions from their account. This involves a means of “signing” transaction requests (private key) and a means for others to check that it’s really your signature (public key).
When you want to send money, you write a message with the transaction details (amount, transaction fee, the “address” (derived from the public key) of the account you want to send to, etc.) and put your signature on it.
You send the transaction message to various “nodes” responsible for updating the list of money in everyone’s account. These nodes pass your message on to other nodes that they’re familiar with.
After enough time passing messages, a special mechanism randomly selects a node as the leader for this round. Choosing a leader randomly is a very hard problem. Approaches like proof-of-work and proof-of-stake tackle it differently.
The selected leader proposes a new list of how much money is in each account. They do this by listing a bunch of transaction messages they’ve received along with the signatures from their owners. They also include other stuff like transaction fees and payouts to nodes (block rewards) that participate in this process.
Other nodes check that the listed transactions have the correct signatures, that the money has been moved between accounts correctly, etc. They vote or otherwise confirm that everyone agrees with the new list of account balances. This is also a hard process, different cryptocurrencies have different approaches.
Now everyone agrees how much money is in each account, that all transfers were approved by the wallet owners, and that no money has been forged. The process starts again.
It’s incredible that such a thing works. We’ve created money out of thin air, just by talking to each other. The process is quite general, you can perform arbitrary computations with it as well. This is why Tim Roughgarten likens it to a Computer In The Sky.
Value and cryptocurrrency
Perhaps you can see that this process prevents people from forging the fake internet money. But how do cryptocurrencies ensure that people find them valuable?
Well … they don’t.
If everyone suddenly agreed that Bitcoin is worthless, it would in fact be worthless. While this is also a risk for physical and fiat currencies, their value is supported by their physical attributes for the former and state enforcement for the latter.
Cryptocurrencies are valuable today simply because people value it. People are willing to exchange real resources for it. Common knowledge of this fact reinforces their value.
This sort of circular reasoning works fine so long as people can stay coordinated on what’s valuable. But it’s a Keynesian Beauty Contest, the value depends on what you think everyone else thinks. That can create big shifts in value as common knowledge changes. That’s why cryptocurrencies are volatile.
Stablecoins try to fix this problem by backing the currency with fiat or a basket of other cryptocurrencies2. These don’t really solve the value problem, they just move it somewhere else.
That said, cryptocurrencies aren’t entirely lacking in fundamental value. They can be a globally-recognized, secure, pseudonymous, and censorship-resistant form of currency. That has value too. But by and large the value comes from this self-fulfilling prophecy.
Currency is informational, costly, alienating, and blameless
To conclude this tour of currency systems, I want to point out their common properties.
Fundamentally, currency is an information system. It coordinates economic activity across space and time. It facilitates common knowledge about the value of different things. That means we can have prices that act both as a signal and an incentive.
Put another way, currency can act as a sort of reputation system. Your wealth and income represent how much real resources people are willing to exchange for your endowments of labor and capital.
Maintaining this information system is fundamentally costly. Even without the problems of physical currency, we need to expend resources to maintain a currency. Fiat currency need enforcement, cryptocurrency needs computation and memory and communication. All currency regimes come with their own risks of devaluation.
Currency works best as an abstract information system. It ebbs and flows with public opinion. It is more valuable the more people use it. It must coordinate capital and labor across the globe. It’s an abstract unit which can measure everything.
This abstract and volatile and global unit of measure is alien to minds adapted to the concreteness of the natural world. Currency is fundamentally alienating because it needs these properties to lift us from our natural poverty.
The progress that currency enabled is well worth that sense of alienation. Rather than blame the currency system or capitalism for the problems of modernity, look instead at what people value. That is the source of all economic activity, currency is just the messenger.
We get quantifiability automatically from the fact that we’re storing numbers.
Algorithmic stablecoins try to stabilize prices by committing to a certain type of monetary policy. But this is no different from normal cryptocurrencies where the value is derived from its properties as a currency alone.