Reflection on Fundamentals of Money: Monetary Theoretical Thoughts on Cryptocurrency and Fiat Currency

I. Introduction: Defining Terminology in the Context of Fraud

One of my blog subscribers brought up cryptocurrency over KakaoTalk, and a few hours after that conversation I came across an interesting article, which led me to jot down my thoughts in a somewhat loose form. I had paid so little attention to the subject that I did not even know what Ethereum was.

KRW 60 Billion Scam Built Around ‘Fake Electronic Money’ (2017.05.18.)

The author of the news article fails to distinguish between money and currency, prompting a necessary clarification of terminology at the outset. What those fraudsters circulated was not electronic ‘money’ but electronic ‘currency.’ The article then calls it “fake” electronic currency, which immediately raises another question: then what, exactly, constitutes a real electronic currency? From the standpoint of fiat currency, Bitcoin and Ethereum―the most representative electronic currencies traded globally―are no less ‘fake.’

II. The Theoretical Framework of Value: Intrinsic, Embodied, and Nominal

1. Money, Currency, and Cash

Money is not a tangible entity but an abstract concept, or more precisely, an institution. It may be understood as the totality of contractual means established among parties who recognize the “exchange ratios of real goods and services,” that is, the ratios at which different real goods and services are exchanged in the market, so that those goods and their value may be traded more conveniently. Currency is what market participants who agree on those exchange ratios―i.e. who formally recognize the circulation of money―create when they institutionalize money as a concrete means of exchange for real goods and services. Cash―i.e. bills and coins―is merely an authorized medium that gives currency physical form. In other words, cash, currency, and money are in themselves nothing more than an abstract concept or its material embodiment. They function as media that convey the value embodied in real goods and services only when market participants agree to treat them as ‘media for exchanging real goods and services,’ and thereby appoint them the market position of ‘a means of preserving the value of real goods and services.’ Cash, currency, and money possess no independent intrinsic value on their own. They acquire functional value only when market participants recognize them as ‘media for the exchange of real goods and services’ or as ‘means for preserving the value of real goods and services.’ Put differently, any instrument that fails to secure recognition from market participants as ‘a medium that conveys the value embodied in real goods and services’ cannot function as money.

2. Intrinsic Value, Embodied Value, Nominal Value, and Market Price

The value of real goods and services exists objectively and absolutely, but it is recognized only relatively, through real goods and services that human beings can actually enjoy, whether physically or mentally. In what follows, I define the objective value inherent in real goods and services as intrinsic value, and the aggregate of all relative utility generated in the process by which that value is realized when a market participant actually enjoys the good as embodied value. For convenience, I will often shorten embodied value to ’the sum of utility.’ To illustrate the distinction more intuitively, the calories in a Big Mac and a Whopper―the energy required for survival; the intrinsic value embodied in the ingredients―and the utility one derives from eating the two hamburgers―texture and taste; embodied value―are not the same thing. But where the intrinsic value of the underlying substance is the same, embodied value will generally not deviate too far from intrinsic value. Different individuals may assign different embodied value to a Big Mac and a Whopper, but that gap will not usually be as wide as the gap between eating a hamburger and eating an altogether different kind of food. I will return later to cases in which intrinsic value and embodied value diverge sharply.

Embodied value, as the sum of utility, is an abstract concept, and nominal value is what results when that concept is rendered numerically through currency. In other words, nominal value is the figure that concretely states the monetary exchange ratio of a real good or service. If a given real good falls within the category of ‘franchise hamburger,’ its nominal value is unlikely to exceed that of caviar, whatever particular hamburger it may be. Nominal value remains abstract because it is still a representation of embodied value―expressed numerically through currency―. It is like a stock order book before any trade has actually been executed. Only when that nominal value is realized in the market in the form of a transaction does the real good finally acquire a determinate value called market price, with―the embodied value of the real good represented as nominal value―that value becoming fixed through trade.

In other words, price is static at the micro level but dynamic at the macro level, and it does not remain fixed even after it has once been agreed upon at the equilibrium point of quantity demanded and quantity supplied. This is because price is the instantiated form of nominal value, which is itself a representation of embodied value, rather than a factor that determines the intrinsic value or embodied value of real goods and services. For the same reason, price may function as an internal variable that adjusts quantity demanded or quantity supplied by moving along the demand or supply curve, but it cannot shift the demand or supply curve itself. By the same logic, shifting the curve itself requires external variables such as technological innovation or tax adjustment that directly affect the objective intrinsic value or relative embodied value of real goods and services. The movement of market price along the curve can likewise be explained clearly once one keeps in mind the fact that it is static at the micro level but dynamic at the macro level.

3. A More Rigorous Restatement

To restate the concepts developed so far in a more rigorous form:

III. The Architecture of the Monetary Economy and Institutional Trust

1. Currency as Functional Medium

Because currency is limited to possessing “functional value” only as a means of exchanging real goods and services, or their intrinsic value, it directly governs only the manifestation of nominal value in which nominal value is displayed as the ‘currency-denominated exchange ratio of real goods and services’; it cannot generate the intrinsic value or embodied value of real goods and services on its own. Crude oil may be stored physically in a drum, or held in a financial account in the form of a futures contract, but only the former can actually be used for transport or movement. In other words, nominal value, as the monetary representation of embodied value, may be linked to the intrinsic value of a real good, but it is not the real good itself, nor can it directly perform that good’s use value. That is why economics treats the real economy and financial markets as analytically distinct. Accordingly, two real goods with the same intrinsic value will generally have similar embodied value―e.g. travel distance, the range of usable applications, and so forth―even if the nominal values assigned to them differ across currencies. By the same token, real goods denominated in the same currency are converted into broadly similar levels of nominal value according to their embodied value, that is, in a way that preserves the exchange ratios of real goods and services. To give a very simple example, a motorcycle is always more expensive than a bicycle, no matter the country.

2. Exchange Rates, Arbitrage, and Real-Market Disequilibrium

An exchange rate is the ’exchange ratio of currencies.’ Should a discrepancy arise between, on the one hand, the ratio of nominal values that appears when the same real good or service is denominated in different currencies and, on the other hand, the ratio implied by the exchange rate itself, that discrepancy can create an arbitrage opportunity. But as noted above, cash, currency, and money do not possess absolute intrinsic value in the way real goods and services do. They merely can function as media of value transmission only when they are accepted among market participants as authorized means of exchanging real goods and services. Moreover, while each market participant’s individual embodied value differs somewhat from everyone else’s, the intrinsic value to which those individual embodied values are anchored remains the same across markets―e.g. one barrel of crude oil yields the same 500-600 kWh of electricity anywhere on earth―so if the spatiotemporal axis of observation is held constant―e.g. if one compares oil-producing countries with one another, or non-oil-producing countries with one another, along the time axis of the twenty-first century―the empirical distribution of market embodied value will not usually show wide dispersion. Since the empirical distribution of nominal value is the distribution of currency-denominated expressions of market embodied value, such arbitrage is eroded by effective conversion costs―e.g. foreign-exchange spreads, settlement costs, remittance costs, and so forth―and by transaction costs when nominal value is transmitted across different currencies. Any arbitrage that remains even after those external costs have been deducted is usually neutralized by tariffs.

The gap between the intrinsic value and embodied value of a real good or service is usually brought into equilibrium by differences in relative value, the resultant of the interplay between demand, which is constituted by relative utility, and supply, which is constituted by absolute production―in introductory economics classes, this is often described as “differences in the purchasing power of real goods and services." That is why I said earlier that “embodied value generally does not stray too far from intrinsic value." But when human desire, which cannot be measured with precision, drives the gap between embodied value and intrinsic value to an extreme, the result may be a nonlinear equilibrium or even the collapse of the market itself in which those real goods and services are exchanged. One example would be the Veblen effect, where embodied value is priced far above intrinsic value; another would be the Dutch tulip mania, where the real market in which the underlying good is traded collapses outright. To prevent such breakdowns, governments intervene through policy―primarily fiscal―in much the same way that they may first stimulate the economy by inflating the real-estate market and then, once that market overheats, restrain it through steeply graduated taxation.

3. From Barter to Nominal Value

The equilibrium state between the intrinsic value and nominal value of a real good or service involves a broader set of variables than the equilibrium state between its intrinsic value and embodied value. Earlier I described nominal value as “the currency-denominated exchange ratio of real goods and services," and to make that phrase fully intelligible I need to spell out more carefully how I am defining embodied value. I have already distinguished embodied value, nominal value, and market price as belonging to different layers, but in what follows I will proceed in sequence: first, I will explain how embodied value appears as an exchange ratio in the context of barter, and then I will show how that exchange ratio is expressed as nominal value through currency and fixed as market price through actual transactions.

What first appears in the setting of barter is an exchange ratio that reflects the relative magnitude of embodied value. In a monetary economy, that exchange ratio is expressed as nominal value and then fixed as market price through actual transactions. When one real good or service is exchanged directly for another, what is first observed is the exchange ratio before the relative magnitude of embodied value has been expressed in monetary terms. That exchange ratio is a realized value that reveals the relative proportion in which the embodied value of one real good or service is evaluated against that of another. In a monetary economy, that same exchange ratio becomes nominal value once it is expressed in units of currency, and becomes market price once it is actually executed in trade. In other words, nominal value is the monetary expression of how much embodied value a real good or service provides to market participants relative to other real goods and services. In textbook microeconomic terms, the relative magnitude of embodied value is revealed through the extent of the purchasing power that the relevant real good or service is observed to possess vis-a-vis other real goods and services.

In this way, the relative magnitude of embodied value appears in barter as an exchange ratio between goods, and among market participants who have pledged to honor “the recognition of the intrinsic and absolute value possessed by a real good or service”―as a contract―that exchange ratio becomes nominal value once it is expressed in units of currency. In more fundamental terms, nominal value is the figure produced when the relative magnitude of embodied value revealed in the exchange of one real good or service for others is stated in units of currency rather than in quantities of real goods exchanged. That is why I abbreviate it as “the currency-denominated exchange ratio of real goods and services."

4. Law of One Price, Inflation, and Monetary Breakdown

Just as the embodied value of one real good or service is observed through its exchange ratio vis-a-vis other real goods and services, currency, as the institutionalized concrete means of exchange of money, also possesses a relative value observed through its exchange ratio vis-a-vis other currencies, that is, the exchange rate. But so long as the market-wide contract captured by “the recognition of the intrinsic and absolute value possessed by a real good or service” remains in force, the intrinsic value of the relevant good is not altered by the type of exchange medium used. Accordingly, unless a gap first opens between intrinsic value and embodied value, no gap will arise between embodied value and nominal value either, which is simply another way of stating the Law of One Price.

While slightly deviating from the main line of argument, this is precisely why inflation, as an increase in nominal price, is ultimately nothing more than a monetary phenomenon. The intrinsic value of real goods and services remains what it is; what changes is market price, the realized numeric figure in denominated currencies at which nominal value is fixed.

But when the contract itself, or its public standing as a contract, that is, its credibility, is damaged, a large gap can emerge between nominal value and embodied value. That damage arises when confidence in the purchasing power of the state that issues currency as the medium of exchange for goods is impaired, that is, when the relative value of the instruments a state uses to exchange goods with other states, such as currency or sovereign bonds, declines, as in the case of exchange-rate depreciation or rising sovereign yields. Earlier, through the examples of the Veblen effect and tulip mania, I noted that when the gap between intrinsic value and embodied value becomes too large, the real market in which goods themselves are exchanged eventually breaks down. By the same logic, a sufficiently severe gap between embodied value and nominal value can also end in market collapse, for example, default. To prevent such breakdowns, governments intervene through policy measures―primarily monetary―such as interest-rate adjustments, changes in bond liquidity, and in more extreme cases, direct adjustments to the volume of money circulating in the market.

Put differently, when the gap between intrinsic value and embodied value becomes severe, the state intervenes in the real economy through fiscal policy, whereas when the gap between embodied value and nominal value becomes severe, it intervenes in financial markets through monetary policy. The same logic is at work when the central government steps in directly as agricultural or commodity markets swing violently, while the central bank intervenes when equity or bond markets are hit by sharp instability.

5. Money as a Trust-Based Contract

To sum up, money is the intangible totality of a contract―grounded in trust―under which, so long as a real good or service possesses a determinate absolute intrinsic value and that value is recognized by all market participants, the intrinsic value of real goods and services can be exchanged not only through barter among the goods themselves, that is, through real transactions, but also through the exchange of instruments that guarantee their intrinsic value, that is, through financial transactions. Currency is what market participants who honor that contract create when they institutionalize the abstract concept of money as a concrete means of exchange for real goods and services, and cash is the authorized medium that gives that currency physical form. Accordingly, money, currency, and cash possess no absolute value in and of themselves, and even the relative value they carry as media for exchanging real goods and services ultimately derives from the intrinsic value of the goods and services being exchanged. We often ask, “How much nominal value must I pay to purchase a given real good or service?” But the more accurate question is, “If I pay a certain amount of nominal value, what real good or service can I purchase?” Just as stocks and bonds cannot exist without a state capable of protecting and guaranteeing the free market in which companies and individuals produce real goods and services, and derivatives cannot exist without stock and bond markets, so too all of this value can arise only so long as the contract remains fully in force, that is, only so long as trust is maintained among the market participants who are party to that contract.

IV. The Structural Isomorphism Between Cryptocurrency and Virtual Game Goods

1. The Problem of Credibility in Cryptocurrency

‘Virtual Currency’ Ethereum Also Soars in Price, Work of a 19-Year-Old Genius Developer (2017.05.26.)

Bitcoin and Ethereum Surge… Fears of Collapse and Criminal Abuse Cast a ‘Dark Shadow’ (2017.05.26.)

However, cryptocurrency, one type of virtual money, can be created by anyone with programming skills, and there are as many as 800 kinds of cryptocurrency alone. No one really knows who the contracting parties are, or who is supposed to guarantee that each crypto’currency’―as one of the concrete media of virtual ‘money’―possesses functional value as a means of transacting in real goods and services. Advocates of cryptocurrency argue that the strength of virtual money lies precisely in the fact that, if the contracting parties agree among themselves, the functional value of cryptocurrency as a medium of transaction can be recognized. I remain skeptical. In a world where even in spot transactions one party often disappears and the guarantor ends up holding the bag, it is hard to believe that a transaction with no third-party guarantee can really be safe. Put simply, there is nothing especially trustworthy anywhere in the chain, from the totality of the contract itself, i.e. virtual money, to the market participants who actually trade its concrete medium, i.e. cryptocurrency traders. The fact that the fraudsters in the 2017.05.18. article cited at the beginning of this post used “issued by a state-owned bank” as a sales pitch rests on exactly the same logic. They were borrowing the authority of trust in government, the issuer of fiat currency and the guarantor of the market economy in which real goods and services are freely traded, in order to claim that the cryptocurrency they were offering was not ‘fake.’

2. Game Money as a Variant of Virtual Money

One might ask “Still, if electronic currency has risen so sharply in price over a long period of time, surely there must be some reason for it." But did the ‘+5 Enforced Executioner Sword’ from the online game Lineage, which once traded for hundreds of millions of KRW in fiat currency, really command that price because it possessed intrinsic value on that scale? Game money, too, is one type of virtual money, and in a given virtual world it functions as―in a broad sense―a kind of cryptocurrency used as a medium of exchange for goods and services. Game money is issued and circulated through rules set by the operator and procedures internal to the platform, while cryptocurrency is likewise created and transferred through rules set by the protocol and verification procedures internal to the network. In that respect, both share the same feature: their nominal value depends not on the intrinsic value of an independent real good or service but on rules internal to a proprietary system or platform.

3. Structural Similarity and the Absence of Public Authority

What distinguishes game money from Bitcoin and Ethereum, which are commonly used almost as synonyms for ‘cryptocurrency,’ is simply this: instead of a coin-issuing mechanism, the game developer manages the volume in circulation; the method of recording and verifying transactions is not based on blockchain technology; and the object of exchange is not a real-world good or service but an in-game item from an online world, e.g. the Lineage ‘+5 Enforced Executioner Sword.’ By contrast, the similarities are substantial. The ecosystem runs on P2P transactions; all transaction records remain traceable and retrievable as long as the log DB exists; one must complete the quests assigned by a given platform in order to accumulate the currency; and currency transactions are valid only within the normative framework of the platform―to put it more academically, the acquisition, transfer, and exchange of the currency are subordinate to the internal rules and verification procedures set by a particular platform or protocol―while, despite operating under such a closed internal rule system, there is still no third authority, i.e. no public coercive power, that actually guarantees and enforces transactional safety―game companies do not intervene in player-to-player game-money transactions, while Bitcoin and Ethereum lack any control tower capable of intervening in transactions in the first place―in either case. The only difference lies in the type of programming technology used to mediate virtual money through a concrete instrument. Conceptually speaking, however, Bitcoin and game money are fundamentally the same in that both are forms of cryptocurrency. If one does not agree with the claim that game money will replace fiat currency, then it is only consistent not to agree with the claim that Bitcoin will replace fiat currency either.

4. Why Online Value Cannot Generalize to the Real Economy

When goods or currencies from an online world trade for fiat money in the real world, such valuations are strictly confined to the cohort of participants in that particular online world who also, in the real world, share and recognize the embodied value of those online goods or currencies. For example, if a Lineage player were to tell a car dealer who has never played Lineage, “I do not have any KRW to wire you, but I do have Lineage game money, so I will exchange that for a Mercedes-Benz S600," he would likely be taken either to a psychiatric ward or to the police station, or first to the police station and then on to a psychiatric ward. That is because there exists no trust or agreement between the Lineage player and the non-player that two different forms of transaction media―i.e. online game money vs. real-world fiat currency―possess equivalent functional value as media for the exchange of real goods and services; there is no guarantor with authority that can coercively secure contractual validity to compensate for the absence of such trust or agreement.

V. Conclusion: The Speculative Reality of Cryptocurrencies as Financial Derivatives

1. Investment or Speculation?

If one notes that the fraudsters in the 2017.05.18. and 2017.05.26. articles each invoked China and the United Kingdom as parties that would supposedly safeguard the credibility of cryptocurrency and in that way pulled in KRW 60 billion, and that Ethereum’s ‘price’ surged―not because it possessed intrinsic value in itself―because global corporations such as MS and IBM, whose influence on the real markets in which real goods and services are traded is enormous, adopted it as part of a transaction medium, and if one also keeps in mind that even that surging price was ultimately calculated in fiat currency, i.e. in the transaction medium that represents the embodied value of real goods and services as nominal value, then it becomes fairly clear whether cryptocurrency trading belongs to the category of investment or speculation.

2. Why Cryptocurrency Cannot Replace Fiat Currency

At least in my view, a privately issued cryptocurrency whose price could collapse to one-tenth after a server hack is not going to replace the existing fiat-currency system and come to function as a universal medium for exchanging real goods and services. That is, unless the United States, China, and Japan were all to abolish their own fiat currencies at the same time and replace them with the ‘same cryptocurrency’ as a representative currency.

More fundamentally, whether one is talking about Bitcoin or Ethereum, the market price of cryptocurrency is ultimately denominated in fiat currencies such as the US dollar and the Japanese yen, and the relative value of those fiat currencies in turn derives from the intrinsic value and embodied value of real goods and services. Given that, I have no idea what it is even supposed to mean to say that virtual money could replace the fiat-currency system. Leaving aside all the technical engineering talk about how cryptocurrency is generated, what I want to hear is a logically coherent economic explanation of how a cryptocurrency, whose market price can be denominated only in fiat currency, could possibly replace the fiat currency that serves as its benchmark. To me, it looks structurally the same as Chinese Wealth Management Products (WMPs)―a structure in which one claims some underlying substance exists and then piles new leverage on top of old leverage―though perhaps that is only because I am technologically illiterate.

The analogy to WMPs delineates the structural isomorphism between the hypertrophic expansion of the cryptocurrency ecosystem and the systemic vulnerabilities of traditional financial derivatives. Just as WMPs and Collateralized Debt Obligations (CDOs) leverage a tangible underlying asset, such as real estate, to issue sequential derivative tranches and artificially inflate nominal value, the crypto ecosystem exploits the practical utility of blockchain technology as its foundational asset to spawn Bitcoin, which subsequently collateralizes an infinite, unchecked proliferation of altcoins, decentralized finance (DeFi) instruments, and staking mechanisms. Ultimately, both architectures share an identical underlying pathology: they hypothecate a foundational asset with limited intrinsic value to endlessly compound derivative nominal value, governed strictly by arbitrary internal mechanics and entirely decoupled from the real economy.

3. A Final Note on Speculative Exposure

That said, given that Bitcoin rose by a factor of 750,000 over the previous seven years―had you put in KRW 1 million back then, it would be worth KRW 750 billion now!―there is nothing obviously irrational about buying a little Ethereum with an amount of money small enough that losing it would be infuriating, but only infuriating. If it were to rise by even one-hundredth of what Bitcoin did, KRW 1 million would turn into KRW 7.5 billion. Even so, before putting any money in, one ought first to know oneself clearly: are you the kind of person who can surf a manic wave made of greed and fear, or the kind who is more likely to be swept away and drown in it?