The United States of Africa: An Idea Whose Time Has Come (Part IV)
Fiat Currency vs. Cryptocurrency
The main difference between fiat currency and cryptocurrency is that cryptocurrencies don’t require government backing, while fiat currencies depend on it.
I. Fiat Currency
Fiat currency is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it.
Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, the British pound, the Japanese yen, the Indian rupee, and other major global currencies. Fiat currency gives central banks greater control over the economy because they can control how much money is printed. One danger of fiat currency is that governments can print too much of it, resulting in hyperinflation.
Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event of hyperinflation. Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country’s central bank began to print money at a staggering pace, resulting in hyperinflation. Experts suggest the currency lost 99.9% of its value during this time. Prices rose rapidly and consumers carried bags full of money just to purchase basic staples. At the height of the crisis, the government of Zimbabwe was forced to issue a 100-trillion Zimbabwean dollar note. Eventually, foreign currencies were used more widely than the Zimbabwean dollar.
Advantages of Fiat Currency
Fiat currencies gained prominence in the 20th century in part because governments and central banks sought to insulate their economies from the worst effects of the natural booms and busts of the business cycle.
Fiat money serves as a good currency if it can handle the roles that a nation’s economy requires of its monetary unit: Storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage, meaning it is more cost-efficient to produce than a currency that is directly tied to a commodity.
Disadvantages of Fiat Currency
Fiat currency is not a fool-proof way to protect the economy. The U.S. mortgage crisis of 2008 and subsequent financial meltdown tempered the belief that central banks could necessarily prevent depressions or serious recessions by regulating the money supply.
A currency tied to gold, for example, is generally more stable than fiat money because of the limited supply of gold.
There also are more opportunities for the creation of bubbles with fiat money due to its unlimited supply. There is always the possibility of hyperinflation when a country prints its own currency.
However, most developed countries have experienced only moderate bouts of inflation. In fact, having some consistent, low level of inflation is seen as a positive driver of economic growth and investment, as it encourages people to put their money to work rather than have it sit idle and lose purchasing power over time.
Having a relatively strong and stable currency is not only a mandate of most modern central banks, but a rapidly devalued currency is harmful to trade and obtaining financing.
Moreover, it is unclear whether or not hyperinflation is caused by “runaway printing” of money. In fact, hyperinflation has occurred throughout history, even when money was based on precious metals; and all contemporary hyperinflation has begun with a fundamental breakdown in the real production economy and/or political instability in the country.
The Merit of Fiat Currency
In contrast to commodity-based money, such as gold coins or paper bills redeemable for precious metals, fiat money is backed entirely by the full faith and trust in the government that issued it. One reason this has merit is that governments demand that you pay taxes in the fiat money it issues. Since everybody needs to pay taxes, or else face stiff penalties or prison, people will accept it in exchange (this is known as chartalism).
Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value.
II. Cryptocurrency
A cryptocurrency is a digital or virtual currency secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Most cryptocurrencies exist on decentralized networks using blockchain technology. A blockchain is a database of transactions that is updated and shared across many computers in a network. Every time a new set of transactions is added, it’s called a “block” - hence the name blockchain. Public blockchains allow anyone to add, but not remove, data. If someone wanted to alter any of the information or cheat the system, they’d need to do so on the majority of computers on the network.
A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.
Cryptocurrencies represent a new, decentralized paradigm for money. In this system, centralized intermediaries, such as banks and monetary institutions, are not necessary to enforce trust and police transactions between two parties. Thus, a cryptocurrency system mitigates the risk of a single point of failure, like the massive financial institutions whose collapse triggered the global crisis of 2008 in the United States.
Cryptocurrencies promise to make transferring funds directly between two parties easier without needing a trusted third party like a bank or a credit card company. Such decentralized transfers are secured by the use of public keys and private keys and different forms of incentive systems, such as proof of work or proof of stake.
Cryptocurrency markets have skyrocketed in value over the past decade, reaching almost $2 trillion. As of July 2023, Bitcoin was valued at more than $565 billion in crypto markets.
In theory, cryptocurrencies are meant to be decentralized, their wealth distributed between many parties on a blockchain. In reality, ownership is highly concentrated. For example, a meager 15,870 addresses, dubbed as “whales,” are found to be in possession of an astounding 59.2% of the total Bitcoin supply.
One of the conceits of cryptocurrencies is that anyone can mine them using a computer with an Internet connection. However, mining popular cryptocurrencies require considerable energy, sometimes as much energy as entire countries consume. The expensive energy costs and the unpredictability of mining have concentrated mining among large firms whose revenues run into billions of dollars. For example, only 98 (2%) of the 4,882 Bitcoin blocks opened from Dec. 29, 2022, to Jan. 29, 2023, were opened by unknown addresses - the other 98% were opened by mining pools.
Though cryptocurrency blockchains are highly secure, off-chain crypto-related key storage repositories, such as exchanges and wallets, can be hacked. Many Ethereum cryptocurrency exchanges and wallets have been hacked over the years, sometimes resulting in the theft of millions of dollars in coins.
Crypto Coins vs. Crypto Tokens
While many people use the phrases ‘crypto coin’, ‘crypto token’, and ‘cryptocurrency’ interchangeably, they’re not the same thing. Though coins and tokens use distributed ledger technology (also known as blockchain technology), there are some significant differences between a coin and a token.
Crypto Coins
Crypto coins are a form of digital currency that are often native to a blockchain. The Bitcoin blockchain coin is BTC. The Ethereum blockchain has ETH. And the Litecoin blockchain uses LTC. These crypto coins are primarily designed to store value and work as a medium of exchange, similar to traditional currencies. This is why crypto coins are also referred to as cryptocurrencies.
When Bitcoin was created, it was envisioned as a replacement for traditional fiat currencies. Along with other crypto coins, it was designed to work in the same ways as paper money and metal coins, meaning it can be used for many of the things normally used with U.S. dollars or euros, including: storing value, exchanging for other currencies, paying for goods and services, and transferring to others.
Crypto Tokens
Like crypto coins, crypto tokens are designed using blockchain technology; however, crypto tokens aren’t native to a blockchain. Instead, they’re built on top of it, often utilizing smart contracts to fulfil a variety of purposes, from representing a physical object to granting access to platform-specific services and features.
While crypto coins mimic traditional currencies, crypto tokens are more like assets or even deeds. A crypto token can represent a share of ownership in a DAO, a digital product or NFT, or even a physical object. Crypto tokens can be bought, sold, and traded like coins, but they aren’t used as a medium of exchange. To use a real-world example, crypto tokens are more like coupons or vouchers, while crypto coins are like dollars and cents.
Altcoins
Altcoins are generally defined as all cryptocurrencies other than Bitcoin (BTC). However, some people consider altcoins to be all cryptocurrencies other than Bitcoin and Ethereum (ETH) because most cryptocurrencies are forked from one of the two. Some altcoins use different consensus mechanisms to validate transactions. The first altcoin was Litecoin, forked from the Bitcoin blockchain in 2011. Litecoin uses a different proof-of-work (PoW) consensus mechanism than Bitcoin, called Scrypt (pronounced es-crypt), which is less energy-intensive and quicker than Bitcoin’s SHA-256 PoW consensus mechanism.
Ether is another altcoin. However, it did not fork from Bitcoin. It was designed to support Ethereum, the world’s largest blockchain-based scalable virtual machine. Ether (ETH) is used to pay network participants for the transaction validation work their machines do.
Bitcoin vs. Ethereum
Launched in 2015, Ethereum builds on Bitcoin’s innovation, with some big differences.
Both let you use digital money without payment providers or banks. But Ethereum is programmable, so you can also build and deploy decentralized applications on its network. There is no limit to the kind of contracts which can be created and agreed upon. For example, smart contracts are computer programs living on the Ethereum blockchain. They execute when triggered by a transaction from a user. Popular examples of smart contracts are lending apps, decentralized trading exchanges, insurance, quadratic funding, social networks, NFTs - basically anything you can think of.
In sum, while Bitcoin is only a payment network, Ethereum is more like a marketplace of financial services, games, social networks and other apps. On September 15, 2022, Ethereum transitioned from its original proof-of-work consensus mechanism to proof-of-stake.
Stablecoins
Cryptocurrency trading and use have been marked by volatility since launch. Stablecoins aim to reduce this overall volatility by pegging their value to a basket of goods, such as fiat currencies, precious metals, or other cryptocurrencies. The basket is meant to act as a reserve to redeem holders if the cryptocurrency fails or faces problems.
Again, stablecoins are cryptocurrencies tied to specific assets. They are a bit of a misnomer, as most of them are actually ERC-20 tokens (i.e., they operate on the Ethereum blockchain through a smart contract). So why are they called stablecoins? The name lends itself to their primary function of being a medium of exchange.
Take USD Coin (USDC), for example. It is a smart-contract-based stablecoin (i.e., it doesn’t have its own chain and is an ERC-20 token). It is backed by U.S. dollars, held by the company that issues the token, to maintain the value of every USDC at US$1.
In Part V, we will examine U.S. currency issues.
Further Reading: