Money can only be useful (and sound) if the ledgers can be trusted to be accurate and honest, and if its supply is kept under control. This means unreasonable amounts of money won’t suddenly be created or destroyed, with consequential impact on its spending power.
So how do fiat currencies solve this today? Simple: the government manages money the ledger for its currency either directly, by controlling .physical money creation (minting) and managing and allowing the creation of credit/debit relationships between itself, banks and people.
To do this the central bank licences a few select institutions (like banks and building societies) to keep ledgers of their own. The sum of the credit of all the records from the ledgers of all the banks of a country (including the central bank) is the total supply of that currency.
We then collectively agree that the only books which are to be trusted are those kept by these institutions, and that they will keep the books properly. This consensus comes from trust that they’ll keep their obligations, as well as in the rule of law.
This authority-based trust system is what holds the traditional money systems together. The reason we can use our money online is because we trust that banks won’t let people cheat and spend more money than they have.
We even trust them to ‘create’ money, lending out more than the deposits they hold, and assuming risks for complex investment strategies (more on this below).
Though the system in practice is far more complicated, the general principle relies on trust. We must trust that institutions will behave in everyone’s best interest, and by doing so we grant them the authority and control over the money system.
Even if this centralised system works most of the time, it still has a few noticeable weaknesses. For example, while your money is legally yours, it’s never really under your custody.
Every time you pay for a €2 coffee with your card, you are effectively asking your bank to subtract €2 from your account, and for the vendor’s bank to add €2 to the shop’s account.
A single central point of failure is more vulnerable to corruption, manipulation, or plain old external pressure. This leaves the door open to abuse, mismanagement, and economic exclusion (e.g. “the unbanked” – we’ll talk about this in another lesson).
However, sticking to our central theme, the most worrying side effect of fiat money – money based only on institutional trust – is how it undermines scarcity.
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