Separation of Money & State

Money is a foundational pillar of human society. Modern states, collectives of immense complexity and sophistication, exist only because the individuals that comprise them can efficiently exchange goods and services. This exchange of value is the engine that allowed isolated tribes of hunter-gatherers to become vast civilisations of scientists and philosophers. As much as science or technology, money has been central to human progress.

Like technology, money also experiences innovation. Its earliest iteration was commodity money — objects which have intrinsic value as well as value in their use as money. The Mesopotamians were the first (c. 3000 BC) to do this at a large scale when they decreed that their money, the shekel, would be backed by a standard quantity of barley. For much of history since then, gold and silver have been the commodities of choice. In time, metal coins have been replaced by more portable paper. Today, we are in the era of fiat money, which is backed by the “full faith and credit” of sovereign governments.

The common thread throughout the history of money has been its inseparability from the state. The Mesopotamians used barley because the state decreed it. The Roman denarius was continually changed by the decree of the Emperor, who usually debased it by decreasing its silver content. Fiat money is an extremum of the intimate link between money and state, deriving its value entirely from a sovereign guarantee.

This link is so stubborn because it is a result of a natural symbiotic dependence. A functioning state must keep control over its money because money is the primary technology to organise its resources. Therefore, a state that loses control of its money is crippled. Greece, which outsourced its monetary policy to the European Central Bank, is an example of what can happen when governments lose control of their money.

However traditional money also needs a guarantor of its value. This could be a vague general understanding that some commodity, like gold, is valuable, but having an inviolable sovereign guarantee is better. Commerce is much easier if the difficult question of “what is money?” is settled by government decree. Traditional forms of money, both commodity and fiat, must ultimately rely on some guarantee from a sovereign. Fundamentally, money represents property rights and the state, through its monopoly on legal violence, is the ultimate guarantor of property rights.

This millennia old link between money and state, apparently invulnerable, is now faced with its first real test: cryptocurrency.

The fundamental innovation of cryptocurrency is that it breaks the dependence of money on the state. To see this, first note that money can ultimately be seen as a list of transactions in a ledger, crediting one account while debiting another. About 90% of the world’s money supply is actually held as digital entries recorded on ledgers. These ledgers are maintained by trusted third parties such as banks and governments. The main innovation of Bitcoin, the first cryptocurrency, was to devise a method by which a trusted ledger of credits and debits can be maintained by a decentralised network of agents that don’t trust each other. The details are technical, but put simply adding new transactions to the ledger involves solving very difficult cryptographic math problems. With the integrity of this ledger — the infamous blockchain — maintained by cryptography, there is no need for a trusted third party.

The ability to maintain a trusted record of transactions independent of the state allows — for the first time — a separation of money and state. For the first time in history, it is legitimately possible for anyone to issue their own currency to millions around the world. Unlocking the functions that were the exclusive preserve of the state for thousands of years gives a once in a generation opportunity for experimentation and innovation on a grand scale. Cryptocurrencies backed by math might not command enough hard power to entirely replace fiat currencies backed by aircraft carriers, but they offer the first viable alternative that can exist in parallel with and compete against traditional money.

This innovation in this parallel structure is already underway. A profusion of blockchains followed Bitcoin, of which the most significant is Ethereum. Whereas Bitcoin’s innovation was breaking money free from the state, Ethereum’s was making money programmable. Ethereum is not only a decentralised ledger like Bitcoin, but also a decentralised computer which can run programmed applications called smart contracts. The best example of innovation on Ethereum is the explosion of Decentralised Finance or DeFi, a class of crypto protocols experimenting with new methods of lending, borrowing, and trading beyond those offered by the traditional financial system and its middlemen. Many of these protocols will fail, and some are outright scams, but the overall trend is clear: the total value locked in DeFi applications has grown by more than 100x since 2018. These services offer real value to people all across the world.

A Historical Perspective on Financial Innovation

Financial innovation is important because it is often upstream of other significant shifts. To see this, consider the examples of Spain and the Netherlands in the 17th century. For much of this period, the Spanish Empire was one of the richest states in the world due to its control over vast stretches of the Americas. By contrast, the Netherlands was a minuscule backwater which had just won independence from Spain. Within a few decades, the tiny Netherlands dominated world trade while once mighty Imperial Spain was mired in stagnation. How did this happen?

The key lies in the divergent financial trajectory of the two states. Shortly after independence, the Netherlands encouraged financial innovation to boost its small economy. This led to the birth of the first ever multinational corporation in 1602, the Dutch East India Company, which was financed by shares from the first modern stock exchange. In 1609, the first true central bank, the Bank of Amsterdam, was founded to finance the booming trade of the Netherlands with Asia. In fact, much of what we see today as “traditional” finance was invented in the Netherlands. Because of this financial innovation, the Dutch were able to create deep capital markets and mobilise resources far more efficiently than any other state. This led to the beginning of the Dutch Golden Age in not only commerce, but also science and art. Financial innovation was one of the main reasons that let the tiny Netherlands to become a global power on par with contemporary heavyweights.

On the other hand, Spain became a victim of its own riches. The conquest of the Americas gave Spain access to huge deposits of gold and silver like the great silver mine at Potosí in modern Bolivia. The influx of vast quantities of precious metal caused inflation as more money chased after the same amount of goods, which caused Spain’s economy to stagnate. The abundance of natural resources also caused a decline in entrepreneurship and innovation as resource extraction became a less risky way to make profits. This was compounded by the irresponsibility of Spain’s Habsburg rulers who squandered this vast wealth in wars instead of encouraging productive investments. Even though on paper Spain was vastly more wealthy than the Netherlands, its financial stagnation set the stage for its broader decline.

One could argue that the story of the tiny Netherlands and mighty Spain was replicated on a larger scale with tiny Europe and mighty Asia. For centuries the Indians and Chinese dominated global trade, but like Spain they failed to innovate and fell prey to complacency. While Europe’s sophisticated capital markets encouraged innovation, Asia slid into luxuriate stagnancy with devastating consequences.

If these examples offer a blueprint for the future, then the explosion of financial innovation in cryptocurrencies may well cause other secondary effects of great importance. We will see new ways to form markets and allocate capital across borders. It is not difficult to think that separating money and state might give rise to entirely new structures parallel to existing nation-states. There are already signs of experiments along these lines.

Perhaps the grandest consequence of breaking the link between money and state could be a fairer financial system, both within countries and globally.

A Fairer Financial System?

The world is full of governments whose irresponsible actions have destroyed the purchasing power of their citizens, such those in Venezuela and Iran. The most obvious benefit of decoupling money from state is that the people of these countries, who often have no say in their government’s actions, have a parallel financial system to tap into to preserve their wealth. By achieving this decoupling, cryptocurrency offers a real chance for people in these countries to compensate for their rogue governments.

This decoupling has impacts beyond borders too. The current global financial system descends from the Bretton Woods System constructed by the victors of World War II. Under Bretton Woods, all currencies were pegged to the US Dollar and only the Dollar was convertible to gold. Since the US was the most powerful country at the time, Dollar primacy was a logical choice. As a result, the US Dollar became the reserve currency of the world, trusted by countries everywhere as a store of value to settle international transactions.

Reserve status brings incredible advantages such as higher buying power as countries around the world scramble to invest their wealth in the reserve currency. It also gives a high degree of control over global financial flows to the reserve status hegemon and necessitates trust that in exchange the hegemon will uphold the rules of the system.

Of course, trust cannot be the basis of a fair system on the international stage where events are driven by cold strategic interest. The US itself unilaterally ended gold convertibility in 1971, ending Bretton Woods and creating today’s system of floating currencies. Due to the primacy of the dollar in international transactions, the American voter commands unbelievable power to sanction and punish entire peoples for the actions of their governments. In exchange, the United States enjoys financial stability as it leads a flagrantly irresponsible fiscal and monetary policy marked by wars and asset bubbles. Clearly this is not a fair deal, but pining for “fairness” in a world where money is inseparable from state is a vain cause. Reserve status has been abused by countless powers throughout the centuries simply because it is useful to do so and they are powerful enough to do it without consequence. If another power somehow manages to displace the United States as hegemon, it will enjoy the same privileges.

By separating money from state, we have the possibility of a neutral global reserve currency decoupled from the interests of any one country. In this world, the people of one nation don’t have the capacity to destroy livelihoods in another at the flick of a financial switch, nor does the world have to finance the irresponsibility of a hegemon drunk on power. More practically, a neutral reserve currency is an increasingly attractive prospect in today’s uncertain world. This is especially true for rising powers like India that don’t want to submit to either the United States or China but want to negotiate as equal partners. Perhaps this reserve currency could be Bitcoin, or maybe it will be something else which we haven’t seen yet. Whatever it may be, it will face a very stiff fight from the current system. Despite this, for the first time ever we can legitimately contemplate the prospect of a neutral global currency and a fairer global financial system.

Money is one of the crucial pillars of human society because it is the fundamental tool for allocating resources. Although for most of its history, money has been inseparable from the state, cryptocurrencies present the first real opportunity for money to function without depending on the state for legitimacy. Decoupling money from state will result in new disruptive forms of financial innovation, such as Decentralized Finance. If history is any guide, these financial shifts could be the harbingers of broader shifts throughout states and societies. The grandest, and certainly most elusive, promise of the separation of money and state is a fairer global financial system independent from the control of any rogue governments and hegemons. It is still too early to tell what the full impacts of the separation of money from state will be, but it is clear that it marks a new era in how we think about organizing our economies and societies.