The Problem
The financial concept of double expenditure is when a financial instrument or unit of value can be spent by more than one person at the same time. The ability for two people to use the same financial instrument at the same time effectively turns one dollar into two, tantamount to monetary inflation by a central bank which leads to price inflation across all markets.
Although the double expenditure problem isn’t unique to digital currencies, the more prevalent digital currencies become, the more interest there is in the problem. In 2008, an unknown entity under the pseudonym of Satoshi Nakamoto, released a white paper describing a new protocol called Bitcoin that claimed would solve the double expenditure problem of digital currency. Since Bitcoin uses cryptography in securing transactions in its ledger, Bitcoin was coined – no pun intended – a cryptocurrency.
Although Bitcoin and other cryptocurrencies do in fact offer a potential solution to the double expenditure problem for digital currencies, they also introduce a new problem, a double expenditure problem for the entire financial system where one never existed before. It creates a double expenditure problem in fiat currency like most monetary systems are today, meaning that most financial systems now suffer from a double expenditure problem created by the introduction of cryptocurrencies.
Neither fiat currencies nor cryptocurrencies suffer from a double expenditure problem in and of themselves but when both exist in the same financial system, they create a double expenditure problem for the entire system leading to monetary and price inflation across all markets regardless of central bank monetary policy and regardless of the cryptocurrency’s inflationary or deflationary nature.
The History
A barter economy is the oldest form of trade in which people trade consumable goods and services with one another. A crop farmer might trade his vegetables for a baker’s bread or a blacksmith might trade his horseshoes for a poultry farmer’s eggs.
A double expenditure problem is impossible in a barter system since there’s no way to turn a chicken into two chickens or a loaf of bread into two loaves Jesus notwithstanding. Counterfeiting is possible in a barter system but that’s not double expenditure since it’s not spending the same financial instrument at the same time, it’s two separate instruments.
So although a barter system solves the problem of double expenditure, it’s an economically inefficient form of trade due to the lack of double coincidence of wants. If the baker doesn’t need vegetables then in order to trade with the baker, the crop farmer has to find someone who not only needs vegetables but who also has what the baker needs and trade with him first, then go back and trade with the baker.
A medium of exchange can be used to solve these inefficiencies. Instead of requiring everyone to have precisely the same coincidence of wants at the same time, they can use a medium of exchange that everyone will accept at any time. A medium of exchange is typically one of the most tradeable goods in an economy. A good that has diverse market value, is durable and can be used as a unit of account. Historically, precious metals such as gold and silver have emerged from markets as mediums of exchange since they have utility across many different markets so they’ll maintain their value. They are natural elements so by nature they cannot be destroyed and they can be divided into diverse units of measure for accounting. It’s important to stress that a real medium of exchange is a market emergence phenomenon, nobody has to tell people to use it, it’s not declared by a central committee, government or anonymous pseudonym. Consumers and producers decide individually that they’ll accept it in trade for goods and services. And there can be more than one medium of exchange circulating in an economy at any given time.
The Origins
The double expenditure problem has its origins in deposits like goldsmiths and banks. If you are a wealthy person, it can be cumbersome and dangerous to carry around a lot of gold and silver with you wherever you go. It’s easier to deposit them somewhere and get a receipt for your deposits so you can withdraw them when needed.
Goldsmiths use gold and silver for crafting jewelry and other things out of metals. They’ll take your gold and silver deposits and pay you for allowing them to use them. Since gold and silver are homogenous goods, they promise they’ll have gold and silver available whenever you want to withdraw it. Banks take gold and silver deposits as well and pay you interest on them so they can lend them out to borrowers at a higher interest rate than they pay you. The difference is their profit.
Over time it became more convenient and efficient to trade the receipts for deposits than to go to the deposit and withdrawal some gold or silver every time you wanted to buy something. This was the origins of paper money and the double expenditure problem.
Since gold and silver are homogenous goods, deposits didn’t have to have the same gold you deposited when you came to withdraw it, they just needed to have some gold or silver regardless where it came from. And once people started trading the receipts rather than the physical metals, they rarely came in person to withdraw them. When the depositing institutions realized that, they began issuing receipts as credit against other people’s deposits. So there were multiple receipts in circulation representing the same gold or silver that could be spent at the same time. Voila`, double expenditures! As long as too many people didn’t come all at once to withdraw their deposits, this system of double expenditure was profitable for the deposit and the economy. But when too many people did come all at once to withdraw their deposits, it was called a bank run and the bank would go bankrupt and everyone would lose their wealth which was bad for the economy.
The Federal Reserve
Ostensibly, as a solution to the volatile nature of private banking systems due to their double expenditure practices, politicians, wealthy businessmen and bankers met in secret on Jekyll Island, Georgia in 1910 to define and implement a single national bank, a central bank, the Federal Reserve uniquely responsible for controlling the supply of US dollars – aside from the treasury printing bank notes and the US mint issuing coins.
The Federal Reserve became law in 1913 and subsequent legal tender laws by the government mandated that the US dollar be used to pay taxes , settle debts and that it must be accepted by anyone offering it in trade in the US. This legal declaration by the government made the US dollar a fiat currency, a medium of exchange by declaration rather than a market emerging phenomenon as decided individually by consumers and producers.
Fiat currency did in fact solve the double expenditure problems of the private banking systems since fiat money is not a receipt for anything, there are no deposits of a real medium of exchange that they represent. They are just entries in a ledger or physical banknotes and coins. People can counterfeit fiat currencies but again, that’s not a double expenditure problem.
But this led to a new problem, it left the value of the currency to a political institution by increasing or decreasing the supply out of thin air as they wish in order to manipulate interest rates. Although they can’t spend the same dollar twice, they can create as many new dollars as they want. This sort of monetary manipulation can be used as a political tool. In the year preceding an election, the president can sit down with the chairman of the Federal Reserve and convince him to increase the money supply, lowering interest rates which has an expansionary effect on the economy and makes the incumbents look like they’re good for the economy. Voters will feel economically better off leading into the election and erroneously correlate the incumbent politicians with their economic prosperity. Afterwards, however, the inflationary monetary policies lead to price inflation and a year or so after the election, everything is more expensive and the economy starts to slow down again. This is known as the political business cycle.
The Technological Revolution
Fiat currency has its benefits but it also has a lot of problems. Since a large amount exists in physical form, it’s difficult and dangerous to transport, it’s at risk of being lost or stolen and it can easily be destroyed.
The technological revolution of the 1980s gave rise to the concept of digital currency. A currency that doesn’t have a physical presence. Transactions are all done and accounted for electronically. But, like gold and silver deposits, a digital currency suffered from the same double expenditure problem since the currency was all digital entries in an electronic ledger and digital information is easily duplicated by malicious actors.
In order to address this flaw, blockchains and Merkel trees were implemented using cryptography making each transaction in the blockchain ledger of a digital (crypto) currency mathematically dependent on the others making it almost impossible to alter a ledger entry and spend a crypto-coin twice. These systems are far from perfect, they have other flaws but for all intents and purposes, double expenditure is not one of them.
The Paradox
Although neither fiat nor any of the cryptocurrencies individually suffer from the double expenditure problem, when used together there is a derived double expenditure problem that affects the entire economy regardless of central bank policy or cryptocurrency hash rates.
Say I have $1, if the cost of “mining” is $1 and the market price of a crypto-coin is at least $1 then I’ll pay the resources necessary to try and win the coin. Then the physical $1 that I had in my hand will now belong to the resources that “mined” for me and I’ll have at least $1 worth of crypto on the blockchain. Effectively, I replicated or cloned my physical $1 onto the blockchain in the same sense that a gold smith replicated or cloned gold by writing a receipt for it. The resources I paid have my physical $1 so there are $2 worth of exchangeable value now in circulation and both can be used in trade for all the same goods. Just like the double expenditure problem with gold and silver. This is what cryptocurrencies have created.
This leads directly to financial and price inflation. For example, if there are three people in the economy, Alice, Bob and Charlie and Alice has $1, Bob has nothing and Charlie has a bike for sale that both Alice and Bob want to buy. Since Bob has no money, Alice can offer Charlie one cent and the sale will be made. But if Alice pays Bob $1 to mine crypto for her, now Alice has $1 worth of crypto and Bob has $1. Now they can both bid on Charlie’s bike starting from one cent. The last one to bid $1 will get the bike. The double expenditure of the financial composition of fiat with crypto inflated the price of the bike from one cent to $1.
You can’t use fiat directly on a blockchain, there must be something on the blockchain that represents fiat since nothing is priced in cryptocurrencies, everything is priced in terms of fiat. A token, a crypto-coin something that acts as the unit of account in the blockchain ledger. These cryptocurrencies aren’t real economic goods, they’re not produced by putting resources together in such a way that the value of the product is greater than the sum of the inputs like bread or vegetables. They are an electronic reward or prize for validating blockchain transactions and being the first one to guess a random number. This is called “mining” and the more “miners” there are the more difficult and more expensive it is to win the prize.
There exist mining farms where people maintain hundreds of computers trying to win the crypto-coin. If the costs of mining a single coin are less than or at least equal to the market price of the coin, then it’s profitable to mine, but where do these costs go? Mining farms require large spaces, lots of computers, cables, cooling devices, people and a lot of electrical power. So the owners of these farms use fiat to pay for mining and the blockchain generates a new crypto-coin on the blockchain with the market value at least equal to the costs of mining.
The fiat spent on mining remains in the economy to be traded and the individual paying the miners now has a crypto-coin worth at least the same value of the fiat he spent on mining costs that he can also use for trade. The same monetary value can be spent by two people at the same time.
It’s a double expenditure problem created by composing two non-double expenditure problems: fiat and cryptocurrency.
That’s because cryptocurrencies are not real goods like a chicken or loaf of bread, they are artificial goods created out of thin air by a computer program as a token for fiat trade on a blockchain in the same sense a gold smith creates a receipt out of thin air for gold. Miners are “digitizing” fiat onto the blockchain but at the same time, the fiat that was digitized remains in circulation so that monetary value has been doubled and can be spent by more than one person at the same time leading to price inflation across all markets.
The Conclusion
Cryptocurrencies solve the double expenditure problem in the context of blockchain transactions and fiat solves the double expenditure problem in the context of acting as a medium of exchange albeit by force of law. But both fiat and cryptocurrencies are artificial goods since their supplies are not determined in the market as a function of demand and price. They are determined by outside forces, central committees or business rules in the software.
This derived double expenditure problem leading to monetary and price inflation exists regardless of the deflationary or inflationary nature of cryptocurrencies or fiat. Bitcoin is deflationary by design but when valued in fiat, the composed financial system is inflationary.
Every mining reward leads to a double expenditure problem and inflates the fiat plus crypto monetary supply putting upward pressure on prices.