Bitcoin and its potential role in the global economy

As it may be expected, as both a technologist, and somebody who works in the financial industry, Bitcoin and other digital currencies have caught the interest of myself and many other people, for many different reasons.  But perhaps unlike others, my interest is purely from an economic standpoint.  Most specifically, the idea that an economy can exist in a zero-inflation environment.

Gold standard

Many of these discussions inevitably stems from the fact that as no central authority like the Fed can control the creation of the currency, this would lend itself to a deflationary economy. It made me really think about what that really meant, and whether or not something like a currency that could not be directly controlled could ever be used successfully as a store of value. History, of course was full of such cases, the most notable and the most recent, of course was the gold standard. Make no mistake though, there is nothing special about gold, before that there was silver, electrum, gems and beads. In fact, there are even cases in some pacific islands where large stone wheels were used as legal tender, in fact, history is replete with cases where the currency was in a form which did not lend itself to be easily manipulated by central authorities. So taken in this light, fiat currencies is only a recent invention, and only has been in effect for just over 40 years, and in the eyes of history, that is nothing more than a blink of the eye. In this short period of time, there is not enough time to show evidence for nor against the success of this system. In fact, the system came about due to the problems that came from attempting the keep the fiat currency redeemable for gold. This restricted the amount of credit that could be issued to the amount of gold the banks had in the reserves. Defenders of fiat currencies will be quick to say that such restrictions to the creation of money, and its ability to quickly increase the money supply, was one of the causes of the Great Depression.

Since the general ‘freeing’ of money from a physical basis and allowing it to be created whenever the Central bank deemed it necessary, the Feds have consistently used this tactic in times of crisis, or even in times when the economy would just dip below the level of expectation that they had forcast. It is akin to a person who is addicted to pain killers, who takes them at the first hint of problems. Soon they begin to take them just to feel normal, as the brain, like the economy, gets accustomed to the drug, and the effect lessons.

Perhaps then, indefinitely inflatable currencies have outlived their usefulness, and it is time that we all took a long hard look at whether it would be sensible to go back to the days of a currency which is grounded? Could Bitcoin fill that need? What issues would that present? Before we can consider this, we have to make very clear that Bitcoin is not the same as gold. Although the two have similar properties, they also differ in some very important ways. Firstly, the intrinsic value of gold is apparent to everyone who has held it in their hands. It’s value is somehow innately obvious to humans since time immemorial. Bitcoin, on the other hand, while having intrinsic value as a payment network, is not something that people can innately understand, and even when explained, people still have a hard time grasping. This is due to the fact that Bitcoin, like the internet, has ‘distributed’ intrinsic value. Namely, it has value only because other people use it, and it’s value stems from it’s utility alone. Imagine an internet comprised only of individuals who could not connect to each other; it wouldn’t be of much value to have an internet web page which nobody could reach. The other marked difference between gold and Bitcoin is that gold, while its reserves on the earth are indeed limited and static, tend not to be lost very easily. (Spanish galleons in the carribean not withstanding) Bitcoin on the other hand, due to its digital nature, make it much easier to store a very large amount of value in a very easy to lose medium. The classic example being of the fellow who threw away over 8 million dollars worth of Bitcoin when he binned his old computer. So Bitcoin, unlike gold, has some interesting digital aspects which make it more difficult for people to accept as a store of value but these I believe can be remedied with time and better education.

International reserve currency

So if Bitcoin can match gold on all its merits, and time and familiarly can lesson its shortcomings, could it be used as a reserve currency? Keynes argued for the adoption of a shared reserve currency called the bancor which would be used to regulate foreign trade by way of being a medium of exchange for a countries foreign reserves. In this way, any country could exchange bancor for another country’s reserves, which it could then use to pay for imports. This proposal, which echoes the current IMF’s SDR system, used as a means of regulating foreign trade deficit accounts between countries, has some merit to it. Though the current system is flawed as it uses the US dollar as reserve currency, which means the dollar is serving a dual purpose of facilitating foreign trade deficits, and also being used to fulfill the requirements of the internal economy of the US. This overloading of the currency is what makes monetary and fiscal policy of the US excessively complicated. Like servants of two masters, policians in America find it difficult to serve both the international community and their own citizens.

Despite the temptation to think of Bitcoin as a reserve currency, the issue with this is that as a facilitator of international trade, it is necessary for governments to restrict the use of it to central banks alone as without this restriction it would erode the governments ability to control it’s own economy.

Replacement for fiat

So what about Bitcoin as a the primary currency of a country’s economy? This too has some problems. Foremost, being unable to print it to stimulate the economy means that the government has it’s hands tied in times of economic crisis. Faced with a real drop in employment and investment and deflation the government would be forced to source more Bitcoin from foreign entities, perhaps paying for them through SDRs like bancors. This may well work but the speed of which this can be effected is relatively slow in a situation where the speed of response is a critical factor on the success of the fiscal stimulus. Additionally this opens up the possibility of other countries unwillingness to lend for political reasons which would limit the governments ability to protect its economy from external forces.

Secondly, and most importantly as an obstacle to Bitcoins adoption as a national currency is one of the fundamental facts of society today: taxes. As long as people have to pay their taxes in the local currency, then there will always be a need for fiat currencies issued by governments.

Thus any natural evolution of Bitcoin will inevitably see it evolve into a third currency or medium of exchange. A sort of neutral currency which is used as a conversion medium between the fiat currencies of the world, a currency which truly reflects the demand of each individual countries fiat and by extension, it’s economic output vs another’s. A sort of USD, but not subject to the policies of any one country. Essentially what this means is that as more and more people use Bitcoin as an inter-fiat currency, it’s value becomes more and more reflective of the true value of a countries balance of trade vis-a-vis it’s international neighbors. Perhaps when this happens then the exchange rate from fiat currencies to Bitcoin instead of USD should replace the current valuation method of the bancor. If you follow this to it’s natural conclusion, then it means Bitcoin will become the defacto reserve currency of the world. One thing that would have to happen first, the regulatory position of governments on Bitcoin will first have to be clarified to the point where speculation on the currency will stabilize.

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