The first ATM machine dispensing Bitcoins is apparently opening this month in Asia. So what exactly is the Bitcoin phenomenon? Variously described as a digital Gold Standard, an internet miracle, a means of conducting illegal transactions, a tulip bubble and much else besides, it is a subject that is irresistibly attractive to the blogosphere.

However, when you add the fact that the founder of the digital currency is known only under the pseudonym Satoshi Nakamoto, the mystery surrounding the whole activity has been enough to dissuade most sensible and honest investors from taking it seriously.

Until now, I have therefore largely ignored it. But John Authers and Tim Harford, after explaining the phenomenon very clearly, conclude that it is time to pay attention. Furthermore, the major private banks and regulatory agencies have started to express serious interest in it.

The Chicago Fed has said that, warts and all, “it represents a remarkable conceptual and technical achievement, which may well be used by existing financial institutions or even by governments themselves”. And even the conservative ECB argues that, if it is not Bitcoin, then another virtual currency may soon start to grow extremely rapidly.

In recent weeks, the authorities in Germany, France, China, India and Malaysia have all taken steps to discourage speculation in Bitcoins. So it is time to ask whether we should be worried about the economic consequences of virtual currencies.

How Bitcoin Works

A quick way to grasp the basics of Bitcoin is to imagine that it provides people with little bags of gold coins (digital “wallets”) which can be used to keep savings, or to spend on goods and services. The “mining” of Bitcoins (again, think of gold) is undertaken by prospectors or “miners” that solve algorithmic puzzles on their computers, and are allocated new Bitcoins when they succeed. There is a pre-determined schedule for the creation of new Bitcoins, shown in the graph, so long-term supply is limited.

A new medium of exchange…

The rest of the world acquires Bitcoins from exchanges, where the initial sales of the currency come from the successful miners. Once in circulation, the technology allows Bitcoins to be transferred from one wallet to another very cheaply, so the virtual currency could become an efficient medium of exchange. (The best simple explanation of all this is in the Chicago Fed Letter.)

There seems to be some risk of digital theft, but the benefits of conducting transactions quickly and easily on a mobile phone is considerable. Even Ben Bernanke has said that this could “hold long term promise”. The likely success or failure of this activity should be judged like any other venture capital business, in competition with alternative providers, of whom there will be many. One, and probably only one, such venture could perhaps succeed.

If the virtual currencies develop simply into a better medium of exchange, then the economy as a whole will gain, and less efficient alternatives (Paypal, the banks) may lose out. But the potential economic consequences go further than that. The success of a new global currency, created by the private sector, would clearly undermine the monopoly of governments in monetary creation, which is why it is such an attractive concept to Hayekians and other libertarians.

…and a store of value

One early consequence has been that the first “miners” of the new currency have already gained “seigniorage” for creating a valuable asset with very low marginal costs, a process conceptually identical to that which the central bank printing presses have monopolised until now. The present value of the Bitcoins created so far is about $10bn. Although that represents a great deal of money in the hands of a few people, it is an almost complete irrelevance in a global economic context. For comparison, $1.2tn circulates in US currency alone.

Still, it is not clear why the distribution of these gains to a few technology wizards, and maybe some illicit traders in drugs and other undesirable activities, instead of to society at large, should be regarded as a good thing. And, if the virtual currency displaces existing national currencies, further very large seigniorage gains would be transferred away from society as a whole. Governments will certainly not welcome this at all.

Regulators are also worried that unsuspecting private individuals may be sucked in to a bubble in an asset that has no underpinning for its price. Decades ago, Milton Friedman established that, if private currency creation were to be permitted, then competing providers of new currencies would emerge until the price of the currency had been reduced to the marginal cost of its creation, which for paper currencies is close to nil.

Tyler Cowen and Brad DeLong say the same could happen to Bitcoin, with new market entrants offering similar capabilities and driving the price towards zero. Supporters reply that this misses the network advantages that Bitcoin already enjoys from its first mover status, giving it the ability to fend off competition in the same way that the winning social networks have done. The outcome is extremely unpredictable. Regulators are concerned about small investors becoming exposed to these risks, especially since the entire legal framework applying to virtual currencies is also highly uncertain.

Issues for monetary policy

These micro-economic regulatory issues have driven the response of the authorities so far but, in the longer term, the successful emergence of a major virtual currency would raise issues for monetary policy more widely. It is possible to imagine Bitcoin displacing some failing currencies completely, like the US dollar did in Zimbabwe.

In an extreme case, this could even happen to the major currencies. We would then need to contemplate a future where many transactions in the major economies might be denominated and transacted in virtual currencies. We would have entered Paul Krugman’s nightmare world of a virtual Gold Standard (a dreamland for libertarians), with discretionary domestic monetary policy ceasing to exist.

But this looks very far fetched. The list of businesses currently accepting Bitcoins is estimated by Brian Wesbury to be only one hundredth of one per cent of US GDP. The current dominance of the dollar and the euro in their respective jurisdictions represents a very stable behavioural equilibrium that will be extremely hard to shift, unless a calamity like hyper-inflation or a political upheaval intervenes first. Such disruptions are, we must hope, not a realistic possibility.

What is perhaps a little more realistic is an interim world, in which a virtual currency is used as a vehicle that enables efficient exchange for many transactions, but where prices and wages throughout the economy continue to be denominated in traditional currencies. This would be a major inconvenience for the central banks, with their power and seigniorage revenue declining, but it would not put them out of business altogether.

To get even that far, however, the winning virtual currency would need to be stable against the dollar and the euro, so that people are happy to hold the newcomers in their virtual wallets [1]. This stability has certainly eluded Bitcoin so far:


Can such a volatile virtual currency really threaten the status quo of the global monetary system, all the way down to its very core? We have learned never to say never in the extraordinary world of the internet. But the combined governments and central banks of the major economies control the legal systems, financial regulation and legal tender laws. They represent a extraordinarily powerful set of interest groups for the techies to overcome.



[1] Many economists have pointed out that there is a contradiction between the rapidly rising price of Bitcoin, as a store of value, and its likely success as a medium of exchange. See Jean-Pierre Landau for example.

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