Sunday, December 08, 2013

Bitcoins and alternate currencies : some speculation

Greenspan seems to say that bitcoins are a bubble. Insofar as he is referring to them being prone to Tulip-Mania like irrationally high price rise and subsequent price fall, he is probably right. However, in claiming that they have no ‘basis’ and are hence a bubble is conceptually incorrect. This is because implicit in such a claim is another – that the ‘real’ currencies are not like this and have a more solid ‘basis’. In fact, they don’t. All modern currencies are fiat currencies. They do in fact have a stronger basis in the central bank, banking system and the home economy. However, conceptually they are no different than a widely accepted form of payment.

That is not to say that bitcoins are on their way to become an alternate currency anytime soon. However, that does bring forth an important question. How does something become a currency? Or less ambitiously, how can something like bitcoins in the modern world become a currency? (The former is too general a question and is very hard to answer. The latter is easier due to the particularization afforded by placing it in the current context.)

It boils down to development of a critical mass of individuals and organizations accepting something as a means of payment. Why they would do so is of course the next question. That has varied answers. Broadly though, I can think of the following three.
1. The (perception of) failure of the currently accepted currencies in some way – massive inflation worries is one possibility, difficulty in online payments is probably another, perception of over-regulation, lack of faith in banking system which backs most of the currency besides the central bank.
2. The opportunity to carry out some project not feasible in the current context.
3. Speculation over the wider acceptance of the new currency
The first and second motives are based in themselves. The third is a transient motive. However, the interplay among these has implications for whether something becomes a bubble and bursts or gets accepted as a real currency.

The question of critical mass is crucial. Currencies have tremendous network effect. If more and more people start accepting a currency, that in itself becomes a strong reason for even more to accept. The reverse also holds. One place where this is being played out even now is the status of Dollar as the reserve currency and the currency of choice for international trade, especially in oil. Below the critical mass, the people trading into the currency for the third motive above will quickly abandon it. With values falling, those in first two motives will also be forced to stop dealing in it.

This is where the institutional framework backing a currency and the economic interests served by it become crucial. If the currency manages to do something very useful for a sufficiently large group of people and organizations, they would try to find a way to make it work. In parallel, if the institutional framework for a currency is well developed and has a sponsor in a suitably empowered entity, it can grow.

Probably the most important element of the institutional set up is that of seigniorage. This is the privilege that comes to the ‘issuer’ of a currency, if there is one. In the gold standard currencies, there is no ‘issuer’ since everything is backed by equal value of gold. In the fiat currencies’ case, the central banks and hence their respective governments are the issuers. (Tangent: Rothbard describes brilliantly the evolution of the federal reserve in the US and the interaction between governments and central banks and monetization deficit etc.)

If the issuers get greedy, inflation ensues and can quickly become hyperinflation (Germany, Poland, Zimbabwe). I don’t know what the issuing mechanism for bitcoins is. I am sure something this obvious has already been dealt with and seigniorage hopefully taken out or made transparent. However, if and when the stature and acceptance of the currency grows, these worries might start haunting the users. It is interesting to draw a parallel with the growth of modern currencies and their convertibility into gold. Till as late as second world war, there was a constant tension between users and issuers of the currencies – the users routinely converting their currency holdings into ‘species’ (a term used for gold and silver) and issuers suspending ‘specie payment’ every now and then. 

For bitcoins, Dollar is the ‘specie’. As the users of bitcoins try to conduct transactions outside the regular users of bitcoins, they will need payment in ‘specie’. This is a crucial juncture. If the non-users of bitcoins keep insisting on payment in ‘specie’, the critical mass of bitcoin users may not grow much – although the legitimacy afforded by the notional acceptance of the bitcoins in the outside world is quite comforting for the present users to stay put. On the other hand if the non-users start to keep the bitcoins and postpone conversion, that could really provide a strong boost to the growth of bitcoins. The non-users thus become users or at least part-time users (they don’t actively transact but store bitcoins for speculative reasons.)
The case of a car dealership accepting bitcoins for payment is thus interesting. Equally interesting is the ban imposed by China onpayments using bitcoins.

The growth of capitalism and government spending in 19th century and early 20th century created the basis for the central banking and modern banking system that we know today – along with the fiat currencies that they support. The growth of internet in 21st century might be able to support a new form of currency – which is as unlike the current currencies as these current currencies were to gold back then!