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!
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