In the past couple of months, the value of Bitcoins has sky-rocketed from $250 to over $400. This rise can be partially attributed to investors who view the currency as a safer place to park their money relative to other investments. As central banks in the major economies attempt to artificially force growth through monetary policy, many are apprehensive about the tactics being employed. Whether it is the Chinese government manipulating their currency, Japan’s extremely low inflation, Europe’s substantial quantitative easing (QE), or the US’s combination of QE and low interest rates, the ripples of the 2008 economic collapse still force these major economies to cushion the blow by devaluing their currencies in the hopes of stimulating growth. These types of fiscal actions might provide short-term relief but at the expense of long-term stability. Bitcoins appear to provide an alternative stable currency in the fickle world of fiat currencies.
What is it?
Bitcoins are a “digital cryptocurrency designed to enable peer to peer financial exchanges without the involvement of a third party.” The concept of Bitcoins came into being in 2009 by an unknown individual or group using the pseudonym of Satoshi Nakamoto. The digital currency can be transferred from one party to another without the need for a trusted third party. Instead leveraging a distributed network, Bitcoins are digitally transferred swiftly, securely, and anonymously at a cost next to nothing.
In addition, Bitcoins have a global register for all to view. “Blockchains” or entries to this ledger can be added by any user and no one can erase it, thus ensuring fidelity. The network’s cryptography secures and ensures the integrity of transfers. As a result, the system allows for anyone to engage in transactions directly and worldwide.
The amount of Bitcoins created or “mined” are not infinite but rather governed by its protocol. Bitcoins are mathematically limited and cannot be altered without a change to the software, which requires the entire community’s consent. This provides assurance to those invested that an arbitrary body cannot devalue the currency by creating more of it.
Why is it important?
The concept of money has helped overcome the impediments and impracticalities of the barter system. One of functions behind money is to serve as a medium of exchange, which allows for more convenience and efficiency than the barter system.
In today’s major economies, central banks administer money through various monetary policies such as their ability to print it. Almost all currencies today are considered “fiat currency,” which means that a government has considered it legal tender but it is not backed by any physical commodity.
Fiat currencies usual accompany economic disasters. The problem typically is that these currencies are open target for manipulation, which provides short-term advantages at the expense of long-term stability. Fiat currencies are therefore more susceptible to inflation and even hyperinflation. Zimbabwe provides a clear example, albeit extreme, of how fiat currency can result in severe hyperinflation.
So how is it that Bitcoins are not considered fiat currency? Similar to almost all current currencies; Bitcoins do not possess an inherent value like gold does, but scarcity established by its protocol (a defined limit of 21 million Bitcoins) gives it an intrinsic value that fiat currencies lack. This production limit is expected to be reached around the year 2040. This limit creates a fixed money supply, which allows for the value of Bitcoins never to be debased through further production like fiat currencies.
One of the main counter arguments against Bitcoins are the deflationary pressures that the currency can place on an economy. Over time, technological advancement as well as capital investments will yield more goods in a given society. Thus with a fixed money supply, this equates to dwindling prices. Deflation typically leads to a population reticent to consume since prices will drop in the future. Hence, the movement of the money supply will slow down since the purchasing power of the individual only increases with time. This leads to the velocity of currency to decrease, which equates to a deflationary spiral.
But the main assumption behind this argument is everyone will save and wait whereas, assuming a reasonable market economy where efficiency is the goal, some will save and some individuals will borrow. Those who borrow to invest will pay a premium on the borrowed money and accept that risk associated with doing business. Everyone has different tolerances to risk and that will ensure Bitcoins are kept in circulation rather than hoarded. Therefore, the velocity of currency in a Bitcoin economy will remain constant rather than being volatile as it is in typical economies based on a fiat currency.
The new global currency?
The recent increase in Bitcoin can be partially attributed to the Chinese government allowing its citizens to exchange Yuans for Bitcoins. This reflects many investors’ belief that Bitcoins can serves as a long-term hedge and source of stability in a volatile economic climate especially as nations enter the digital age. As the global economy still recovers from the glut that the 2008 recession wreaked upon it, larger economies around the world are utilizing their monetary authority to continue to print money in an effort to stimulate growth. This continued printing will further debase their currencies. Smaller and developing nations will be more susceptible and harder hit with these monetary manipulations by larger economies. Even though Bitcoins will perhaps never replace a nation’s currency, it can serve as a reserve currency for developing nations as they hedge their bets against the devaluing practices of the larger economies.