Beware nerds bearing algorithms. Virtual (or digital) currencies are all the rage, with Bitcoin leading the pack. Nobody seems to know who invented Bitcoin (or why) but it’s creator certainly knew a thing or two about cryptography, central banking and gold mining. Most of the publicity surrounding this new currency has focused on its use in the drugs trade: a key feature of Bitcoin is near total anonymity of its users which immediately makes it attractive to anyone keen to stay in the shadows. Completely unverifiable data is available which purports to show that digital currencies are overtaking more traditional forms of payment in the financing of cross border transactions.
Bitcoin is truly ingenious. Networks of computers compete and collaborate to solve mathematical puzzles in order to win prizes: newly minted coins. Those prizes are in fixed supply and will one day stop completely, thereby putting an upper limit in the total stock of virtual money. That’s the supply side: a bizarre mixture of the principles of central banking and gold mining. The demand side is less easy to describe: apart from crooks and cranks, why would anybody bother to switch old fashioned currency into something that is very difficult to understand? Bitcoins could represent a cheaper way of transferring money around the globe - representing a threat to one source of traditional bank profits - but it’s volatility and lack of transparency seem to me to be fundamental stumbling blocks.
US Senator Thomas R. Carper, Democrat of Delaware and chairman of the Homeland Security Committee (yes, it is seen in part as a security issue in the US, not just a financial puzzle) summed it up well, : "Virtual currencies, perhaps most notably Bitcoin, have captured the imagination of some, struck fear among others and confused the heck out of the rest of us, including me."
Money is weird - and not just for the obvious reasons. Few of us think we have enough of it but it’s familiarity lulls us into thinking we understand it. Without blinking, we accept intrinsically worthless pieces of paper in exchange for just about everything. In principle, this means that Bitcoin is no different to any other form of money. But governments demand their taxes in currencies that only they control; it will be a long time before the Revenue Commissioners accepts virtual currencies. More generally, it’s about trust and ease of use, neither of which is yet associated with digital currencies.
Money has been at the heart of many controversies in finance and economics. Modern day academics still fight bitterly over monetary policy: how much money should a central bank create? One argument is almost as old as money itself: do changes in the money supply affect real economic activity? If printing money only affects inflation, Quantitative Easing (QE) as practised on both sides of the Atlantic is unlikely to end well, according to die-hard monetarists at least.
In one sense, money is just like and other commodity: there is both supply and demand and something that brings the two together. Beneath these very simple concepts lies bewildering complexity. Thankfully, the mathematical pyrotechnics that go along with thinking about all of this are usually confined to the sealed monasteries of academic economics.
Unusually, in the bitter fight between schools of economists, there is tentative evidence of people beginning to change their minds. When QE began, there were dire predictions of an inevitable inflation disaster, none of which have proved remotely accurate. This new evidence has caused one or two prominent practitioners to think again (and has allowed Paul Krugman to say I told you so). Most significantly, a Federal Reserve Governor, Narayana Katcherlakota, has publicly switched his policy position: an opponent of QE, he now advocates doing even more. He deserves kudos for looking at evidence and for changing his mind as a result, something that is astonishingly rare. Imagine the Bundesbank's representative at the ECB, Jens Weidmann, doing something similar.
The growth of virtual currencies may be a function of simple distrust of current policies, a reflection, in part at least, that different central banks are now pursuing very different policies. It is noticeable that demand for digital money is strongest where monetary restrictions are high (China) or where trust in the local currency is low (Argentina). There is a strong sense amongst many market analysts that while the denouement may be years away, the euro remains stuck on an utterly unsustainable path. I don’t think that Bitcoin is the answer to all of this but where it is one of few practical alternatives, it may become even more popular.
