Whenever there is global economic instability the Forex market becomes the hot war zone for currencies. Almost all currencies come under focus and closely monitored by various people for their performance. The Ministry of Finance of different nations along with their central banks are under pressure during such period to stabilize the currency and take steps towards it. Heated debates between economists, financial experts and politicians on monetary policies becomes a routine topic of discussion in prime time news broadcast. Its only during monetary crisis that the general populace start to pay attention to money and currency. This is the time when people begin to question what is money, what is currency and the role it plays in our lives. Mostly common mistake of the people in general is that they believe money and currency is exactly the same thing. In recent times due to the economic crisis and after the Cyprus crisis; Bitcoins has caught attention of mainstream news and economist. Bitcoins was mostly known within the libertarian circle and usually a part of their discussions. Unlike government controlled central bank issued currencies like the US Dollar, Euro, Japanese Yen, Pound Sterling, Indian Rupees, etc; Bitcoins is a virtual digital currency based on P2P and cryptography technology which is not backed by any government or central bank. In fact Bitcoin is the only non government issued private currency in circulation. Bitcoins hit an exchange rate of US $147 for 1 Bitcoin recently. This valuation of Bitcoins given by the free market tells us that the demand for Bitcoins is very high and rising. It also shows that the market has accepted it informally as money. The rapidly growing popularity of Bitcoins has generated a lot of curiosity and interest among the general people as well as the economist. "What is Bitcoin" - is the most often asked question by people. It is natural for most of us to get confused with so many views and opinions of it. Moreover for the average person it is difficult to interpret and make sense the technical working of bitcoins with regards to crypto-anarchy and peer-to-peer networking. The economist and financial experts have their own opinions to further complicate the matter for the average person. Thus it will be wise to check the fundamentals of Money and Currency to get a fair bit of idea of Bitcoins.
Money and currency are interchangeable terms. They are at times used to denote money or to denote currency or wealth (capital). For example one can say that they have money in their wallet. What they actually mean is that they have currencies in their wallet in form of banknotes and coins. We also refer wealth as money. For example a person who owns commodities like land, car, cows, horses, warehouse full of wheat, residential building, gold, copper, steel plates etc and may not have any banknotes or coins still we say that person has money. In another case, lets assume there are two people from two different countries and their country uses different banknotes acceptable within their country as money. The two people have banknotes in their respective wallet which will be acceptable locally but not in each others country. For example a person residing in India where Indian Rupee is the national currency of India will consider Indian Rupee as money where as another person residing in Sudan will consider Sudanese Pound as money. It is quite possible that Sudanese Pound may not be recognized as currency in India and not acceptable as money. In other case like that of the US dollar, it may be universally accepted as a form of money. A Zimbabwe Dollar may not be considered as money anywhere in the world and instead be seen as completely worthless piece of paper. These differences in valuation of currencies are not accidental but natural phenomenon which is studied extensively and explained in theory by economists.
Money is a commonly used medium of exchange. People who want to procure goods and services to meet their ends often have to trade. They can exchange their goods directly as well as indirectly. In case of direct exchange, for example if you are trading 10 grams gold coin of 99% purity for 750 Kg of rice then in this case gold serves as the money to buy rice. For the rice seller, rice served as the money to buy gold. Direct exchange can take place only if they have matching preferences and suitable goods for the trade to take place. Here we can also say that gold and rice are currencies as well. 1 gram of gold has a purchasing power of 75 Kg of rice and the other way round. Direct exchange is also called the barter system. Assume another scenario where the rice vendor wish to buy gold but the gold vendor doesn't want to exchange his gold for rice and asks for a certain measure of wheat instead. The rice vendor then has to find a wheat vendor who is willing to trade wheat against rice. Once he is successful in doing so then only he can trade it with the gold vendor for the gold which he intends to buy. This is called indirect exchange where wheat served as a medium of exchange for the rice vendor to procure gold. In indirect exchange goods are purchased indirectly, with the help of another good, the medium of exchange. Gold, silver and other metals like copper and nickel were used as a medium of exchange for other goods as they were readily accepted across the globe. These metals were mined and sent to mints to be molded into coins of different dimensions. This is why we had ancient domestic and international trade where exchange of goods took against a specific number of metal coins. Prices of goods and services were quoted as the number of coins the goods will be sold at. The differences in dimension, weight and purity of the metals between two different coins of the same composition, especially those molded in different dimensions, were determined and the parity of exchange thus calculated. The use of goods as money is called as commodity money. The unit of money is denoted in currency.
I will quote from excerpts from Mises Wiki.
In the history of mankind, a great variety of commodities — cattle, shells, nails, tobacco, cotton, copper, silver, gold, stone wheels, and so on, have been used as media of exchange. In the most developed societies, the precious metals have eventually been preferred to all other goods because of their physical characteristics (scarcity, durability, divisibility, distinct look and sound, homogeneity through space and time, malleability, and beauty).
For a good to become money, it must have the physical properties and be considered valuable by itself. The price of a good, when employed only for nonmonetary purposes, is a good starting point to estimate its price for use as a money. Should the good stop being money, it will still have value due its other uses.
Historically, there were often several types of money used concurrently and for different purposes. For example, silver tended to be widespread in daily use, while gold served for larger and international transactions.
The emergence of money happens through a gradual process, in the course of which more and more market participants, each for himself, decide to use one commodity rather than others in their indirect exchanges. Thus the historical selection of gold, silver, and copper was not made through some sort of a social contract or convention. Rather, it resulted from the spontaneous convergence of many individual choices, a convergence that was prompted through the objective physical characteristics of the precious metals. Money selected in the free market. i.e. money that comes into use by the voluntary cooperation of acting persons, is also called natural money.
Ludwig Von Mises says:
Money is merely the commonly used medium of exchange; it plays only an intermediary role.
In time we know that commodity money was replaced by paper money. We can easily reason that it wouldn't be easy to carry around a huge pile of coins when we go out shopping and we can say this to be a big disadvantage in use of metal coins as money. This gave rise to institutions where you could keep your coins and get a paper receipts of various denominator for the coins. Anyone can get back the deposited coins by producing the paper receipt. This institution was called as bank and the paper receipt called a banknote. The banknote could be traded for goods and the banknote could be redeemed for the deposited metal in any branch of the bank. These banknotes were type of a legal tender or a promissory note. On the Indian Rupee you'll find a promissory clause by the Central Government of Indian as "I promise to pay the bearer a sum of X rupees" which meant that the banknote in the past could have been produced to demand a certain unit of gold to which the banknote was backed with. These paper receipts were called as money substitutes.
In recent times the paper money which used to be money substitutes for gold or silver became fiat paper money. Unlike the coins (or paper substitutes which are the same thing as they can be substituted) which has an intrinsic value; fiat currency doesn't have any intrinsic value. Intrinsic value is the market value of the constituent metal within a coin. For example there are low denominator coins like 1 anna, 1 paisa, 2 paise, 10 paise, etc coins no more in circulation. However the metal constituent in the coin still has a market value. We can melt the metal and make pipes or bars or rods out of it and sell them in the market. Fiat money is in a wider sense any money declared to be legal tender by government fiat (ie law). In a narrower sense, fiat money is an intrinsically useless good declared to be legal tender by government fiat. In other words the currency that we use today is simply pieces of paper which has value because we have faith in it and the government declared it as a legal tender.
Investopedia explains fiat money as:
Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith.
Most of the world's paper money is fiat money. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation's paper currency, the money will no longer hold any value.
Today the Indian Rupee is a fiat currency just like every other government issued currencies of the world. We'll discuss money and currency in detail in other future articles as it is beyond the scope of this article. However I would extend the discussion with few excerpts from the Mises Wiki:
Money did not and never could begin by some arbitrary social contract, or by some government agency decreeing that everyone has to accept the tickets it issues. Even coercion could not force people and institutions to accept meaningless tickets that they had not heard of or that bore no relation to any other existing money.
If anyone could produce paper money on their own, without backing by an underlying commodity, a hyperinflation would soon follow. Free entry into the note-production business must be restricted, and a money monopoly must be established. Fiat money can be only established via the development of money substitutes (paper titles to commodity money) - but only fraudulently and only at the price of economic inefficiencies.
If a state forces its citizens to use the money and pay taxes with it, it becomes universally desirable because no one wants to be in prison. The fiat money can be exchanged for specific goods, such as the ability to escape aggressive violence.
Unlike commodity money or money substitute receipts, there is no limit to the amount of fiat money that can be released for circulation. An economic system based on fiat currency will not have any upper limit to the volume of money or currency in circulation thus such economic system will be inflationary by nature. The government simply prints money and spends it until the point there is hyperinflation and the faith in value of the currency comes in question. The process of printing money and injecting the new money into the economy via easy credits with very lower interest rates and easy loans as well as by the means of government spending is called inflation. After a certain point when the purchasing power of currency decreases and prices of all goods rise its called hyperinflation. The Zimbabwean currency became defunct due to hyperinflation. The Zimbabwean government controlled central bank simply printed money till the economy collapsed. Remember that all Zimbabwean's are billionaires in terms of currency but without money or capital wealth in real sense. Therefore they are one of the poorest billionaires in the world. Today most of the world currencies including the US dollar is facing the problem of hyperinflation and stagflation. The inflationary practices of the government has resulted into a great recession which refuses to go.
Now we have a fair idea about different type of money and currencies we should start to look at Bitcoins. Bitcoins if we see doesn't fit into any of the above types of money or currency. Indeed Bitcoin is a new type of money or currency and the most recent one. Bitcoin is purely electronic money. It is a form of fiat currency. Bitcoins are not simply generated at will but there are complex algorithms based on energy and time functions which allows new bitcoins to be mined. Thus Bitcoins follows the concept of production of money. Like other currencies a bitcoin is divisible. One bitcoin is subdivided into 100 million smaller units called satoshi. It can be transacted as we transact other currencies digitally. Unlike other fiat currencies which do not have an upper limit on how many units of currency or the volume of money that will be in circulation, Bitcoins has a fixed hard limit of 21 million bitcoins which will be reached during the year 2140. There is a steady limit on the number of new bitcoins generated by the system. 25 bitcoins are generated in 10 minute block. Thus like gold, silver and other metals which are traditionally used as commodity money, bitcoins are scarce to find. Unlike the current fiat currencies, Bitcoin won't loose its purchasing power. In fact due to the limited imposed it will behave as a deflating currency whose purchasing power will gradually increase. Like every fiat currency, Bitcoin derives its value from faith and not law or that of being a legal tender unlike other fiat paper money issued by the government. Bitcoins are generally abbreviated as BTC like the US Dollar is abbreviated as USD or Indian Rupee abbreviated as INR. The Bitcoin.org states:
Bitcoin uses peer to peer technology to operate with no central authority; managing transactions and issuing Bitcoins are carried out collectively by the network. Through many of its unique properties, Bitcoin allows exciting uses that could not be covered by any previous payment systems.
Bitcoins have opened the door for private currency. In fact Austrian Economists had always believed that private currency will re-emerge and break the fiat currency monopoly. F.A. Hayek predicted the emergence of private money. He was extremely radical for free banking and private money. Hayek otherwise was pretty mild in his other views.
Hayek argues that, if only government obstacles were removed, the free market would provide the optimal quantity (and variety!) of monetary products. Just as the forces of competition lead to low prices and superior quality in every other line, so too would competition in the "fiat money industry" lead to monies that were infinitely better than their government-produced counterparts. For example, the private monies would be far more stable in their purchasing power, would be harder to counterfeit, and would be available in more convenient denominations.
Bitcoins has proved Hayek right. Many Austrian Economists as well as economists from other school of thought were skeptical about Hayek's views and if fiat money without being backed up by anything valuable or an assurance can never take off the ground. Bitcoins did that. It seems that Bitcoins took off due to instability in almost all currencies of the world since 2008, the debt crisis and political crisis. All government and central banks implemented the same policies. It has become a trend for almost all nations central banks to follow what the US Central Bank FED does. Moreover the Keynesian Economic theories prescribe inflation as a solution to most economic problems. Thus there left no fiat currency which was not highly inflated. Inflation destroys the purchasing power of money and savings of people. Normally people invest in commodity money like gold and silver whose prices remain stable for saving over time. This is the reason gold and silver are considered precious metals and are considered as money or wealth for thousands of years. Their purchasing power has remained more or less the same over the years. In other words gold and silver are used hedge against risks of hyperinflation destroying the purchasing power of fiat currencies. Even the central banks purchase and reserve stocks of gold and silver to hedge the risk. The government interventions to control the flow of gold and silver, market speculation, derivative market, bulk purchasing and dumping of gold by central banks, etc brought instability to the prices of gold and silver as well. The soundness in price of gold and silver diminished. Bitcoins remained the only form of money which offered the advantages of both fiat currencies and sound commodity money at the moment.
Does that mean Bitcoin is the best currency that man has come out till date? From Austrian Economics perspective which is the best type of currency is subjective. Bitcoins presently do not have any competitor of its kind. We cannot say for certain that other forms of digital currencies based on different mechanism will not come up in future. The Bitcoin technology will certainly be tested for its efficiency and capabilities. Software are imperfect. It might have security vulnerabilities or technical limitations which we do not know now. This might open the door way for newer form of digital currencies to come up. As Bitcoin is kind of fiat currency its value is simply based on faith. There will be many who won't have faith in Bitcoins. Thus a different medium of exchange needs to be employed for trading with those who do not accept Bitcoins. The state never wants to give up its monopoly over money. With the rise of demand and popularity of Bitcoin we will see government intervention rising to regain its control. If there are critical bugs in the algorithm or if hackers exploits a crack in the Bitcoin system then the faith put on Bitcoins will suffer. There is no certainty that the faith might completely wear off and Bitcoin will be worthless as it has no intrinsic value of its own. It is hence advisable to understand the risk-rewards of Bitcoins and go ahead accordingly. From the Austrian economics perspective all subjective valuation lies on the person. To use Bitcoin or not is simply upon you. We can simply attempt to understand and describe a particular phenomena but the decision on how to act and what to choose lies entirely on you.