Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments.  Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt.  When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply.  Under the gold standard, currency was redeemed for gold.  The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime.  That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it.  Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply.  Cryptocurrencies add a new category to our discussion of money.  As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’”  “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything.  The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks.  So what makes the value of the dollar relatively stable over long periods of time?  The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year.  Over the past 15 years the dollar’s value has declined less than 2% each year.  Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments.  Almost no Bitcoins are held to make payments as almost no one will accept them for payments.  But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency.  Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board”  The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods.  A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them.  If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price.  Such gold could be resold in the market at the higher price.  But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation).  Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars).  Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies”  Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank.  Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin.  The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140.  There are currently about 19 million in existence.  The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject).  Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins.  Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced).  When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether.  She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash).  “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system.  The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices.  Our government, wisely, generally did not make such decisions for use.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit). 

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so.  The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults).  Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins.  In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition.  Large and intrusive governments tend toward corruption.  The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency.  “Econ 101-Central  Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created.  I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules.  “A libertarian money”  

A Libertarian Money

Some people claim that libertarians like cryptocurrencies like bitcoin because they do not rely in any way on government. Perhaps those people meant “anarchists” because libertarians (to be safe perhaps I should just refer to my own views though I know that they are widely shared by other libertarians) accept the critical importance of government in defining and protecting property rights and personal safety. Bitcoin and most other cryptocurrencies do not satisfy the requirements for a good libertarian money because they do not satisfy the requirements for good money. This note explains why this is so and defines what is good libertarian money.

Are Cryptocurrencies the Answer?

Economists note the incredible power of markets and market prices in directing our scarce resources (our labor, capital, and technology) to their best uses. But prices are expressed in terms of money. The presumption, and actual reality, is that within each market prices are expressed in terms of the same money. It would not facilitate our choices if apples were priced at $6 per bushel and oranges at 3 bitcoin per bag. Presently, virtually nothing is priced in bitcoin. In addition, sellers don’t generally accept payment in a currency other than the one in which the good’s price is expressed, thus very few sellers will accept bitcoin in payment. Moreover, you can only accept bitcoin in payment if you have a bitcoin account together with the software required (a bitcoin wallet).

None of these are insurmountable barriers to growth in the use of bitcoins, but they do require strong incentives for putting up with and/or overcoming them. I explained the basics of bitcoins value in the following blog in 2014: “Cryptocurrencies-the bitcoin phenomena”   One incentive would be to replace the established currency in a market (a country’s legal tender) that has very unstable value (think Venezuela, Argentina, Brazil at various times in their histories). Another would be the need for anonymity (as is achieved with paper currency) that an illegal drug dealer or a political dissident in a repressive regime might require and find convenient.

Bitcoin’s claim to eliminate the trusted third party (bank accounting systems) required by existing electronic (digital) payments with bank deposits, is particularly attractive to libertarians.  But this claim is a gross exaggeration. To prevent the double spending of the same bitcoin, each transaction must be verified by so called miners (third parties you don’t need to trust) which takes five to ten minutes and very large amounts of electricity to process as miners race to solve increasingly difficult mathematical puzzles. Also, all transactions are very public on block chains, though accounts may be held under pseudonyms and are thus described as pseudo-anonymous.

Though actual bitcoin transactions have been made easier via the development of software wallets, many assign their bitcoins to exchanges (trusted third parties).  “The future of bitcoin exchanges”  The loss of a bitcoin owner’s password to his account is fatal and final. Those bitcoins are lost forever. But more deadly to the use of bitcoin as money (unit of account and medium of payment) is the volatility of its value.  The price of a bitcoin has ranged from just under $30,000 to over $67,500 over the last year. It is currently $39,268. Thus, payments of bitcoin generally involve temporarily purchasing them with dollars or some other stable currency and then exchanging them back to dollars as quickly as possible after receipt. The costs of these exchanges are often overlooked when claiming that bitcoin transfers are cheaper than traditional means of electronic payments. Most buyers and sellers of bitcoin are indulging in a form of gambling.

The Libertarian Alternative

There are monetary regimes, however, that satisfy libertarian preferences for minimal government involvement and manipulation. The Constitution of the United States provides the authority for such a regime in Article I Section 8 “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;” The classical gold standard was such a system. However, its “rules” were diluted when taken over by central banks. Moreover, the practice of actually buying and storing gold distorted its market price and was costly, flaws that are avoided in the system I propose below.

In the U.S. today, as well as every other country in the world, there are thousands of private companies that create and offer their own currency. Most of them are banks. While that would seem to make libertarians happy, thousands of individual bank producers of money would not constitute an efficient monetary system without rules and mechanisms for linking them into what we think of as one currency–in our case the U.S. dollar.

While the dollars deposited in my bank are my bank’s liability, I am protected from the bank’s failure by deposit insurance. Your bank accepts my deposits in my bank because my bank credits your bank’s account with the Federal Reserve (by debiting its account with the Fed). In short, the deposits at thousands of different banks are accepted by every other bank because they are all ultimately claims on the Fed. This is similar to the gold standard in which the money created by thousands of banks were accepted everywhere because they were redeemable for a well-defined amount of gold.

Libertarians want a currency and monetary system that can’t be manipulated by the government (central bank).  The dollar is now a fiat currency (redeemable for nothing–except a claim on, i.e., deposit with, the Federal Reserve). Thus, its supply is determined by the Fed’s judgement of what is needed for “price stability and maximum sustainable employment.” We libertarians want a currency that we each individually control the supply of. In short, we want a currency with a hard anchor (which was the case for the gold standard) supplied according to currency board  rules (which historically were violated by central banks nominally anchored by gold). Currency board rules require the currency issuer to sell or repurchase its currency at its fixed price in response to public demand. Any number of private producers of dollars redeemable at an officially fixed price for a well-defined anchor (gold, aluminum, a basket of goods, etc.) would result in a money supply determined by the public that was consistent with and appropriate for its fixed price to the anchor and that was fully interchangeable. The central bank would be passive. It would have no monetary policy (beyond the fixed price for the anchor). This seems like libertarian heaven.

I led the IMF teams that established the Central Bank of Bosnia and Herzegovina, which follows currency board rules. I have written a book about that experience:   “One Currency for Bosnia-Creating the Central Bank of Bosnia and Herzegovina”   or  “Amazon– One Currency for Bosnia” I also participated in Bulgaria’s adoption of currency board rules. The currencies of both countries are anchored to the Euro and their currency experiences have been outstanding. Their money supplies are basically regulated by market arbitrage. If the market exchange rate of the Bulgarian lev to the Euro rises above its official rate, it would be cheaper for the banks that issue lev to buy Euros from the Bulgarian National Bank thus reducing the supply of lev in the market and lowering its market price for Euro. See my blog on Bulgaria’s experience: “Bulgaria and the Chicago Plan

A Libertarian International Reserve Currency

What about cross border payments? In brief, cross border transactors have found it economical to price and settle transactions in a vehicle currency, usually the US dollar. The increasingly frequent deployment of sanctions enforced by restricting the use of the dollar has intensified the search for alternatives. See my more detailed discussion: “The Empire and the Dollar”  The search for alternatives to the dollar risks fragmenting the global market place as proposed by Russia’s Sergey Glazyev.  “A new global financial system”

The International Monetary Fund has already created such an alternative. An internationally established unit (anchor) is much less likely to be abused for national political purposes, but the IMF’s Special Drawing Right (SDR) suffers from some serious defects. However, these can be fixed. “Time for a New Global Currency”   Why the World needs a new Reserve Asset with a Hard Anchor

The SDR can be “fixed” in two stages. The first is to develop the private sector’s uses of the SDR unit of account (invoicing oil and other globally traded commodities in SDRs, borrowing and lending denominated in SDRs, SDR bonds and bills, and digital SDR deposits–eSDRs). See my more detailed discussion:  “Promoting Market SDRs”  As with national currencies, where hundreds of individual producers of the national currency are made interchangeable by being claims on the central bank, the market SDRs of many competitive producers would be interchangeable as the result of being redeemable for the official SDR of the IMF.

The second stage would require a reform of the IMF’s official SDR. Rather than allocating them from time to time to all IMF members, they should be issued according to currency board rules. In addition, the valuation of the official SDR should be changed from its current basket of five currencies to a small basket of homogeneous, globally traded commodities. The IMF’s existing rules for periodically adjusting the SDR’s valuation basket are transparent and appropriate and should continue to be used. In one sense, this would reestablish an improved international gold standard like system. It would be improved by replacing a single commodity anchor with a small portfolio of commodities and its supply would be improved by adopting the market driven rules of a currency board.  “Free Banking in a Digital Age”

A shift in monetary regimes?

By Warren Coats[1]

This Sunday, August 15, is the 50th anniversary of President Richard Nixon’s closing of the gold window as part of the “Nixon Shock.” “Fifty years later Nixon’s August surprise still reverberates”  He announced on that day that the U.S. Treasury would no longer redeem its dollars for gold at $35 an ounce. Over the subsequent few years, the world moved from national currencies whose values were anchored to the market value of gold, to currency values determined by central banks’ regulation of their supply relative to the market’s demand. The value of one currency for another floated in the foreign exchange market. Central banks have deployed various approaches to determining the supplies of their currencies and most have now settled on targeting an inflation rate (often 2% per year) in one way or another.

With the rapidly increasing interest in cryptocurrencies, some have asked whether we are on the brink of another monetary paradigm shift? Specifically, might the dollar be replaced as the dominant international reserve currency. To explore that question we need to understand how the existing monetary systems work and how the widespread use of cryptocurrencies might add to or change these systems.  

In describing the existing and potential future monetary systems, we need to distinguish “money” from the “means of payment.” Money is the asset that people accept in payment of debts or for the purchase of goods and services. The U.S. dollar and the Euro are “money.” The means of payment refers to how money is delivered to the person being paid. Do you personally hand dollar bills and coins to the Starbucks cashier, write out a check (bank draft) and put it in the mail, or electronically transfer “money” from your bank account to an Amazon merchant via eWire, Zelle, Venmo, PayPal, or some other digital payment service? Or perhaps you purchase goods and services with borrowed money (Visa, MasterCard, American Express) that you pay back at the end of each month or over time. Or if you don’t have a bank account (a form of digital money) you might hand-deliver physical currency to a Hawala dealer or a MoneyGram or Western Union office to be electronically transferred to their office nearest to the person you are sending it to, potentially anywhere in the world. If you are paying in a currency that is different than the one the payee wishes to receive, your currency will be exchanged accordingly along the way in the foreign exchange market.

Discussions of cryptocurrencies include both the latest and evolving means of payment (digital payment technologies) as well as new, privately created moneys such as bitcoin, Ethereum, or Ripple.  Private currencies vary enormously with regard to how their value is determined. By private currencies I do not mean privately created assets redeemable for legal tender, such as our bank accounts. When we speak, for example, of the U.S. dollar, we invariably include dollar balances in our bank accounts, dollar payments made via our Visa card, etc. These are all privately produced assets that are ultimately redeemable for Federal Reserve currency or deposits at a Federal Reserve Bank. They are credible claims on the legal tender of the United States. Most U.S. dollars are privately created.

The value of all money is determined by its supply and demand. The demand for money arises from its acceptability for payment of our obligations and the quantity of such obligations (generally closely related to our incomes). Within each country, its legal tender money (e.g., the U.S. dollar in the U.S.) must be accepted by payees. In particular, it must be accepted by the government in payment of taxes.  Truly private currencies (those not redeemable for legal tender, of which there are over 11,000 at last count) have a serious challenge in this regard. Very few people or businesses will accept bitcoin, or any other such private cryptocurrency. As a result, the demand for such currencies for actual payments is very low. The demand for bitcoin, for example, is almost totally speculative–a form of gambling like the demand for lottery tickets. Such private currencies are more attractive in countries whose legal tender is rapidly inflating or has unstable value (e.g., Venezuela). 

The acceptability of a currency in cross border payments raises special challenges. My currency is not likely to be the currency in general use in other countries. Someone in Mexico paying someone in Germany will generally have Mexican pesos and the recipient in Germany will want Euros. The pesos will need to be exchange for Euro in the foreign exchange market. It would be very costly for dealers in the FX market to maintain inventories of and transact in every bilateral combination of the world’s 200 or so currencies. It has proven more economical to exchange your currency for U.S. dollars and to exchange the U.S. dollars for the currency wanted by the payee. The dollar has become what is called a vehicle currency.

The economy of a so-called vehicle currency can be illustrated with languages. Two hundred and six countries are participating in the 2021 Olympic Games in Japan. To communicate with their Japanese hosts participants could all learn Japanese. It is unrealistic to expect the Japanese hosts to learn 205 foreign languages. But what about communicating with their fellow participants from the other 205 countries. For this purpose, English has become the default second language in which they all communicate. Unlike more isolated Americans, most Europeans speak several languages, but one of them is always English. English as the common language is the linguistic equivalent of the dollar as a vehicle currency.  

The rest of the value of money story focuses on its supply. Bitcoin has the virtue of having a very well defined, programmatically determined gradual growth rate until its supply reaches 21 million in about 2040. The supply today (Aug 2021) is 18.77 million. See my earlier explanation: “Cryptocurrencies-the bitcoin phenomena”  The other 11,000 plus cryptocurrencies each have their own rules for determining their supply, some explicit and some rather mysterious. The class of so called “stable coins” are linked to and often redeemable for a specific anchor, sometimes the U.S. dollar or some other currency. The credibility of these anchors varies.

The highly successful E-gold (from 1996-2006) is an example of a digital currency that had well-defined and strict backing and redemption for a commodity at a fixed price. “E-gold”  The supply of such currencies is determined by market demand for it at its fixed price–what I have elsewhere called currency board rules. I describe how currency board rules work in my book about establishing the Central Bank of Bosnia and Herzegovina:   “One currency for Bosnia-creating the Central Bank of Bosnia and Herzegovina”

The dominance of the U.S. dollar in cross border payments reflects far more than its use as a vehicle currency. Many globally traded commodities, such as oil, are priced in dollars and thus payments for such purchases are settled in dollars. Pricing a homogeneous commodity trading in the global market in a single currency makes that market more efficient (the same price for the same thing).  Making cross border payments in dollars (or any other single currency) also avoids the costly need to exchange one for another in the FX market. The dollar is most often chosen because its value is relatively stable, and it has deep and liquid securities markets in which to hold dollars in reserve for use in cross border payments.

So, what are the chances that current cryptocurrency developments might precipitate a shift from the dollar to some other currency and means of payment. Several factors of U.S. policy have heightened interest by many countries in finding an alternative.  Specifically, from my recent article in the Central Banking Journal on the IMF’s $650 billion SDR allocation:

Cumbersome payment technology. Existing arrangements for cross-border payments via Swift are technically crude and outmoded.

The weaponization of the dollar. The US has abused the importance of its currency for cross-border payments to force compliance with its policy preferences that are not always shared by other countries, by threatening to block the use of the dollar.

The growing risk of the dollar’s value. The growing expectation of dollar inflation and the skyrocketing increase in the US fiscal deficit are increasing the risk of holding and dealing in dollars.”  “The IMF’s 650bn SDR allocation and a future digital SDR”

Most central banks are upgrading their payment systems. But the Peoples Bank of the Republic of China (PBRC) is one of the most advanced in developing a central bank digital currency (CBDC), the e-CNY. However, it has little potential for displacing the dollar for several reasons. The Federal Reserve is also modernizing its payment technology, including exploring the design of its own CBDC, and can match China’s payment technology in the near future if necessary. More importantly, China’s capital controls, less developed Yuan financial markets, and less reliable rule of law make the Yuan an unattractive alternative to the dollar. These latter impediments do not apply to the Euro, however. “What will be impact of China’s state sponsored digital currency?”

Rather than looking for another national currency to replace the dollar, there are several advantages to using an international one. These include greater ease in making cross border payments and the reduced risk of political manipulation, or a national currency’s domestic mismanagement.  Bitcoin, for example, can make payments anywhere in the world without being controlled by any one of them. The serious drawbacks of Bitcoin’s blockchain payment technology might be overcome with one or another overlaid technology. But to become a serious currency, bitcoin must be dramatically more widely accepted in payment than it is now. Widespread acceptance in payments could generate the demand to hold them for payments, which would tend to stabilize its very erratic value. This seems very unlikely. A digital gold-based currency, such as the earlier E-gold, would enjoy the advantage of an anchor that is well known and that has enjoyed a long history. However, gold’s value has been very unstable in recent years. Aluminum has enjoyed a very stable price and elastic supply and will be the anchor for Luminium Coin to be launched in the coming weeks: https://luminiumcoin.com/

But the world has already established the internationally issued and regulated currency meant to supplement if not replace the dollar, the Special Drawing Rights of the International Monetary Fund. The IMF has just approved a very large increase in its supply.  “The IMF’s 650bn SDR allocation and a future digital SDR”  The SDR’s value is determined by the market value of (currently) five major currencies in its valuation basket. While all five of these currencies have a relatively stable value, the value of the basket (portfolio) of these five is more stable still. The rules for determining the SDR’s value and supply, as well as its uses, are well established and transparent and governed by the IMF’s 190 member countries. In short, the SDR is truly international. However, it can only be used by IMF member countries and ten international financial institutions such as the World Bank and the Bank for International Settlements.

While the SDR has played a limited useful role in augmenting central bank foreign exchange reserves, it has failed to achieve a significant role as an international currency because of the failure of the private sector to invoice internationally traded goods and financial instruments (such as bonds) in SDRs and the absence of a private digital SDR for payments. If the IMF is serious about making the SDR an important international currency it should turn its attention to encouraging these private sector uses of the unit. “Free Banking in the Digital Age”

In the long run the IMF should issue its official SDR according to currency board rules and anchor its value to the market value of a small basket of commodities rather than key currencies: “A Real SDR Currency Board”


[1] Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to the central banks of more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kazakhstan, Kenya, Kyrgyzstan, Serbia, South Sudan, Turkey, and Zimbabwe). He was a member of the Board of the Cayman Islands Monetary Authority from 2003-10. He is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  He has a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago.

Bitcoin Excitement

Interest in bitcoin is growing. Its promotors are generally good guys wanting to provide the world a better payment system. Its users are often bad guys happy to move their ill gotten money pseudo anonymously (though the Feds tracked down and recovered some of the ransomware paid in bitcoin by Colonial Pipeline). 

Ezra Fieser reports in Bloomberg on a fascinating effort in the El Salvadorian village of El Zonte to expand the use of Bitcoin for making payments.  [“World’s biggest bitcoin experiment is a surf town in El Salvador”]  On June 9th, El Salvador approved President Nayib Bukele’s proposal to add Bitcoin to the U.S. dollar as legal tender in the country (El Salvador does not have its own currency).  El Zonte has no bank, thus storing money and making payments of it from a smart phone wallet would be very attractive.

Michael Peterson is the acknowledged father of efforts to establish bitcoin in El Zonte. The requirements for its use are apps for acquiring, storing, and paying bitcoin on smart phones and the proliferation of people and merchants with such apps willing and able to deal in bitcoin. Peterson “used Wallet of Satoshi, one of the many existing smartphone apps created for small transactions using Bitcoin, which is notoriously impractical—expensive and slow—for everyday purchases.  As more stores began asking how they could accept Bitcoin, Peterson decided El Zonte needed its own app. The Bitcoin Beach Wallet, which launched in September, similarly uses technology that allows for small transactions.” [Bloomberg, ibid]

Bitcoin ownership and transactions are recorded on blockchains that are replicated thousands of times around the world and publicly accessible. Blockchain is a slow and expensive approach to record keeping, but avoids the so called “trusted third party” of, say, a bank account ledger. Thus, work arounds have been developed for small payments that can be spent without the slow and cumbersome mining that prevents double spending for digital currencies on distributed ledgers (e.g., blockchain).  Despite the touted attraction of avoiding a “trusted third party”, most bitcoin users hold them with exchanges such as CoinDesk. These exchanges also facilitate finding sellers for those wishing to buy bitcoin and buyers for those wishing to sell them. Bitcoin traders no longer gather in park meetings that brought buyers and sellers together. [“The future of bitcoin exchanges”]

But the value of bitcoin has been highly unstable. On April 15 Bitcoin traded at $64,829.14, rising unevenly from virtually nothing starting in July 2010. On May 23, it traded for $31,248.42 and as I write this it is trading at $34,616.24, not exactly a stable value.

Thus, bitcoin has not been used to fulfill one of the key functions of money, i.e., to set prices. Though a growing (but still relatively small) number of establishments in El Zonte will accept bitcoin, they all price their goods and services in U.S. dollars. Thus, before bitcoin can be used for payment, an exchange rate (bitcoin equivalent of the required dollar amount) must be agreed. 

To succeed and be widely accepted and used as a currency, the value of bitcoin will need to become much more stable. In fact, to be competitive with the dollar or other sovereign currencies, bitcoin will need to become more stable than its competitors. Improving payment technology can be used for the dollar or any other currency, so the issue is the currency itself rather than the technology for paying it.  See the very successful example of M-Pesa in Kenya. That technology is very unlikely to rely on the clunky blockchain. Even Facebook’s Libra (now called Diem) only pretended to use blockchain, stating that it intended to switch to blockchain in the future. [“Bitcoin, cybercurrencies, and blockchain”]

As explained in my first article on bitcoin written over seven years ago [“Cryptocurrencies-the bitcoin phenomena”] the value of bitcoin or any other currency results from the matching of its supply with its demand at a particular value. Achieving that equilibrium requires either an adjustment in its supply or in its value. Widespread use of bitcoin for payments (rather than just speculative investments) will create demand to hold it for future payments. Bitcoin’s supply is totally predictable. It is growing gradually to a maximum of 21 million units by the year 2040. The supply is currently 18.74 million. Thus, its value depends on what happens to its demand for payments.

While the demand for money (dollars or whatever) tends to be relatively stable in relation to income over moderate periods of time, it is subject to seasonal and other temporary short-term fluctuations.  In the search for a rule based monetary policy, Milton Friedman proposed that the money supply should grow at a constant rate (e.g., 3 to 5%) over time to match the increase in the demand for money as income grows.  But short-term (even day to day) fluctuations in money demand would have resulted in very volatile interest rates in order to keep money demand in line with the steadily increasing supply. Central banks around the world have generally targeted interest rates instead to allow short run adjustments in supply to short-run changes in demand. But setting and adjusting the policy interest rate can be tricky as well.

The ideal monetary regime is to fix the value of currency to something (such as gold, or a basket of currency as in the case of the IMF’s SDRs, or a small basket of widely traded commodities) and then allow the public to adjust the supply to match its changing demand for that fixed value. Such a system follows currency board rules. The central bank passively supplies or redeems its currency in response to the public’s demand at the fixed price. Such a system has been adopted by several countries as is described in detail in my book on the creation of the Central Bank of Bosnia and Herzegovina.  [“One Currency for Bosnia-Creating the Central Bank of Bosnia and Herzegovina”]

Even under the most favorable conditions of widespread use for payments, bitcoin would suffer the weakness of the Friedman rule. With no elasticity to its supply, a holder of bitcoin wanting to sell some would have to offer a price that another holder would be willing to accept and visa versa. Its value would remain volatile (though less so). It is hard to imagine bitcoin ever succeeding as a widely used currency. https://www.economist.com/finance-and-economics/2021/06/10/cryptocoins-are-proliferating-wildly-what-are-they-all-for?frsc=dg%7Ce