Saturday, April 20, 2013

Matthew Ridley: Bitcoin as Synthetic Money

The impressive and articulate Matthew Ridley on his blog explains that Bitcoin is a form of synthetic money: 
Bitcoins resemble “commodity money”, like gold or cowrie shells, which rely on scarcity and indestructibility to be a good store of value. Real commodity money is vulnerable to inflation if there is suddenly a new discovery of gold — or deflation if there is suddenly a demand to use the commodity differently. In theory “fiat money”, such as we use today, avoids these problems — but governments have always removed the check on supply by printing money at whim to reduce debts.

There might be a way to cross fiat with commodity money and capture the benefits of both. Selgin calls this “synthetic commodity” money. Unlike fiat money it would have absolute scarcity; unlike commodity money it would have no non-monetary use. For example, a government could print paper money and then ostentatiously destroy the lithograph plates to show that it would never print any more.

In effect, this happened to the Swiss Iraqi dinar in the 1990s. Saddam’s regime used high-quality money engraved in Switzerland and printed in Britain. But during the first Gulf war in 1990 the supply dried up because of sanctions. Saddam began to print dinars at home, but these were easily faked, so they fell in value. The Swiss dinars remained in circulation for many years (though growing tatty) and held their value against the dollar.

Metaphorically, Bitcoin’s creators have destroyed the plates by making it impossible for anybody to change the programmed supply. So far that part of the experiment is succeeding, but Bitcoins are not yet ready for prime time. A friend who acquired some is sitting on a handsome profit, but finds the only thing he can exchange them for in his nearest city is chocolate.

Selgin points out that to get an exchange network going from scratch is hard enough when a new currency is fully compatible with established money, as in Birmingham; or when it consists of a commodity with other uses. But to do so using something with no non-monetary uses, so no one ought to want it at all except as a means of trade, should be almost impossible.

This only makes Bitcoin’s modest foothold even more impressive. An appetite for new kinds of money is there. The use of mobile phone credits as a currency in Africa, pioneered by M-pesa, is another example, and has had as jealous a reaction from central banks as Birmingham’s private coins did from the Royal Mint.
Read the rest here.

I would add that bitcoin’s evolution has also been a function, not only of as a cross between fiat money and commodity money, but also of the technology adaption lifecycle or technology diffusion via the S-curve.

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