Money need not be paper in the pocket. Money needs neither government nor regulatory approval. Money is more an adjective than a noun, a way to make trade easier, and holds no intrinsic value.
From the “electrum lumps of Lydia,” which passed from bag to bag (circa 650 BCE), shells, gold and specially inked paper have functioned as money. The latest innovation is the digital currency bitcoin. Critics howl that privately issued digital money could never replace the mighty U.S. dollar. But a quick tour through bitcoin's place in a theory of money offers investors a glimpse into the future and shows that, more than anything, the technology that underlies bitcoin can change the future of transactions.
SCROOGE AND MEDIA OF EXCHANGE
What counts as currency, if not the government stamp of approval? Three features distinguish those things that count as currencies: they trade easily, hold value and can be used to price a wide array of goods and services.
First, money is a liquid media of exchange. Nobody, except Scrooge, holds money for money's sake; we hold dollars, gold, or bitcoin because we plan to exchange such currency in the future for the other goods and services we desire. Throughout history, humans used the most marketable commodity available as money. Marketability arose from demand for use, divisibility without loss of value and transportability over large distances. In short, consumers prefer to exchange commodities that make trade easier.
Unlike present digital payment systems (e.g., Paypal), which require a third party to authenticate and track transactions, bitcoin is a direct, peer-to-peer exchange network: Bitcoin users can buy and sell among themselves, requiring no other intermediation.
Bitcoin is durable, divisible, portable and secure: a medium of exchange par excellence. The more that paired parties mutually consent to using a cheaper medium of exchange, the more liquid such a medium becomes. Even if bitcoin doesn't ultimately unseat the U.S. dollar, lower transaction costs give holders an incentive to use it.
WHAT MONEY MUST HOLD
The second feature of money is as a store of value. In other words, collective agreement on the fact that this “thing” will hold its value over time is a prerequisite for any “money.” On this point, governmental action bears directly on currency. If a political authority requires payment of taxes in a certain form of money, those under the regime typically prefer to transact in the publicly approved store of value. However, where public trust in official currencies erodes (Argentina, Zimbabwe, etc.), actors adopt other forms of currency, even if they are not officially accepted.
Take bitcoin, for example. No embargo or dictum forces those holders of bitcoin to continue holding the asset. Indeed, they do so only under the assumption that others value bitcoins enough to trade them for other goods and services.
'THAT'LL BE TWO BITCOINS, PLEASE'
Finally, to be a bona fide currency, a given commodity (or Internet good) must qualify as the unit of account: Actors in the economy will want to quote commodities in terms of the currency.
Today, the world uses U.S. dollars, not bitcoin, as the final unit of account for most international transactions. To move more seamlessly between less liquid currencies, banks typically perform international, cross-currency transactions in dollars. No matter the prices of the original and final currencies in the transaction (could be Peruvian sols and Polish zlotys), banks make dollar quotes to each other.
Final arrival for bitcoin would take the shape of brokers quoting the price of dollars in bitcoin — unlikely in the near future, but not impossible. After all, before World War I, international prices were quoted in British pounds. Don't be surprised if in the near future the inquiry arises at a local coffee shop, “Do you accept bitcoins?”
WHAT REALLY MATTERS?
Whether or not bitcoin gains wide acceptance, the virtual currency has important and ground-breaking technology embedded within it that could change the way humans transact. At its heart, bitcoin is less a currency and more a system for verifying person-to-person payments without the need for third-party verification.
Here's how it works. The bitcoin network consists of a publicly distributed ledger that documents ownership of all bitcoins in existence. The ledger is called a blockchain. A copy of this blockchain is publicly available on every computer in the bitcoin network. In the future, the ledger could be used for tracking ownership of anything: property, equity shares, royalties, etc. The ledger would leave a public trail of ownership, tracked in real-time and verified by a distributed network.
When someone sends a bitcoin to another as payment, the recipient broadcasts a message to the global network. Bitcoin miners verify that each transaction is the transfer of an actual bitcoin from one person to the other by checking their copy of the blockchain. Indeed, “miners” are not miners at all, but function instead as auditors.
Not just anyone can be a miner (verify transactions). Miners compete with each other by solving a complex mathematical equation to prove that they did the work to verify the transaction. In return for performing the verification task, they receive newly minted bitcoins as a transaction fee. The computing resources required to conduct verification become higher as the bitcoin network grows, slowing the growth in the supply of bitcoins and keeping them relatively scarce.
In the end, whether or not bitcoin becomes a currency that rivals the dollar may not matter. The technology behind it solves important problems faced by currency and payment systems. The bitcoin platform therefore could serve as a wonderful springboard for future monetary innovations.
Peter Beer is an economist at Payden & Rygel