Are Digital Currencies the Future of Finance? (Part 3/3)

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The fast rise of the Bitcoin has spurred controversy around the world because it challenges everything we think we know about money. This post is the conclusion of a series of three articles about Bitcoin and digital finance. In order to develop an informed opinion about digital currencies, you ought to understand the history of money. Therefore I will take you through a brief summary of how money works, and I will explain under which circumstances digital currencies can create a major change in the economic and financial landscape. You MUST read this from beginning to end.

What is money and where does it come from?

At its inception in the 7th century, paper money acted as a promissory note that the payee could redeem at the bank for a portion of the commodity backing the value of the note. Precious metals like gold, silver or copper have always been valuable commodities because of their practical use in the real world. At the time, paper money just represented a more convenient way to trade because of its portability. However, with the gradual removal of metals from the monetary system, banknotes evolved into fiat money, which is just paper, backed by nothing and with no intrinsic value. More particularly, since 1971, currencies are not backed by gold anymore. This means the only reason we still transact in say, Dollars or Euros is because they have been established as legal tender by governments, and people will be willing to exchange those currencies for goods and services they desire, as long as they trust the system.

The monetary system today

So the money bills in your wallet are essentially worth nothing. But because everybody within a geographic area accepts to transact with a certain currency, they have been established as a valuable asset. It is important to understand that the annulment of the gold standard has meant money could be created out of thin air, since its supply was no more limited to the amount of gold available. This in return had major consequences, such as:

1)   The depreciation of money: Central banks around the world have been drastically increasing the amount of money in circulation over the last decades. This measure has stimulated economic growth in western economies, through consumption and production. However the resulting inflation causes currencies to depreciate over time. In other words, 10 years from now, a dollar will buy you less goods than would the same dollar today.

2)   The centralization of the monetary system: Governments started playing an overwhelming role in the economy in order to control macroeconomic indicators like inflation, interest rates and exchange rates. Unfortunately some governments have abused this power and have damaged the economy, for example by printing money to pay for debt, to finance wars or to hold an unfair advantage in international trade.

3)   The explosion of credit: Because the fiat money system is less constraining than the gold standard, banks have been able to lend much more money to borrowers. Credit is a good way to stimulate the economy by increasing households’ consumption. However it also contributes to the creation of money, sometimes at a faster rate than the rate of economic growth. In countries like the U.S, this has accelerated the long-term depreciation of the Dollar.

Can digital currencies improve the current system?

Digital currencies have a lot of the desirable characteristics of money: durability, portability, divisibility and fungibility. However the fact that money is digital does not make it different (i.e. a dollar you transfer electronically is worth the same as a dollar bill you hand to the cashier in a store). For a digital currency to improve the economic and financial environment, it has to be implemented along with a different monetary system that will solve the problems of the current one, which almost all revolve around the depreciation of money. More precisely, to stay valuable over time, money has to be a scarce resource; and scarcity can be created by:

  • Limiting the amount of money available to people;
  • Backing the value of the money by a tangible asset like gold, silver, energy or any non-perishable commodity.

Some digital currencies like Bitcoin can only be produced up to a certain limit, and others like E-gold, have been designed under a commodity standard. I explained the main critics of models like the Bitcoin in ‘Bitcoin review: Pros and Cons’.  Now let’s take a look at commodity-backed currencies like the E-gold.

A note about E-gold and the commodity standard

Way before Bitcoin and it counterparts, the E-gold was a digital gold currency founded in 1996 and was the first successful digital currency system to gain a widespread user base and merchant adoption. Its value was backed by gold, making it a kind of representative money, like US paper gold certificates used from 1873 to 1933 and exchangeable for gold on demand under a fixed exchange rate. E-gold was a global currency, that could be used anywhere in the world. Unfortunately the U.S. government eventually shut down E-gold, after its users had become victims of several criminal abuses from third parties. The crimes included account hacking, phishing scams and Ponzi schemes like

It’s important to point out that like any type of commodity-backed money, the digital gold currency system has the following advantages:

  • Price Stability: Because the money supply can only grow at the rate that the commodity supply increases, inflation can be avoided and governments cannot manipulate (some would say stabilize) the economy by just printing more money.
  • Low exchange rate risk: A commodity standard provides fixed international exchange rates between participating countries and thus reduces uncertainty in international trade.

However a commodity standard has the following disadvantages:

  • The commodity standard is more advantageous for countries that produce a lot of it. So for example, countries with a lot of gold reserve will have a natural advantage in a gold standard system.
  • The scarcity of the commodity limits economic growth, and the resulting reduction in aggregate demand can cause deflation.
  • There could be run on banks if everyone decides to exchange their notes for gold at the same time, as seen in extreme circumstances like war or financial recession.

Conclusion: Are digital currencies the future of finance?

The ‘NO’

To date, governments have shut down a lot of the major digital currencies that have existed, because of security issues. Also, I believe the fact that digital currencies are generally issued by individuals or private organizations instead of central banks, puts a lot of legal and regulatory pressure on them, because of the high risk of criminal abuse and the difficulty for the government to trace the transactions. Therefore, whether it’s under a commodity standard or a limited supply system, digital currencies may never be widely adopted by the financial system if governments do not have any kind of control over them.

The ‘YES’

Today, despite the risk of criminal abuse, several digital currencies have been able to establish themselves as a store of value. This means there is a demand on the market, with people willing to recognize them as valuable assets that can be stored and retrieved over time to exchange goods and services. In addition, even if digital currencies are not widely used in mainstream finance, the fact that they are global and decentralized makes them:

1)   A very convenient method of payment around the world;

2)   A powerful tool that even citizens in the poorest economies can use, to gain more control over aggregate supply, demand and the redistribution of wealth in the world. I’m talking about the next generation of e-commerce, e-trade, crowdfunding, micro-finance and mobile money. I’ll let you imagine the rest.

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