As we consider the digital-currency phenomenon that is Bitcoin, bear in mind that there are, broadly speaking, two accounts of the origin and history of money. One is elegant, intuitive and taught in many introductory economics textbooks. The other is true.
The financial economist Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, laid out the two views in a 1998 paper, "The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas."
The first view, the "M View," is named after the Austrian 19th century economist and historian Karl Menger, whose 1882 essay "On the Origins of Money" is the canonical statement of an argument that goes back to Aristotle:
As subsistence farming gives way to more complex economies, individuals want to trade. Simple barter (eight bushels of wheat for one barrel of wine) quickly becomes inefficient, because a buyer's desires won't always match up with a seller's inventory. If a merchant comes through the village with wine and all a farmer has to offer is wheat, but the merchant wants nuts, there's no trade and both parties walk away unfulfilled. Or the farmer has to incur the costs of finding another merchant who will exchange wheat for nuts and then hope that the first merchant hasn't moved on to the next village.
But if the merchant and the farmer can exchange some other medium, then the trade can happen. This medium of exchange has to be what Menger calls "saleable," meaning that it's easily portable, doesn't spoil over time and can be divided. Denominated coins work, shells and beads also fit the bill. So do cigarettes in POW camps and jails and Tide laundry detergent for drug dealers. This process, Menger argues, happens without the intervention of the state: "Money has not been generated by law. In its origin it is a social, and not a state institution."
Goodhart points out, however, that Menger is just wrong about the actual history of physical money, especially metal coins. Goodhart writes that coins don't follow Menger's account at all. Normal people, after all, can't judge the quality of hunks of metal the same way they can count cigarettes or shells. They can, however, count coins. Coins need to be minted, and governments are the ideal body to do so. Precious metals that become coins are, well, precious, and stores of them need to be protected from theft. Also, a private mint will always have the incentive to say its coins contain more high-value stuff than they actually do. Governments can last a long time and make multi-generational commitments to their currencies that your local blacksmith can't.
But why oversee money creation in the first place? This brings us to the second theory of money, which Goodhart calls the "C View," standing for "cartalist" (chartalist is a more common spelling). To simplify radically, it starts with the idea that states minted money to pay soldiers, and then made that money the only acceptable currency for paying taxes. With a standard currency, tax assessment and collection became easier, and the state could make a small profit from seiginorage.
The state-coin connection has far more historical support than Menger's organic account. As Goodheart points out, strong, state-building rulers (Charlemagne, Edward I of England) tend to be currency innovators, and he could have easily added Franklin D. Roosevelt's taking the U.S. off the gold standard in 1933 or Abraham Lincoln financing the Civil War with newly issued greenbacks. The inverse is true too: When states collapse, they usually take their currencies with them. When Japan stopped minting coins in 958, the economy reverted to barter within 50 years. When the Roman Empire collapsed in Western Europe, money creation splintered along new political borders.
If money came about independent of states, as according to the M View, one would think it would outlast transient political structures. Historically, however, this tends not to be the case, a strong argument in favor of the C View.
How does this relate to Bitcoins? The electronic currency, introduced in early 2009 and popular with libertarian geeks, online gamblers and Internet-based drug dealers, is having its moment. Perhaps influenced by the banking crisis and deposit haircuts in Cyprus, Bitcoins have seen their value skyrocket in the past month, from around $33 a Bitcoin on March 3 to just over $140 today, and more than doubling in the past two weeks.
Although the creators and heavy users of Bitcoins tend to be skeptical of the security and value of state-issued fiat currency, the state-centered account for how money came about actually helps explain why Bitcoins have been fairly popular. Only with powerful computers and sophisticated digital cryptology can a private currency come close to working along side traditional monies.
If the requirement for money, whether it be metallic coins, paper backed by coins or paper backed by government promises, is that it has to be portable, durable and divisible, then Bitcoin fits the bill.
An open-source program run by computers all over the world creates Bitcoins at a predetermined rate. Each "network node" -- a group of networked computers -- solves a complicated math problem requiring a fairly large amount of computer power and is rewarded with 25 Bitcoins. The program is set up so that there will be 21 million mined Bitcoins by 2140, and then it stops (there are about 11 million Bitcoins in circulation today).
Each transaction has a unique digital signature so that everyone in the network can keep track of every Bitcoin and prevent counterfeiting or double-counting. Because the number of new Bitcoins is set to grow at predetermined rate, their value can't be diluted or inflated away, they are far more portable than normal currency for use in online transactions, and they can be denominated down to 0.00000001, a "Satoshi" (named after Bitcoin's pseudonymous creator, Satoshi Nakamoto). This has all the properties of a medieval mint -- security, limited supplies, and trustworthy denominations -- but is entirely decentralized.
It's a remarkable success, but it won't be the future of money. Even putting aside security problems -- not surprisingly, a digital currency is a favorite target of hackers -- there's the potential that Bitcoin will turn from a way of doing anonymous, simple digital transactions and into a speculative-asset investment item, especially if it continues to soar in price. That might promote hoarding of Bitcoins by early adopters and choke off the marketplace. Although transactions haven't fallen off a cliff yet, a currency whose value is distinctly bubble-tastic is not something that even digital libertarians will readily spend.
Here's where a state could easily step in by just ... printing more money, so that economic activity is not choked off by scarcity or hoarding. This would be totally consistent with the C View, where money is created by states to facilitate economic activity. But since Bitcoins can only be produced at a predetermined rate, deflation is a constant possibility, or that Bitcoins turn more into a commodity people buy than a currency people use.
Even if Bitcoin remains a niche item for online libertarians, it is still a potent lesson in monetary economics. Call it the B View.
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