Bitcoin and the question of competing currencies

Bitcoin and the question of competing currencies

There has long been a debate about the option of governments allowing concurrent, or competing, currencies. The reason for this debate stems from the theory that such concurrent currencies would, through the market pressures of competition, lead to a more sound money system and more stable currencies in the long run. This advocate view is held most strongly by Austrian Economist Friedrich Hayek. The general argument states that since currencies would be allowed to compete, just as any other good, consumers would seek out the best investment; the one that is most stable and secure. This would encourage the backing of certain currencies with commodities to compete with fiat currencies (which the Austrian School believes are suspect to great inflationary pressures and political whims). Its opposition has most recently been led by the economist Milton Freedman. Freedman argues that the benefits of competing currencies would be less than expected, mainly because the process of establishing such a system would be inhibited by network effects and transition costs. Network effects refer to the theory that the value of money or a currency is partially derived from the number of other people holding that currency. Transition costs refer to the cost of both holding wealth in two different currencies and the costs associated with moving from one currency to another.

This has been proposed by many scholars and politicians before. Libertarian oriented individuals have suggested that allowing a commodity based currency to compete with the US dollar, and allowing the market to decide the value of the currencies would benefit stability. Recently, the first modern example of competing currencies took place in Somalia. After the collapse of Mohamed Siad Barre’s  regime in the Democratic Republic of Somalia, the Central Bank of Solamia collapsed, bringing about a system of four operating currencies. These included the Na’Shilling, the Somaliland Shilling, the Balwayn I, and the Balweyn II. However, this situation did not end the way that advocates such as Hayek hoped. Though Somalia had many other social and economic issues that could have affected the concurrent system, it appeared that the network effects and transition costs that Friedman suggested had taken place.  For instance the Na’Shelling circulated mainly within one clan and thus failed to gain significant usage by others in the country. This exhibited network effect limited ability to trade in the Na’ Shilling. In addition, even in the face of extreme depreciation, 67%, the Somali Shilling maintained its status as the dominant currency. This suggests that there were increasingly large psychological and economic transition effects.  Similar effects were present in the other currencies.

As was shown in the Somalia example, it appears the Milton Freedman was correct in that transition costs and network effects inhibit the system of concurrent currencies from establishing and functioning correctly. However, my opinion is that this may soon change. The creation of virtual currencies such as Bitcoin, eliminate many of the transition costs associated with concurrent systems as well as provide more of an opportunity for more wide spread usage.

In January of 2009 Bitcoin emerged as a new virtual currency. More correctly, it is defined as a cryptocurrency. The creation of the currency is the result of an open-source cryptographic protocol which is not linked to any central bank or government. Bitcoins are totally virtual (no tangible store of value) and can be transferred via computer or smartphone. They are essentially a new form of fiat currency. They act as any other means of exchange – you can exchange your Bitcoins for products, trade them like any other currency, and exchange them for other currencies in the market. This new cryptocurrency has many advantages such as its volume being capped at 21 million (to combat inflation). It is also produced using a stable algorithm which makes it impossible to create more money with little notice, which usually is thought to lead to instability in common currencies.

It is possible that this new cryptocurrency could solve or at least lessen the network effects and transition costs associated with concurrent currencies – making it a much more reasonable system within which to operate. Since Bitcoin, as well as other virtual currencies, can be obtained and stored via the internet, the cost of switching currencies is much less. No longer must an individual have to make their way to a currency exchange to make a physical transaction. Switching currencies becomes less costly also because you no longer have to pay the premium for a physical location and workers at such currency exchanges.  Furthermore, since Bitcoin is centered on the internet, both buyers and sellers are less likely to suffer from the negative network effects present in other cases of concurrent currencies. This is because people from all over the world now have the ability to possess this currency. It is not limited to a certain geographic location. Such a spread in availability makes the currency more likely to be used and desired because the quantity of producers and consumers using the currency has increased.

Though past examples have showed that concurrent currencies may only be desirable in an ideal world, it is possible that the emergence of virtual currencies such as Bitcoin, which reduce network effects and transition cost, will change this. The next few years will serve as the time period for this great currency experiment, shedding light of the long going debate of whether or not it is likely that two currencies can effectively exist at one time, competing directly against one another. Lastly, as the global economy continues to see low growth and instability in the US Dollar and Euro, we may see virtual currencies take a strong foot hold as a major medium of exchange.   This is not to say that virtual currencies will be a panacea for stability, only that their emergence is a great opportunity for us to try out a system of competing currencies.

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