By Prof Jayanth Varma
I believe that everybody who is interested in money should study the digital currency Bitcoin very carefully because monetary innovations can have long lasting consequences even when they fail miserably:
- Chinas experiments with paper money ended in inflationary disaster (as almost all fiat money appear to do), but it succeeded in replacing Chinas long standing bronze coin standard with a silver unit of account (see for example, Richard von Glahn (2010), Monies of Account and Monetary Transition in China, Twelfth to Fourteenth Centuries, Journal of the Economic and Social History of the Orient, 53(3), 463-505)
- Johan Palmstruch who brought paper money to Europe and founded the worlds first central bank (the Sveriges Riksbank of Sweden) was sentenced to death. Though he was reprieved, he still lost everything and ended up in jail.
There is little doubt in my mind that digital currencies represent a vast technical and conceptual advance over the currencies in existence today. This would remain true even if Bitcoin implodes in a collapsing bubble or is destroyed by technical flaws in its design or implementation.
Nemo at self-evident.org has an excellent ten part series providing a gentle introduction to all the mathematics that one needs to understand how Bitcoin works. This is a good starting point for somebody wanting to go on to Satoshi Nakamotos seminal paper introducing the idea of Bitcoin.
From a finance point of view, what is most interesting about Bitcoin is that it is perhaps the first currency to be designed with a strong deflationary bias.
There is an upper limit on the number of bitcoins that can ever be created even lost bitcoins cannot be replaced unlike normal central banks that replace worn out notes with newly printed ones. In paper currencies, if I lose a currency note, somebody else probably finds it, and so the note remains in circulation. By contrast, Bitcoin is so designed that if the owner loses a bitcoin, the finder cannot use it, and so the lost bitcoin ceases to exist for all practical purposes. (If you are puzzled by the apparently inconsistent capitalization of bitcoin/Bitcoin in this paragraph, you may want to read this).
Bitcoin is designed to combat deflation by using smaller and smaller denominations. | Photo Courtesy: PixabayWhile most fiat currencies end up printing notes in higher and higher denominations to combat inflation, Bitcoin is designed to combat deflation by using smaller and smaller denominations like milli bitcoins and micro bitcoins all the way down to the smallest unit named the Satoshi which is equivalent to 10 nano bitcoins. As a result, the zero interest rate lower bound could be an even more serious problem for Bitcoin than for existing currencies.
One theoretical possibility is that the deflation overshoots significantly so that the currency can experience a mild inflation from that point onward somewhat on the lines of the Dornbusch overshooting model. But for that to work on a sustained basis, there would need to be periodic bouts of intense episodic deflation. The sharp appreciation of the bitcoin in the last few weeks in response to the Cyprus crisis suggests one way in which this could happen, but that would be a nightmare to model.
Prof. Jayanth R. Varma is a professor of finance working mainly in the field of financial markets and their regulation. He is currently a director on the Board of Infosys BPO Limited and Gujarat International Finance Tec-City Company Limited. He has carried out extensive research in the field of Indian financial markets and finance theory and published extensively in Indian and international journals. He has also authored extremely popular books on portfolio management and on the Indian securities scam.
This article was originally published on Prof. Jayanth R.Varmas blog.
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