As an example, assume someone goes into a store to buy a can of soda. At the front counter, the customer pulls out his ledger book, crosses out his old cash balance, and writes in a number $1.25 lower. The clerk at the counter takes the store’s ledger book, crosses out the store’s old cash balance, and writes in a number $1.25 higher.
Remarkably, no physical or electronic money changes hands.
In this system a decision had been made that the government would no longer be involved with creating or managing the country’s money, and that the banks would be closed. Individuals added their final bank statement balances to their cash on hand, and this was their starting cash going forward. Now that they had recorded their balances, they threw out their old physical cash and bank statements.
The traditional vessels for money are of no use and have fallen away: paper money, coins, bank accounts, and even gold. All that remains are numbers, which when added together for the system as a whole remain unchanging, allowing them to retain their value. How much of this simple decentralized system can we retain, and still satisfy the real world’s need for trust?
Let’s start off by electronically transferring the country’s currency directly to the people, who can hold it on their own computers (in the form of digital wallets), instead of on old-fashioned ledger books. Each digital wallet has a private key, which is used to interact with a decentralized digital network that is outside the control of any central authority; a network based on the Bitcoin model.
Bitcoin is the peer-to-peer digital currency that has been around since 2009. Its open source program that is distributed throughout the network is considered mathematically impossible to hack, and compensates those who contribute the processing power from their own computers to perform the tasks of maintaining the system. Transactions can be validated, yet are anonymous.
Unlike with transferring an entire currency to the Bitcoin model, the actual Bitcoin was released into a world with existing national currencies, so its initial money supply was small. This creates several challenges:
(1) The small size lends itself to price manipulation by buyers and sellers of the currency. The money supply will increase as more users come on board, before leveling off when it reaches a certain size. This leveling off will create deflation allowing early savers a built in gain on their Bitcoin currency. This expectation of gain lent itself to parabolic pricing. An October 2010 price of 6 cents per Bitcoin rose to a March 2011 price of 87 cents, a June 1, 2011 price of $8.67, and a peak at about $30 on June 10, 2011. Then a rumor caused a market crash, and the price is still dropping (the current price is approximately $5.)
(2) Bitcoin is not legal tender, so like Paypal there are many places where it is not yet accepted.
(3) The currency could be abandoned, due to competition from competing currencies using similar models, especially if a national currency converts to a system based on the Bitcoin model.
A national or world currency based on the Bitcoin model would not face these challenges, but there are other issues to consider.
National Currency Bitcoin:
One of the premises of Bitcoin is that it allows the currency to maintain its value, because government cannot change the size of the money supply. Before converting Bitcoin to a national currency, the government should clean up existing imbalances so that it is already used to matching taxes with spending. Government debt should be settled, and outlawed going forward. A balanced budget amendment to the Constitution should be adopted.
A national currency Bitcoin would require no government funding for its upkeep. Members of the network who use their own computer’s power to perform tasks that benefit the system are compensated in the form of fees collected from the transactions taking place on the system. (The original Bitcoin initially compensates with newly issued Bitcoins, but as the money supply increases and then stops growing, this form of compensation phases out and is eventually replaced by transaction fees.) This lends itself to an easy form of tax collection. While the system would still be outside the government’s control, transaction taxes could easily be collected at the same time maintenance fees are deducted.
So far, the Bitcoin model seems ideal for a national currency. It is decentralized so the size of the money supply can’t be altered, and the network is mathematically hack proof, providing the needed trust. But let’s dig a little deeper regarding trust.
With Bitcoin, transactions are anonymous, and people can choose to use an escrow service when they are not sure if they can trust the other party. The system uses both public keys (which are broadcast throughout the network but contain no personal information) and private keys. The identities of the holders of the private keys on each side of a transaction cannot be matched with each other.
Each customer is responsible for safeguarding his own digital wallet (his private key), since unlike with a bank, there is no third party keeping track of it. If a customer loses it he loses his money, and it cannot be recovered. This can occur due to either theft or accidental data loss.
The rumor, which caused the value of Bitcoin to crash from its parabolic rise, was caused by a hacking incident. Although the Bitcoin network cannot be hacked, the computer of a customer or his agent can, since it holds the customer’s private key.
Each Bitcoin customer should make a backup of his digital wallet, and keep it in a separate, secure location such as a safety deposit box. This backup only needs to be done once; not after every transaction. Even so, where there is a national currency Bitcoin, this may be asking too much of people, since many people are not computer savvy, and everyone is forgetful at times.
People frequently need proof of payment; often realized after the fact. Transactions through traditional banks provide an excellent paper trail, but Bitcoin provides none.
Computers are ideally suited for tracing stolen funds, recovering lost data, and keeping records of transactions. These are all functions that instill trust in a currency. It is ironic that Bitcoin, which is otherwise a showcase of modern computer application, fails in these areas. While this makes it unsuitable in its present form as a national currency, the development of digital currency is still in its infancy, and Bitcoin’s issues involving anonymity may eventually be resolved.
There are many who consider anonymity to be a virtue of Bitcoin. People who want to perform transactions anonymously can simply use the original Bitcoin or other currency that is introduced based upon its model. Now that the model has been introduced, it will always be around, since by definition it is beyond the control of any central authority.
Next, read the PieEconomics essay titled: Fate of Banks and Physical Currency.