Haider Anwar Khan
Bitcoins have surged many-fold in value since last year. The concept is simple – use of peer-to-peer technology to operate and no central supervisory authority managing the transactions. Issuance of Bitcoins is carried out collectively by the network. Being an open source, Bitcoin’s design is public, everyone can take part and nobody owns or controls the Bitcoin.
What is it?
Developed in 2009, Bitcoin is a digital currency which can be used for personal or business transactions. As a form of payment service, Bitcoin has seen rapid growth as merchants have an incentive to accept it lower fee than credit cards. Bitcoins are created by a process called ‘mining’ whereby a complex mathematical algorithm needs to be solved.
Bitcoin’s pseudonymous creator, Satoshi Nakamoto (who could be a single person or a group of people), solved three key problem central to all currencies:
- How to limit the supply,
- How to stop the users from spending the same unit of currency over and over, and
- How to prevent the counterfeiting.
On the face of it, the idea is extremely intelligent and attractive and hence, the surge in the value of Bitcoin (see figure below).
Surge in the value of bitcoin
Source: Bloomberg
Those who loaded up early on Bitcoin have earned a tremendous return, with one Norwegian student who reportedly spent $26.5 “on the stuff” in 2009 and forgot about it until Bitcoin became the biggest thing on the internet in 2013 when he logged back to his bitcoin banking site to see his that his investment was worth $885,520.
Economic Foundations of Bitcoin
Form economy theory standpoint, the roots of bitcoin can be traced to Austrian School of Economics whereby Ludwig von Mises and Friedrich A. Hayek were huge critics of the existing fiat money system and interventions (such as recent quantitative easing and open market operations) undertaken by the government. This, according to Austrian School, exacerbated the business cycles and volatility, leading to higher inflation.
According to Von Mises and Hayek, expansion of bank credit as a result of low interest rates causes money supply to expand in the fractional reserve banking system, which in turn results in interest rates kept artificially low. Although this would lead to rise in investments and consumption in the short-term, however, over time, this widespread imbalance and expanded central bank balance sheet can no longer be sustained, leading to recession.
Hayek, in his influential publication, Denationalisation of Money (1976) posits that governments should not have a monopoly over the issuance of money. Instead, he is of the view that any currencies able to guarantee a stable purchasing power would eliminate other less stable currencies from the market. Such a competitive system would result in highly efficient monetary system where only stable currencies would coexist, according to Hayek (1976).
In line with the principles of Hayek on monetary policy, the supporters of Bitcoin share similar ideas.
- They see bitcoin as a good alternative to ending the monopoly, which central banks have on the money supply and supply of money.
- Investors in bitcoin notice similarity between bitcoin and gold standard period, which also happened to be the most stable economic period in the modern financial history.
- Bitcoin investors are big proponents of existing fractional reserve banking system.
On the other hand, there are two key differences between Austrian school and the characteristics of bitcoin.
- Bitcoin has no intrinsic value like gold and instead, and instead, comprises of mere bits stored in the computer.
- The system fails to satisfy the “Misean Regression Theorem” according to which, the money is accepted not as a result of government pronouncement, but because it has its roots in a commodity expressing a certain purchasing power.
Monetary aspects of bitcoin
As bitcoin is a decentralized system with no central monetary authority, the new money is created and stored into the system only through the mining activity, whereby complex algorithms need to be solved. Therefore, the supply of money does not depend on the monetary policy of any existing or virtual central bank. According to Bitcoin website, the scheme has been devised in such a way that the money supply will develop at a predictable pace (see figure below).
Source: Bitcoin
The algorithms to be solved become increasingly complicated, which would lead to bitcoins generated per block reducing geometrically, with 50% reduction every four years. The result is that number of bitcoins in circulation will reach 21 million by 2040, after which it will stop growing.
Role of central banks
Although the rules of virtual currency game have yet to be decided, the idea is being embraced at the highest levels of Finance. Ben Bernanke, the former Chairman of the Federal Reserve said that digital currencies “may hold long-term promise”.
Central banks worldwide have expressed increased scepticism on the future of bitcoin, as well as warned their citizens to exercise caution in using the virtual currency. Just like a rise in price of precious metal like gold, rise in the value of bitcoin indicates to central bankers that investors are losing trust in the currencies (which are backed by the central banks). Therefore, it is not in the interests of any central bank that currencies such as bitcoin gain popularity amongst investors.
This is particularly the case in contemporary macroeconomic environment where monetary base of major central banks such as Federal Reserve, Bank of England and Bank of Japan have expanded rapidly, whereas the supply of gold and bitcoin is finite, indicating their potential attractiveness to investors from the limited supply standpoint.
In order for the bitcoin to gain traction with big investors, it is vital that bitcoin be regulated, so that these institutional investors (mainly pension funds and insurance companies) could potentially take the currency more seriously as a ‘store of value’ and ‘unit of account’ only after a credible regulatory procedure has been adapted. As regards its regulation, it is not so straightforward to regulate bitcoin, as recently found by Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) officials, due to absence of a central issuer or network operator to regulate.
Arguably, greater attention from regulators such as SEC and CFTC, along with Financial Conduct Authority (FCA) and Prudential Regulatory Authority (PRA), coupled with greater combined action from regulators globally would mean that a framework is likely to be put in place for consumer protection and for the future prospects of the bitcoin.
Haider Anwar Khan holds a Masters in Finance from University of Cambridge, United Kingdom and works in investment banking industry in London. Haider has a keen interest in global macroeconomic situation and invests in various asset classes in personal capacity. You can reach him at haider.a.khan1@googlemail.com
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