Saturday, April 27, 2013

Fed power limits after bitcoin (part 2)

The basic idea expressed by if some economy somewhere experiences hyperinflation and responds with de facto adoption of bitcoin (or some other similar crypto based currency), this would stabilize the value of that currency and engage network effects that would nearly guarantee that all subsequent currency changes would choose the same crypto currency, eventually making it the dominant strategy and crowding out all national fiat currencies. Reading that post got me thinking.

I think of bitcoin as a virtual commodity. I was curious about what effect it could have on central bank policy effectiveness while it is still marginal. I now think this boils down to the question of what effect mutual fund-style checking accounts have on central bank policy effectiveness, since those sorts of accounts already use non-monetary assets as if they were part of the payment system. So the question is more general and less interesting. The spread of money market mutual fund accounts with checking privileges that happened in the 1980's did not particular rein in the federal reserve.

Bitcoin has two uses currently. People can use bitcoin to make anonymous transactions, with no paper trail and ignoring national boundaries and legal restrictions. Bitcoin transfers may be less expensive than other transactions, even with a paper trail, by reducing or eliminating bank transfer fees. These provide bitcoin with value, but they will disappear if people fear a cash too much. If we ignore issues around hassling with the mechanics of the transfers, the minimum value of bitcoin to a particular person equals the value of the fee that it avoids or the value of avoiding a paper trail. . 

I think it is interesting that bitcoin is so easy to transfer, whether locally or internationally. I guess I am concluding that even in a severe hyperinflation, bitcoin would not be likely to replace dollars. But the d
ollar is a special case because it is the default global reserve currency. Currency boards using the dollar as the reserve currency seem like the current alternative to national fiat currency, and are sometimes used to end or avoid hyperinflation. Under what sorts of circumstances might a government experiencing hyperinflation create a currency board based on bitcoin rather than dollars or euros?

Can a commodity whose value in terms of other commodities is varying wildly become the unit of account? How much variation in value can a unit of account tolerate before it breaks down or is replaced?

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