Keeping Currency Valuable

The Bank of Canada is rolling out a new series of bank notes made of plastic. These polymer notes provide better durability than paper notes and, more importantly, will be harder to counterfeit. The US Bureau of Engraving has recently redesigned the 100 dollar note, too, in the ongoing arms race between governments and would-be counterfeiters.

Keeping counterfeit notes out of circulation is vital to the health of a paper currency. Think about a 20 dollar bill: it’s a dirty,  crumpled bit of paper that’s probably contaminated with cocaine.  However, we are willing to trade things of real value — like our labor — for them, because we believe that we will be able to exchange them later for something we value more.  When people lose faith in the ability to exchange money in the future, it quickly loses its value.

We’ve seen cases of this happening during hyperinflations, but counterfeiting has the same effect.  An interesting place to see this, and many other monetary phenomena, play out is in the bitcoin market. A bitcoin is a digital currency that was created to mimic a key feature of cash: anonymity. Bitcoins allow two parties to transact digitally without leaving an obvious paper trail. There is no central bank that prints bitcoins, instead, a new bitcoin is created by solving a difficult math problem on a computer, a process known as bitcoin mining. The math problem gets progressively more difficult, slowing down the supply of bitcoins.

Besides exchanging bitcoins for goods and services, bitcoins can be exchanged for other currencies through bitcoin exchanges.  The most popular exchange, Mt Gox, claims to handle 80 percent of all bitcoin transactions.  The figure below plots the bitcoin-dollar exchange rate.

The bitcoin-dollar exchange rate.

Since their introduction in 2009, the price of a bitcoin increased until June at a price near 30 dollars, when the currency peaked.  It now trades at about 4 dollars.

What happened?

In mid-June the user accounts at Mt Gox were compromised by hackers who sold millions of dollars of bitcoins, crashing the price.  The bitcoins that people thought they owned, and could exchange for goods and services later, were gone.  This brought about substantial uncertainty in the bitcoin itself: how would any person know if that bitcoin could later be stolen?  Or if their account could be closed on the exchange?  People fled the bitcoin — as they would any unstable currency — and prices never recovered.

The value of a currency with no intrinsic worth is only as good as its reputation, be it bitcoins, dollars, or poker chips from Caesar’s Palace.