Keeping Currency Valuable

December 29, 2011

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.

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.

4 Responses to “Keeping Currency Valuable”

  1. Stan Zin Says:

    Surprisingly, stable governments with low inflation can also experience problems getting people to use their “faith-based money” (did I just make up that term, or am I accidentally quoting Ron Paul?). In the 1950s there was a Canadian 20-dollar bill that had to be withdrawn and redesigned. No one would use it because it was thought to bring bad luck: the portrait of Queen Elizabeth II on the face of the bill contained an unmistakable picture of Satan embedded in her curly black hair. (No one knows if this was the fault of the portrait artist or the Queen’s hair stylist.) The US 2-dollar bill likewise doesn’t circulate because it is deemed unlucky. When it comes to money, as with most other things, Stevie Wonder got it right: Superstition ain’t the way.

  2. bitteeded Says:

    BitCoin Prices already dropped from $145 USD to $112.00 USD so far Today,
    for inside on the BitCoin market visit –

  3. […] by Bitcoin and the nature of money, here’s a cool video on the supposed creator. Thanks to Kim Ruhl, our local expert, and to David Friedman for the link. And here’s a related classic from […]

  4. […] Bitcoin is a popular topic in class, but some of the most interesting experiments with electronic money are in Africa. With Kenya’s M-Pesa, people pay bills with mobile phone minutes. It’s a simpler technology than Bitcoin, but perhaps more useful for precisely that reason. This striking map shows similar innovation throughout Africa and the developing world. […]

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