Private innovation in currencies is a good thing

I have a column in the Times on bitcoins and their implications for private money

Bitcoins — a form of digital private money — shot up in value from $90 to $260 each after Cypriot bank accounts were raided by the State, then plunged last week before recovering some of their value. These gyrations are symptoms of a bubble. Just as with tulip bulbs or dotcom shares, there will probably be a bursting. All markets in assets that can be hoarded and resold — as opposed to those in goods for consumption — suffer from bubbles. Money is no different; and a new currency is rather like a new tulip breed.

Yet it would be a mistake to write off Bitcoins as just another bubble. People are clearly keen on new forms of money safe from the confiscation and inflation that looks increasingly inevitable as governments try to escape their debts. Bitcoins pose a fundamental question: will some form of private money replace the kind minted and printed by governments?

It has happened before. Pennies and halfpennies were effectively privatised by industrialists in Birmingham in the 1790s. New industrial employers had to pay workers in cash rather than kind, as farmers had done. But there was a chronic shortage of small coins. The Royal Mint had given up making silver coins because people melted them down when their value as metal exceeded their face value and had stopped striking copper halfpennies, which were too easily counterfeited.

So Thomas Williams, the owner of an Anglesey copper mine, and Matthew Boulton, keen to put steam engines to work, offered to make pennies for the government. Rebuffed, Williams made coins anyway. Called druids, they were harder to fake or clip (because they had raised rims) and cheaper to strike than state coins. Being convertible into guineas and pounds at a fixed price of one penny, they were soon accepted all over Birmingham and even in London.

By 1797 there were 600 tons of such tokens in circulation and the counterfeiters were put out of business. The coiners started making silver tokens too but a jealous Royal Mint lobbied Parliament to outlaw the competition. It succeeded in 1818, three years before it could produce new copper coins to match the high standards of the private ones, so the coin famine resumed.

More recent private currencies — from Green Shield stamps and air miles to Lewes “pounds” (designed to encourage spending in the East Sussex town) — have been less ambitious than the Birmingham tokens, whose story is told in an outstanding book Good Money. Its author, the economist George Selgin, has now turned his attention to Bitcoins, which he thinks come close to having the characteristics of an ideal currency.

Bitcoins are virtual money created by a piece of computer software designed to grind away inexorably producing them at a decelerating rate — it halves every four years — until almost 21 million are in circulation, by which time the rate of production will be extremely slow. About 11 million have currently been “mined”. Private software writers can improve their “mining” rate (by solving maths problems of increasing difficulty), but only at the expense of competitors; they cannot increase the supply.

Thus, Bitcoins resemble “commodity money”, like gold or cowrie shells, which rely on scarcity and indestructibility to be a good store of value. Real commodity money is vulnerable to inflation if there is suddenly a new discovery of gold — or deflation if there is suddenly a demand to use the commodity differently. In theory “fiat money”, such as we use today, avoids these problems — but governments have always removed the check on supply by printing money at whim to reduce debts.

There might be a way to cross fiat with commodity money and capture the benefits of both. Selgin calls this “synthetic commodity” money. Unlike fiat money it would have absolute scarcity; unlike commodity money it would have no non-monetary use. For example, a government could print paper money and then ostentatiously destroy the lithograph plates to show that it would never print any more.

In effect, this happened to the Swiss Iraqi dinar in the 1990s. Saddam’s regime used high-quality money engraved in Switzerland and printed in Britain. But during the first Gulf war in 1990 the supply dried up because of sanctions. Saddam began to print dinars at home, but these were easily faked, so they fell in value. The Swiss dinars remained in circulation for many years (though growing tatty) and held their value against the dollar.

Metaphorically, Bitcoin’s creators have destroyed the plates by making it impossible for anybody to change the programmed supply. So far that part of the experiment is succeeding, but Bitcoins are not yet ready for prime time. A friend who acquired some is sitting on a handsome profit, but finds the only thing he can exchange them for in his nearest city is chocolate.

Selgin points out that to get an exchange network going from scratch is hard enough when a new currency is fully compatible with established money, as in Birmingham; or when it consists of a commodity with other uses. But to do so using something with no non-monetary uses, so no one ought to want it at all except as a means of trade, should be almost impossible.

This only makes Bitcoin’s modest foothold even more impressive. An appetite for new kinds of money is there. The use of mobile phone credits as a currency in Africa, pioneered by M-pesa, is another example, and has had as jealous a reaction from central banks as Birmingham’s private coins did from the Royal Mint.

Remember the lesson of the Anglesey druids: private entrepreneurs designed far better coins far more cheaply than sclerotic bureaucracies. Entrepreneurial innovation among Bitcoin’s imitators may yet solve the unsolved money problem — how to provide a ready medium of exchange that is also a trustworthy store of value.