The comparisons that are being made between the United States dollar and Bitcoin, the new crypto-currency, are not really legitimate. The first is issued by the United States government, and is used for almost all transactions in the world’s largest economy. The latter, on the other hand, is a peer-to-peer software system, created in 2009 for transferring value through the Internet. It is traded for other currencies on a growing number of online exchanges, but as of yet is only accepted for payment by a limited number of merchants. These two currencies are not providing the same features. The dollar and Bitcoin compete in different market niches.

The NPR Planet Money team, for their podcast on Bitcoin a few weeks back, interviewed the Harvard economist Benjamin Friedman. As another economist that I recently wrote about, in arguing that Bitcoin will ultimately fail, he appealed to the role the government plays in bolstering and securing the widespread adoption and use of the US dollar. According to the argument, Bitcoin will fail because it does not have a powerful government behind it to support its value and enforce its use. Friedman asked his listeners to consider the inscription on US dollar bills: “This note is legal tender for all debts public and private.” The US government has made it illegal for anyone under its jurisdiction to not accept US dollars in payment. They have, through their authority, secured a monopoly for the dollar among currencies circulating in the US economy. Bitcoin, by comparison, does not have a powerful agency behind it to oblige people to accept it. It is for this reason, suggests Friedman, that it will never be able to compete with the US dollar.

What Friedman and those who make this sort of argument ignore is that there is another basis for a currency’s strength, the strength of the economy in which it circulates. In the case of the US dollar, it is easy to conflate the power of the United States government with the strength of the US economy. However, it is not difficult to come up with counter examples, where relatively strong economies are associated with governments that are relatively weak. When it comes to currencies, the economy itself can be its own autonomous basis for power and legitimacy. In ignoring this, Friedman does not adequately address Bitcoin. It would be better to consider each currency as offering a distinct set of features, and then to consider how those features might give it relative advantages for different types of transactions. The future of Bitcoin depends on whether the features it provides as a currency will prove to satisfy emerging needs and desires in an increasingly interconnected and Internet-based world of commerce.

It is clear from the arguments being made that one of the features that the dollar provides is that it is backed by the US government. In the niche that Bitcoin competes, however, this does not confer on the dollar much of an advantage. What seems to be commonly ignored is that Bitcoin is designed to reduce the level of mediation necessary in long-distance and international transactions, as well as the associated costs. If I want to transfer money over a long distance, assuming that I am not willing to send cash through the mail, I will need to use the services of a bank, credit card company, or some other mediating institution. Bitcoin eliminates that need.

Bitcoins can be sent directly from one private individual to another via the Internet. US dollars bills, no matter how fiercely the US government supports them, cannot. Furthermore, if I send some funds, say through my bank or PayPal, to someone across the globe who wishes to draw on those fund in another national currency, this will entail a series of transaction costs. As it is now, I could use Bitcoin to do the same transfer for a fraction of the cost. I would change my dollars into Bitcoins, send the Bitcoins over the Internet free of charge, and the person would change those Bitcoins into his or her local currency. The expense of exchanging Bitcoins in and out of national currencies on online exchanges is but a fraction of the expense for exchanging one national currency into another and making a transfer from one bank to another across international lines.

This, however, only represents the beginning of the possibilities. If the Bitcoin market develops more fully, if more merchants begin to accept the currency, then we can imagine a situation where the need to change into other currencies is reduced, lowering transaction costs even further. Even now it is possible for someone in Beijing to send a single Bitcoin to someone in New York, without paying any transaction costs whatsoever, and for that person to go out and use the Bitcoin to buy a felafel sandwich. It would be ridiculous to do this with national currencies alone because one would spend more in transaction fees than the amount of value that ends up being transferred. The dollar cannot compete with Bitcoin in the niche of long-distance micro-transfers, and even in larger transfers, why would individuals choose to pay high transaction costs when they could do it for less with Bitcoin?

Some proponents of Bitcoin lament that there are not more brick-and-mortar merchants who accept the currency. If we adopt the market model I am suggesting, however, we would expect Bitcoin to first develop in those areas where it has the greatest market advantage. This explains in part the proliferation of online exchanges (see here and here). The exchanges provide not only the opportunity for speculation, but perhaps even more importantly (in the long run) the ability to exchange Bitcoin for national currencies thereby facilitating international transactions. This is one market niche in which Bitcoin is much more competitive than the US dollar.