Arecent tweet that went viral beautifully captures the bitcoin dilemma. A son asks his father for one bitcoin on his birthday. The answer is epic: “What? $15,554? $14,345 is a lot of money! What do you need $16,782 for anyway?" The tweet highlights the fact that bitcoin prices have been moving a lot almost every second.

The wild swings in bitcoin prices have made the digital currency a big topic of discussion across the world. I recently overheard a bunch of college kids excitedly exchanging notes on bitcoin prices at the Goa airport. They were treating bitcoins like an investment asset rather than a new form of currency that could eventually be used more widely for a range of economic transactions.

Most of the debate right now is on whether bitcoins are a bubble inevitably floating towards the pinprick of reality. I have often heard people talk about bitcoin in terms of its market capitalization, as if it were a financial contract rather than a new form of money. Far less attention has been paid to bitcoin as a currency to replace the paper money printed by central banks, which is supposed to be its main attraction.

Also Read: Going beyond the problems of bitcoin

Any form of money has three main functions—as a medium of exchange, a unit of account and a store of value. Does bitcoin meet the first two requirements? A modern economy needs monetary stability because it is profoundly dependent on contracts. Let us take an example. Suppose your employer offers to pay you the salary over the next year in bitcoins. Will you accept the offer unless you are sure that the purchasing power of the currency will be more or less the same as today? It is very similar in the case of contracts with suppliers, lenders and consumers. Future payments are accepted only when the value of money is stable.

Few would risk signing contracts in a volatile currency. Some argue that participants in an economy can hedge the risk through derivatives, but that still entails higher transaction costs. One important reason money exists is to drive down transaction costs in an economy. The Chicago Board of Trade has already begun to offer bitcoin futures. It will be worth seeing how much the cost of hedging in bitcoins differs from the cost of hedging in traditional currencies.

Why are bitcoin prices so volatile? Monetary economists have for long pointed out that the demand for money has become unstable after the proliferation of alternatives since the advent of financial liberalization. The demand for bitcoins too is bound to be volatile. However, its supply is relatively rigid. The algorithm underlying the bitcoin process limits the supply of the cryptocurrency to 21 million units. That limit has not yet been reached, and, for now, the available supply of bitcoins can be increased by miners.

The attractiveness of mining increases with the rise in the price of bitcoins. In that sense, money supply is endogenous in the case of bitcoins. Yet, the relative rigidity of bitcoin supply, despite big swings in demand in practice, destroys the possibility of monetary stability. It could even be argued that the libertarian fear of the inflationary consequences of fiat money issued by governments has led to a denationalized currency that has a deflationary bias. The fact that supply is restricted means that there is little scope for discretionary monetary expansion to deal with economic downturns—an attribute that cryptocurrencies share with the old gold standard.

Defenders of digital money quite realistically argue that the problem of limited supply of one cryptocurrency such as bitcoin does not necessarily mean that the entire ecosystem has the same problem. The beauty of cryptocurrencies is that there will be competing currencies, so that the money supply in the economy as a whole will be far more responsive to circumstances than one currency alone. There is more than a modicum of truth in this. The issue that needs to be watched is whether the inevitable network effects will in practice ensure that only a few cryptocurrencies will be in common use.

Also Read: Blistering bitcoins

The growing popular interest in bitcoins is important despite signs that prices are now in bubble territory. The stratospheric rise in bitcoin prices has made millions aware of the radical possibility of currencies issued by algorithms rather than central banks. There are still many fundamental economic question marks about the ability of cryptocurrencies to replace traditional money. This column has highlighted some of these concerns—rigid money supply, volatile purchasing power, the lack of monetary stability, higher transaction costs and the impossibility of discretionary monetary policy dealing with business cycles. There are several parallels to the old gold standard (and some differences as well).

The cryptocurrency ecosystem is still an emerging one. The recent swings in bitcoin prices should not take away from the fact that digital currencies—and, more broadly, the blockchain technology on which they are based—offer a profound challenge to existing monetary systems. The big question is whether nation states will ever give up their monetary powers, as well as the small matter of seigniorage. The issue is as much political as it is economic.

There are now growing signs that central banks are trying to figure out how to embrace the blockchain future. What will that mean for the money supply process as well as for monetary policy? That is a question this column will return to in the next instalment.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com. Read Niranjan’s previous Mint columns at www.livemint.com/caféeconomics

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