Brew-Up Ideas Winning Entry: Bitcoin- Can it be replacement for fiat currency?

Bitcoin – Can it be replacement for fiat currency?

Authors: Chetan Kothavade and Tushar Gupta(MDI Gurgaon)

 

Today’s fast paced world is quite adjustable to the rapid changes happening around it. From fire to an artificial but intelligent robot, we have come a long way and have become quite adept at exploring and experiencing new things. The age old process of ‘transaction’ has not been any different and has experienced quite substantial changes over its course of 8000 years. Today, in the age of digitalization, there is considerable interest among people if the existing system of transaction can take a fillip and enter into the realm of cryptocurrencies.

Brief history of fiat: 

The meaning of the Latin word ‘fiat’ means “It shall be”. In simple terms, fiat currency is not backed by any commodity (like gold) but shall be valid by government’s declaration. It came into initiation in 1971 after the then US president Richard Nixon, announced unilaterally that United States would no longer trade dollar for gold and the new currency would be backed by “faith and credit” of the US government.

As currencies of other countries were linked to the US dollar up untill 1971 (under the Bretton Woods system), these countries de-facto adopted the fiat currency system. Today, almost all countries have adopted it. One of the primary reasons to severe links with gold was that the government wanted to keep its unemployment rates in check. But, linkage with gold obstructed the supply of more money into the system. It was believed that pumping more money would generate economic activity and help resolve the problem.

Effects of fiat:

Immediately after the introduction of the fiat currency, there was rise in inflation as US government started printing money. But, the US economy (and so the world economy at large) started facing a peculiar problem called Stagflation due to the rising oil prices and the persistent high rates of unemployment. This phenomenon baffled economists and scholars with the Keynesian bend of mind. Moving to fiat for expansionary growth as well as for removing the economic-slum did not seem to work as planned. Ultimately, it was the raising of the interest rates during the mid-1980s that corrected the economy.

The inter-linkage of the global financial systems during the 2007-08 sub-prime loan crisis again made the world economy to undergo a deflationary phase. It was again the Quantitative Easing scheme which helped the big banks to stay afloat and avoid a complete collapse. Quantitative easing in simple terms really means “creating money” and providing it to the banks to steady their balance sheets. The interest rates were also kept very low to attract more investments. Today, the US Federal reserve has increased its balance sheet to $4.4 trillion from $870 billion in 2007.

We can observe from the above examples that, every time there was a crisis, governments monetary policy handling has helped cool down situation. Although monetary policy seems to be a positive tool in the hands of the governments for general well-fare of its public, it is exactly what irks the supporters of a decentralized monetary system. They believe that controlling money supply gives too much power to a too small number of individuals. It is to be noted that Reserve banks (responsible for creating money) are not entirely under the ambit of the governments. Thus, at any moment, creation of money for economic expansion, bail-outs etc. simply can increase the circulation of money in the economy thereby leading to inflation. It is common belief among these groups that inflation is nothing but ‘hidden tax’ to the general public, as the purchasing power of the money in hand is simply reduced by inflation.

Economies continuously creating money

During crisis situations, there have been examples where governments have reduced money supply in the economy and imposed sanctions on withdrawals of money on its citizens from their own bank accounts. Greek can be considered a great example of this. Banks there provided negative interest rates on deposits. Additionally, ATMs allow a withdrawal of only 45 euros per account per day. The pensions have taken a hit. At home, the recently introduced Financial Resolution and Deposit Insurance Bill includes the bail-in clause where-in depositors might lose their hard-earned money if ever the banks fail.

Thus, it is this substantial control of government on monetary policy that is seen by some in a distasteful manner rather than just the problems of money printing and inflation. These people eventually want that the general public be empowered and have more control on their own money. This is where “Bitcoins” take an entry.

Bitcoin:

We all might be well aware by now that bitcoin is a form of digital currency, whose concept was published in a paper by someone called Satoshi Nakamoto in 2009. With the help of bitcoins, people can carry out transactions like remittances and online shopping without requiring an intermediary (peer-to-peer) to aid them. It is regarded as highly secure mode for transaction which involves fairly complex mathematics at the core of its functioning. The maximum number of bitcoins in circulation will be at the most 21 million and all of the bitcoins are speculated to get mined (created) by 2140. A bitcoin can be divided up to 8 decimal places.

Advantages of bitcoin:

A bitcoin ticks all the boxes for it to be called money. A basic difference between definition of money and currency is that apart from being fungible, divisible, durable, portable and a unit of account it is also a store of value. A bitcoin is only generated after considerable amount of work is done on solving a math problem successfully. Thus, unlike fiat currency bitcoin has an intrinsic value. Another advantage is that being limited in quantity (max 21 million), usage of bitcoins will keep aggregate prices in check. But, the greatest benefit of bitcoins to users is the decentralized way in which transactions take place. Everybody has the information of every transaction, and the journey of a particular item can be tracked from its origination to current user. Thus, manipulating the prices as well as the encrypted information regarding the transactions is almost impossible. For transmitting say a certain amount overseas banks charge remittance up to 10 % of transactions, but through bitcoins this can be done for free. With heavy penetration and adoption, bitcoin can even help people not having access to any financial services in and around their vicinity to transact in a secure way. No wonder, bitcoin evangelists are travelling places to the spread the propaganda on bitcoins.

Disadvantages of bitcoins:

The selling of illicit items by sites like Silk Road, bitinstant etc. through the medium of bitcoins are famous examples of how the black market can misuse the anonymity and security factor of bitcoins to carry out their activities. One major concern is the ‘storage’ of bitcoins.  Currently, it is regarded highly unsafe to store your bitcoins online. Users are literally advised to store their bitcoins on hard drives. But, someday, hard drives can crash. It is important to note that once these bitcoins are lost, they cannot be regained. Thus, the number of bitcoins in circulation can decrease considerably. This brings us to another aspect of bitcoin – bitcoins being limited in supply, can be deflationary in the long run. This will be a cause of serious concern, if we were to move into complete adoption of bitcoins as people will hoard more coins and spend less as their value increases.

Currently, the usage is quite complex and transaction settlements are slow. The Indian government has not yet provided legal status to cryptocurrencies. The volatile nature of its prices is another cause of concern. Its value has rose 4 times since last two months, giving it a nature of a stock more than a currency. Some argue that bitcoin can face the same fate as Tulips in 17th century (Tulip mania) due to the similarity in their price structure over years as shown below.

Can it really replace fiat?   

Year spans of different monetary systems – What’s next?

At present, bitcoin are a buzz due to their rising values as compared to dollars. One of the speculation is that the value of bitcoin will stabilize once it equals the amount of dollar value currently present. But, what after it takes over? Is it compatible to survive on its own? A bitcoin standard closely resembles a gold standard. And history shows, gold standards do falter after a specific time. Will governments allow its unregulated usage? To what extent and how, a government body is going to intervene in its functioning (especially in the coin mining area) is a question as the whole point of bitcoin is – no third party regulation.

The current fiat system seems to have survived the longest of all monetary systems (in its 40th year now) and seems to be holding good. Of course there have been open and shut cases of money laundering and funding of illegal activities by banks. Fractional reserve banking system can be a valid threat to depositors as the current money creation spree can make banks have more cavalier approach to lending. Hence, we do need decentralized cryptocurrencies as a way for banks to be more accountable and competitive.  The two systems of currencies can co-exist. Currently banks charge 2-3 % per transactions to merchants. As mining of bitcoins becomes more expensive (complexity of math problems increases with number of coins mined), data miners might as well charge a certain percentage as transaction fees. Thus, it is also important to keep the bitcoin system in check. Along with bitcoins, other cryptocurrencies like Ethereum, Litcoin, Ripple and Dash are also gaining traction. They are creating their own niche in terms of services offered. In conclusion, I believe that cryptocurrencies are here to stay and a peaceful co-existence of fiat and cryptocurrencies likely looks to be the scenario for the near future.

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