So, will bitcoins ever become money? It’s tricky… I would like to discuss a scenario where bitcoins (or something like it) would be money, why central banks would want to create their own crypto-currency protocols, and how monetary policy would be conducted in such a world.
Imagine that a private entity with significant resources and credibility implements a crypto-currency (like Bitcoin) that it backs with real, hard, good old-fashioned central bank currency. So imagine Google creates a protocol similar to Bitcoin called gCoin, and publishes the protocol publicly so that anyone can use it. In particular, anyone is able to mine gCoins by contributing computational power to the network. At the same time, Google says that it will buy unlimited gCoins in exchange for dollars, say at a price of 1 for 1, and that it will also sell gCoins that it has already mined for the same price. Thus gCoin would initially derive its value from Google's promise to exchange gCoins for real dollars at any time.
First off: Why would Google do this? Who knows! Google is very well known for building useful services that it isn’t yet sure how to monetize. And gCoin is useful: Like Bitcoin, using gCoin to buy and sell goods on the internet is faster and much cheaper than using a credit card. A simple way to monetize gCoin would be for Google to provide a ‘wallet’ service that helps facilitate the use of gCoin, which you could just think of as a chequing account for gCoins. You would “deposit” your gCoins with Google, use their online service to keep track of them and transact them, and Google would charge you a monthly fee just like a regular bank. Google would also have a reserve amount of gCoins that it initially mined before publicly releasing the protocol, which would be very valuable if the use of gCoin became widespread. I’m sure there are other and better ways to monetize crypto-currencies that we can’t even imagine yet — we don’t need to discuss this.
Now, who would use gCoins? Only someone who had faith in their value. If people believed Google would always convert their gCoins into dollars, they would gladly accept gCoin as payment. But as you see, we are in the same situation as we were with the gold-backed bank notes in the 19th century: What if there is a bank run on Google? And if other organizations like Amazon, Facebook, Apple (and PayPal?) have their own digital currencies, a bank run on just one of them could cause bank runs on the others — the same financial contagion effect that paper currencies experienced. Privately issued crypto-currencies are susceptible to the same problems as privately issued bank notes.
You can thus imagine that, just like what happened with paper currencies, central banks will eventually step in to create their own crypto-currency protocols and forbid the use of any others. For simplicity, let’s call the central bank crypto-currency protocol BitDollar. Of course, these BitDollars would always be redeemable in regular dollars by the central bank, at least at first.
The exchange rate between BitDollars and regular dollars does not necessarily have to be 1 for 1. In fact, the central bank could adjust this exchange rate in order to conduct monetary policy, although there is a better, more natural way to do monetary policy — more on that in a minute. Assuming the exchange rate is fixed, say 1 for 1, the distinction between dollars and BitDollars no longer exists. Just think of dollars as an abstraction which can be manifested in traditional paper form and now digital form. And like original gold-backed currency, we eventually won't even need regular dollars to back BitDollars, as long as the network effects of BitDollars exist to justify their value — though this transition will happen gradually.
Indeed, a similar type of network effect is what most Bitcoin startups today are betting will give bitcoins their value in the future, and they are building services that allow customers to easily transact regular bitcoins instead of building their own protocols. You can think of these startups as Bitcoin banks: They provide banking services for bitcoins. Currently these banks operate with 100% reserve ratios because they record your ownership of bitcoins on the official Bitcoin blockchain. We will have to wait to see how the value of bitcoins plays out and what banking business model emerges, but it is clear to me that Bitcoin banks and the Bitcoin network will be just as prone to bank runs as Google's gCoins would be, or traditional banks were before the days of central banking. More simply: Bitcoin needs a central bank. And BitDollar would be the answer to that.
But what type of protocol would BitDollar be? Well certainly, the central bank needs the ability to conduct monetary policy, so it would need a protocol where it could easily adjust the money supply at will. It would also need the ability to be the lender of last resort, which means access to an unlimited supply of BitDollars.
The simplest way for a central bank to create its own crypto-currency is for it to fork the Bitcoin protocol into a new protocol that is unchanged in every way except that, going forward, the central bank would set and adjust the block mining reward at its discretion. (Remember, the block reward is arbitrary in Bitcoin and other crypto-currency protocols, and can change to anything that the network agrees upon going forward.) In this world, the central bank can conduct monetary policy by changing the block reward, which in turn changes the future supply of base money. In particular, increasing the block reward corresponds to loosening monetary policy, and decreasing the block reward corresponds to tightening monetary policy. A more intuitive way to think about this is that increasing the block reward decreases transaction costs, while decreasing the block reward increases transaction costs — for every single transaction. For central banking, this is the key to understanding crypto-currencies. And like paper currency, the central bank's crypto-currency would be both decentralized (in transaction) and cenralized (in supply).
Why would people start using the BitDollar protocol and not the original Bitcoin protocol? Again, it’s simply a matter of network effects, and the fact that BitDollar would be legal tender under the law, including the requirement to pay taxes with them. The answer to this question is the same answer to: Why do people US dollar bills instead of notes printed by private banks? It's tautological: People use US dollar bills because people use US dollar bills.
We still need to resolve how the central bank can access an unlimited supply of BitDollars so that it can continue to act as a lender of last resort. The central bank can create unlimited BitDollars for itself by leveraging the the network effect — let me explain. Remember, BitDollars can only be created by solving a block in the blockchain (i.e. processing transactions) and, as we have discussed, the reward for solving a block is now set by the central bank. But also remember, the transaction history in the blockchain is impossible to change, so the central bank can only change the reward for future blocks. So to create BitDollars for itself, the central bank would announce two things to the network, both at its discretion: (1) It announces a future transaction block, and (2) It announces a one-time reward amount for that block. Once that transaction block comes to pass, the central bank will solve the block and announce the updated official blockchain to the network, walking away with the reward. Anyone else that tries to solve that block will not be recorded as such on anyone else's copy of the blockchain because everyone else will be using the official blockchain released by the central bank. Again, why would people using the protocol simply agree to this? Because…networks. The central bank said so. In fact, the central bank doesn't even need to solve the block itself for this process work, simply by also providing an additional transaction reward for whoever processes the block.
Of course, with the ammunition of unlimited BitDollars, there is no need for the central bank to change how it conducts monetary policy by using the block reward method I described previously. But I think that adjusting the block reward is a much more natural way to change future money supply and conduct monetary policy because it affects every transaction in the economy — it is very broad based.
A smooth transition from paper-currencies to crypto-currencies will require central banks to understand the importance of crypto-currencies early on, as they develop. If central banks wait too long, there will be risks of bank runs and financial instability from privately issued crypto-currencies. It is important that central banks recognize this and respond accordingly.
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This is Part 4 of a discussion on the economic consequences of Bitcoin. You can access the remaining parts here:
1. A Friendly Introduction for Economists to the Bitcoin Protocol
2. A Monetarist View of Money and Bitcoin
3. A Brief History of Paper Currency and Central Banking
4. Will Bitcoins Ever Become Money? A Path to Decentralized Central Banking