Bits and bob

MILTON FRIEDMAN famously called for the abolition of the Federal Reserve, which he thought ought to be replaced by an automated system that would increase the money supply at a predetermined rate and so keep a lid on inflation. A virtual version of this now exists.

Bitcoin, the world's “first decentralised digital currency”, was devised in 2009 by a programmer called Satoshi Nakomoto (thought not to be his, or her, real name). Unlike other virtual monies, such as Second Life's Linden dollars, it can be used to purchase real-world goods and services. And rather than relying on a central monetary authority to monitor transactions and manage the money supply, Bitcoin is run by a peer-to-peer network (akin to file-sharing services like BitTorrent).

This absence of a central monetary authority to control the money supply is what many find exciting about Bitcoins. Quantitative easing is not possible. Coins are created at a constant average rate to reward users who give up some of their computing power to track and validate transactions that are made with the currency*.

The rate at which Bitcoins are minted is designed to mimic the extraction of minerals. As the most accessible resources are exhausted, the supply dwindles. The Bitcoin supply increases at a rate of 300 coins every hour on average at the moment, but every four years that rate will fall by a half. The total supply will level off at 21m coins or so around 2030. That appeals to those who distrust paper currencies.

The currency can be used by anyone (unlike credit cards), anywhere. Transaction costs are also likely to be lower than those for traditional payment systems, though they are not zero. Some are reflected in the hardware and energy used to police the system. Some creep in whenever those who have no wish to mine Bitcoins themselves purchase them for dollars, euros and other currencies at specialised websites such as Mt Gox.

Critics point out that Bitcoins suffer the same flaws as other metal-based currencies with finite supply. Many economists put at least part of the blame for the severity of the Depression on the strictures of the gold standard, as countries clung to gold and put off stimulus. In the case of Bitcoins, some think that decreasing the rate of money creation over time will entail deflation. People who own Bitcoins will prefer to hold on to them rather than spend them, because deflation will mean that their stash of Bitcoins will buy more real goods in the future than now.

That assumes that Bitcoins are something people are happy to take in return for goods, or at least to exchange for paper money. As wild swings in their dollar price have demonstrated, the currency is young and illiquid—only 6.5m units are currently in circulation among some 10,000 users (including several hundred merchants who accept payment in Bitcoins).

Attracting enough users to smooth such volatility seems unlikely in the foreseeable future. Established fiat currencies—ones where bills and coins, or their digital versions, get their value by dint of regulation or law—are underwritten by the state which is, in principle at least, answerable to its citizens. Bitcoin, by contrast, is a community currency that requires self-policing on the part of its users. Most people would rather devolve this sort of responsibility to the authorities.

Moreover, Bitcoin may be useful for trading goods and services but it does not yet allow borrowing or lending. In the physical world this happens through financial intermediaries: you put money in a bank, and someone else borrows it. A virtual Bitcoin bank might spring up but that would create problems of its own. How would a saver be assured that he would get his money back when he wants? If a bank got into trouble, who would be the lender of last resort? The usual answer is a central bank: exactly what Bitcoin is trying to avoid. Bitcoin is technically sophisticated. As a monetary system, it looks primitive.

* Learn more about how Bitcoin works