Thanks to HB0019 and SF0111, there is a discussion under way about the use of alternative currencies, primarily digital, here in our state.
I am happy to see this discussion, especially since it means opening up Wyoming to a possibly new industry of technological innovation. It would be a great accomplishment if we can attract businesses without throwing hundreds of millions of taxpayer dollars after them.
As for the hopes that many people have of establishing a digital currency as legal tender in Wyoming, in other words an alternative to the dollar, there are a few obstacles in the way. I am not opposed to that idea per se - some alternative currency systems have proven successful, such as the British LETS system - but it is important to know the potentials as well as the limitations, of such a system.
The potentials first. Obviously, trade taking place in an alternative currency is not liberated from the laws of the United States or of Wyoming. However, it can help people get around some of the institutional hurdles associated with the U.S. dollar. For example, you can create a credit system that is independent of the recording practices used in the traditional banking system. In theory, this is possible with dollars as well, but for institutional reasons the alternative currencies tend to be door openers for this type of institutional innovation.
Institutional innovation is an essential part of a free-market economy. It keeps the economic system and its agents on the alert. If we have a financial system that is getting stale because of old age and lack of competition, trade in an alternative currency can be the starting point of an invigorating challenge to an institutional status quo.
Another potential benefit of wider use of digital currencies is that they are not as easily forfeited. To the best of my knowledge, so far there have not been any fraud cases in bitcoin. There is a limit to what fraud protection a digital currency can offer, but there is a credible argument being made for these alternative means of payment based on their higher fraud deterrent threshold.
There are also some drawbacks or risks that we should not look away from. The most important problem is currency inflation. To illustrate this point, let us look at a schematic of the market for bitcoin, under the assumption that bitcoin became frequently used in regular economic transactions. Figure 1 shows the supply curve of bitcoin as per the algorithm that defines the "mining" of new bitcoins. By design, the slope of the supply curve is supposed to flatten out completely by an already known date.
Figure 1 also has a demand curve. Suppose that, so far, there has been a reasonable long-term balance between bitcoin demand and supply. Then, as bitcoin hypothetically takes of as a currency of transaction, demand soars; because of the deterministic flattening of the supply curve, we rapidly end up with excess demand for bitcoin:
Excess demand for a currency drives up its price - and since a price is always relative in nature, this is the price in U.S. dollars.
By definition, we now have an exchange rate between the dollar and the bitcoin. All other things equal, the exchange rate is going to rise, appreciating the value of the bitcoin, as demand grows. Here, we run into the same type of problem as we have with existing currencies when there is a big shift in the exchange rate. Bitcoin holders will be wealthier in dollars, but it will also become cheaper for everyone to buy products denominated in dollars.
For example, suppose a computer made by Hakkapeliitta in Finland is sold for 8,000 Finnish markka, and the markka-to-dollar exchange rate is 8:1. Suppose a computer built by Dell in Texas costs $1,000. The two computers are now priced equally on the Finnish market (again, all other things equal). Suppose, now, that a surge in demand for dollars drives up the exchange rate to 9:1. If Dell wants its $1,000 for its computer, it is going to have to charge 9,000 markka; the option is to keep the price constant and only take home $889.
By the same token, suppose Plumber Pete charges his customers in bitcoin and Plumber Paul charges in dollars. The exchange rate is 8:1 when Pete offers to put in new pipes in your house for 1,000 bitcoins and Paul offers to do it for $8,000. Since you have $8,000 to spend, the means of payment is of less importance; what matters is entirely the quality of the work. If Pete gets the job, you buy 1,000 bitcoins for your $8,000 at no transaction fee.
Suppose, now, that the exchange rate rises to 9:1. All of a sudden, your $8,000 can only buy 889 bitcoins. Pete has to cut his price, or lose out to Paul.
Over time these exchange-rate and transaction costs issues are taken care of by a functioning market. It would take a carefully crafted regulation-free market to make that happen, where government gives no preferential treatment to either currency.
Which brings us to another problem with a new currency: its status with government. If Pete the Plumber is successful in selling his services at bitcoin prices, as things are today he still faces the problem of paying his taxes and fees in U.S. dollars. So long as government gives preferential treatment to the dollar, accepting no other currency for tax payments, it is unrealistic to see bitcoin reach quite the same status as the dollar.
That said, if we can create a functioning market for bitcoin with the same liquidity as we have in the dollar market, it is probably only a matter of time before bitcoins (or whatever alternative currency we are talking about) will become acceptable as means of tax payments.
There is more to be said about this, but let us make do with these basics for now. More later.