Bitcoin competing against the US dollar

The comparisons that are being made between the United States dollar and Bitcoin, the new crypto-currency, are not really legitimate. The first is issued by the United States government, and is used for almost all transactions in the world’s largest economy. The latter, on the other hand, is a peer-to-peer software system, created in 2009 for transferring value through the Internet. It is traded for other currencies on a growing number of online exchanges, but as of yet is only accepted for payment by a limited number of merchants. These two currencies are not providing the same features. The dollar and Bitcoin compete in different market niches.

The NPR Planet Money team, for their podcast on Bitcoin a few weeks back, interviewed the Harvard economist Benjamin Friedman. As another economist that I recently wrote about, in arguing that Bitcoin will ultimately fail, he appealed to the role the government plays in bolstering and securing the widespread adoption and use of the US dollar. According to the argument, Bitcoin will fail because it does not have a powerful government behind it to support its value and enforce its use. Friedman asked his listeners to consider the inscription on US dollar bills: “This note is legal tender for all debts public and private.” The US government has made it illegal for anyone under its jurisdiction to not accept US dollars in payment. They have, through their authority, secured a monopoly for the dollar among currencies circulating in the US economy. Bitcoin, by comparison, does not have a powerful agency behind it to oblige people to accept it. It is for this reason, suggests Friedman, that it will never be able to compete with the US dollar.

What Friedman and those who make this sort of argument ignore is that there is another basis for a currency’s strength, the strength of the economy in which it circulates. In the case of the US dollar, it is easy to conflate the power of the United States government with the strength of the US economy. However, it is not difficult to come up with counter examples, where relatively strong economies are associated with governments that are relatively weak. When it comes to currencies, the economy itself can be its own autonomous basis for power and legitimacy. In ignoring this, Friedman does not adequately address Bitcoin. It would be better to consider each currency as offering a distinct set of features, and then to consider how those features might give it relative advantages for different types of transactions. The future of Bitcoin depends on whether the features it provides as a currency will prove to satisfy emerging needs and desires in an increasingly interconnected and Internet-based world of commerce.

It is clear from the arguments being made that one of the features that the dollar provides is that it is backed by the US government. In the niche that Bitcoin competes, however, this does not confer on the dollar much of an advantage. What seems to be commonly ignored is that Bitcoin is designed to reduce the level of mediation necessary in long-distance and international transactions, as well as the associated costs. If I want to transfer money over a long distance, assuming that I am not willing to send cash through the mail, I will need to use the services of a bank, credit card company, or some other mediating institution. Bitcoin eliminates that need.

Bitcoins can be sent directly from one private individual to another via the Internet. US dollars bills, no matter how fiercely the US government supports them, cannot. Furthermore, if I send some funds, say through my bank or PayPal, to someone across the globe who wishes to draw on those fund in another national currency, this will entail a series of transaction costs. As it is now, I could use Bitcoin to do the same transfer for a fraction of the cost. I would change my dollars into Bitcoins, send the Bitcoins over the Internet free of charge, and the person would change those Bitcoins into his or her local currency. The expense of exchanging Bitcoins in and out of national currencies on online exchanges is but a fraction of the expense for exchanging one national currency into another and making a transfer from one bank to another across international lines. 

This, however, only represents the beginning of the possibilities. If the Bitcoin market develops more fully, if more merchants begin to accept the currency, then we can imagine a situation where the need to change into other currencies is reduced, lowering transaction costs even further. Even now it is possible for someone in Beijing to send a single Bitcoin to someone in New York, without paying any transaction costs whatsoever, and for that person to go out and use the Bitcoin to buy a felafel sandwich. It would be ridiculous to do this with national currencies alone because one would spend more in transaction fees than the amount of value that ends up being transferred. The dollar cannot compete with Bitcoin in the niche of long-distance micro-transfers, and even in larger transfers, why would individuals choose to pay high transaction costs when they could do it for less with Bitcoin?

Some proponents of Bitcoin lament that there are not more brick-and-mortar merchants who accept the currency. If we adopt the market model I am suggesting, however, we would expect Bitcoin to first develop in those areas where it has the greatest market advantage. This explains in part the proliferation of online exchanges (see here and here). The exchanges provide not only the opportunity for speculation, but perhaps even more importantly (in the long run) the ability to exchange Bitcoin for national currencies thereby facilitating international transactions. This is one market niche in which Bitcoin is much more competitive than the US dollar.

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8 responses to “Bitcoin competing against the US dollar

  1. irdial August 7, 2011 at 12:21 PM

    You article is spot on, and I make a similar set of arguments here:

    http://irdial.com/blogdial/?p=3140

    by taking the text from a recent article on a Forbes blog and replacing the word ‘Bitcoin’ for ‘US Dollar’. As you can see, it very effectively refutes the articles illogic.

    There is another aspect of Bitcoins that make it superior to the US Dollar; they cannot be inflated at will by a venal central authority. Also, the total supply of Bitcoins is known in advance and at all times. On the other hand, The Federal Reserve has stopped publishing ‘M3′, the number of dollars in circulation. The transparency and predictable supply of Bitcoins, combined with the advantages you list here make it superior to the US Dollar in terms of utility and its foundations.

    What is just as interesting as the technical details of each currency and the arguments about them are the clearly irrational positions held by ‘Economists’ and specialist writers, who supply no sound arguments for why they believe Bitcoin must fail.

  2. presentcynosure August 7, 2011 at 1:45 PM

    @irdial, thank you for sharing. Your post (for which you provide the link) is very smart. It puts in stark relief some of the nonsense that people are arguing about Bitcoin, in particular with comparison to the US dollar. I think that you could make your point even more dramatic, though, if you put the value of dollars in terms of ounces of gold. Over the past hundred years the value of the dollar has fallen from approximately 0.05 ounces to 0.0008 ounces of gold. Indeed, Mr. Timothy Lee, might not the decline in value of the dollar represent its demise?

  3. archimerged August 7, 2011 at 7:03 PM

    @presentcynosure, 0.05 ounces to 0.0008 ounces of gold in 100 years is 4.22% inflation per year. The U.S. dollar is not supposed to be a store of value: it is the unit contracts are written in and salaries and taxes are paid in. Its value drops as a way of giving deadwood pay cuts without seeming to and to pay off long term debt by paying only the interest. If you want to store value, buy something of value. Which is not gold or bitcoins. Both take their value from the demand for them. Buy something that produces value.

    Bitcoin is a medium of exchange, not a store of value either. But because the U.S. congress rolled over and played dead in response to terrorism (by passing the “Patriot” act, instead of refusing to be intimidated), bitcoin will certainly be forced underground in the U.S.

  4. jjj August 7, 2011 at 9:36 PM

    Another aspect where bitcoin is in stark contrast to other currencies is that of programmability.
    For the first time, there is the possibility for software agents to have their own wallet – ie be in direct control of some cash. Combined with some of the new features being discussed regarding bitcoin ‘scripts’.. there are some fascinating possibilities.
    e.g setting up a cryptographically secure Business Relationship Session within which true instant microtransactions can safely occur… all using the bitcoin protocol with no intermediary required.

  5. Steve August 21, 2011 at 11:53 AM

    @archimerged: It seems to me that before something can be a medium of exchange it first has to be a store of value, ie., you transfer value to the medium which then delivers it to the recipient. By definition, the “medium” has to store the value before it can transmit it.

  6. gwern August 21, 2011 at 3:53 PM

    > The US government has made it illegal for anyone under its jurisdiction to not accept US dollars in payment. They have, through their authority, secured a monopoly for the dollar among currencies circulating in the US economy.

    From https://secure.wikimedia.org/wikipedia/en/wiki/Legal_tender#United_States

    > the Coinage Act of 1965, specifically Section 31 U.S.C. 5103, entitled “Legal tender,” which states: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.” There is, however, no Federal statute mandating that a private business, a person or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.

    I see.

  7. presentcynosure August 21, 2011 at 4:50 PM

    @archimerged, by your definition I am not sure what you would consider a store of value (cows?, property?, factories?). I think most people would consider gold to be a store of value. Also, people who bury dollars in a jar in their backyard consider dollars to be a store of value. And yes, all you have to do is go to the Bitcoin forums to find discussions on how best to “bury” Bitcoins. If you are burying anything it is because you think that it will hold some value that you will be able to recuperate once you dig it back up. I am using store of value in this common way of understanding it.

    @jjj, I too am eager to see how things develop along these lines. I limited myself to giving one example of a currently possible microtransaction that gives Bitcoin an edge over anything else that is out there, but depending on the technologies that are developed this market advantage could increase with time.

    @Steve, your argument is compelling to me.

    @gwern, in my post I am referring to the argument as given by Benjamin Friedman, the Harvard economist in the NPR Bitcoin podcast. Here is how he explains the inscription on US dollar bills: “What it means is that it is not legal for someone to refuse to take dollars in payment for something you buy, or to refuse to pay you in dollars.” You might be right, but in that case you will need to enlighten Benjamin Friedman on the matter. Regardless, though, his broader point still stands. The dollar has its monopoly in the US economy because the US government stands behind it and enforces its use in many ways (not least of which is collecting taxes in dollars). But even if we admit Friedman is correct on this point, he is wrong to think that Bitcoin will not survive just because it does not have a government (or another strong enforcing institution) behind it. That is my argument.

  8. Pingback: bitcoin-competing-against-the-USD | Bitcoin News

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