The Inflationary Effects of New Electronic Money
|March 9, 2014||Posted by Fred Foldvary under Editorials|
The emergence of electronic currencies such as bitcoin has caught the imagination of economists, speculators, and fans of non-governmental financial alternatives. Electronic currencies are created by software and held in computer files. These are also called “cryptocurrencies,” since they apply cryptography for security.
Most of the electronic “coin” currencies are generated by computer programs that require much time and resources, in order to limit the supply. When new units of the currency are created, this has the same effect as mining new metal for commodity money, and so the electronic currency creation is also called “mining.”
The creation and expansion of an electronic currency is similar to that of other alternative currencies. In some cities, people have established local currencies, some based on labor hours. Some merchants accept these, and the notes circulate as a medium of exchange. The effect of these local and alternative currencies is to expand the overall money supply.
Suppose in some U.S. city with a population of one million persons, there is $100 million in money held by the public. Then a financial entrepreneur enters the picture. He introduces labor-bucks as a local currency, which exchanges at one labor-buck per $1. He gives each person in the city 100 labor bucks, for a total of 100 million labor bucks. On the average, each person now has $100 plus 100 labor bucks. If the labor bucks stay within the city, each person has twice as much purchasing power, and that drives prices up. If the city were an isolated economy, and the total amount of goods for sale is unchanged, the labor bucks distribution will, after some time, double prices, including a doubling of wages and rent.
But since the city is in an open economy, any increase in prices would make people buy at nearby cities. So the prices do not rise by much. Instead, the local people buy twice as many goods. Is this a free lunch? Has the new currency created value out of nothing?
There are free lunches, contrary to the usual slogan, but this is not one of them. The increase in the local money supply will increase the demand to buy goods beyond the city, and unless this stimulates new production, the effect will be a small increase in the general price level of the country, and to a lesser extent, an increase in the price levels throughout the world. In today’s open economies, the creation of new money is at the expense of the value of all the other money.
The same thing happens when the Federal Reserve or other central banks expand the national money supply. The purchasing power of those first getting the new money is offset by the reduction of purchasing power of everybody else. New money is at the expense of old money.
Since it takes time for money to circulate and increase demand and raise prices, those who first obtain the new currency at no cost or at a discount will profit at the expense of everybody else.
It is not surprising, therefore, that many new electronic currencies have sprung up. Besides the well known bitcoins, a new electronic currency, the auroracoin, is being introduced in Iceland. Half of its mined coins will be distributed to the entire population of Iceland, starting on 25th of March 2014. After its banking crisis, the government of Iceland imposed restrictions on the use of foreign currency. The hope is that auroracoin will enable the people of Iceland to engage in international transactions in the alternative currency.
By better enabling transactions, and by providing an alternative to loans, electronic currencies don’t just add to the global money supply but may also stimulate more production and trade. Recovery from recessions is typically held back by credit constraints, and if people can instead obtain cryptocurrencies, this reduces the need for credit, and also reduces the transaction costs of international financial exchanges.
A confederation of tribes in the Oglala Lakota native-American nation in the U.S. is also creating an electronic currency, the MazaCoin. A leader of the Lakota Nation, Payu Harris, hopes that crypto-currencies will be the “new buffalo.” The Lakota nation will hold some of the coin in a Tribal Trust for loans and support to local businesses.
Electronic currencies will serve to facilitate trade, investment, production, and employment if they are used for buying and selling goods rather than mainly for speculation. Bitcoins have been a medium of speculation, and there was a reported hacker attack on the bitcoin exchange Mt. Gox that stole the funds. The US government is also involved in seeking to prevent the use of cryptocurrencies for money laundering and illegal goods.
We are still in the pioneering stages of electronic money. There is room for a new currency that would be in the hands of the general public and have a stable purchasing power, and which would balance privacy and security with public information that minimizes its use for criminal purposes.
A problem with a new currency is how to set its value. One way is to anchor the value to some commodity such as coffee. Suppose coffee generally sells for US $2, and there is a new electronic currency, newcoin. For three months, people would buy newcoins for $1 each, and merchants would sell the coffee for one newcoin. Many people would want to use newcoins for the inexpensive coffee. The newcoin miners would then reimburse the merchants one newcoin per coffee sold. After three months, the special price would end, and from then on, the value of newcoins would be based on market trading.
The alternative method is to let the market establish the value of the currency prior to its use. Since the coin is not tied to any commodity, its value could fluctuate widely, as has bitcoin.
At any rate, the introduction of many electronic currencies will result in a great expansion of the global money supply. The supply of each electronic currency is limited, but the number of electronic currencies is unlimited. Economic theory, namely the quantity theory of money, the proposition that the monetary inflation causes price inflation, predicts that the increase in cryptocurrencies will increase the demand for goods and will increase global price levels.
One can therefore expect a global inflation of prices, perhaps hyperinflation. That will greatly increase the price of monetary commodities, especially gold, and also land values. I therefore expect the price of gold to erupt up during the next decade. I may be incorrect, but if there is a commodity in limited supply, and purchasing media that can increase without limit, it’s not a bad bet to believe that the quantity theory will hold up.