Bitcoin, negative interest rates and the future of money

I believe that everybody who is interested in money should study the digital currency Bitcoin very carefully because monetary innovations can have long lasting consequences even when they fail miserably:

1. China’s experiments with paper money ended in inflationary disaster (as almost all fiat money appear to do), but it succeeded in replacing China’s long standing bronze coin standard with a silver unit of account (see for example, Richard von Glahn (2010), “Monies of Account and Monetary Transition in China, Twelfth to Fourteenth Centuries”, Journal of the Economic and Social History of the Orient, 53(3), 463-505)
2. Johan Palmstruch who brought paper money to Europe and founded the world’s first central bank (the Sveriges Riksbank of Sweden) was sentenced to death. Though he was reprieved, he still lost everything and ended up in jail.

There is little doubt in my mind that digital currencies represent a vast technical and conceptual advance over the currencies in existence today. This would remain true even if Bitcoin implodes in a collapsing bubble or is destroyed by technical flaws in its design or implementation.

Nemo at self-evident.org has an excellent ten part series providing a gentle introduction to all the mathematics that one needs to understand how Bitcoin works. This is a good starting point for somebody wanting to go on to Satoshi Nakamoto’s seminal paper introducing the idea of Bitcoin.

From a finance point of view, what is most interesting about Bitcoin is that it is perhaps the first currency to be designed with a strong deflationary bias. There is an upper limit on the number of bitcoins that can ever be created – even lost bitcoins cannot be replaced unlike normal central banks that replace worn out notes with newly printed ones. In paper currencies, if I lose a currency note, somebody else probably finds it, and so the note remains in circulation. By contrast, Bitcoin is so designed that if the owner loses a bitcoin, the “finder” cannot use it, and so the lost bitcoin ceases to exist for all practical purposes. (If you are puzzled by the apparently inconsistent capitalization of bitcoin/Bitcoin in this paragraph, you may want to read this).

While most fiat currencies end up printing notes in higher and higher denominations to combat inflation, Bitcoin is designed to combat deflation by using smaller and smaller denominations like milli bitcoins and micro bitcoins all the way down to the smallest unit named the Satoshi which is equivalent to 10 nano bitcoins. As a result, the zero interest rate lower bound could be an even more serious problem for Bitcoin than for existing currencies.

One theoretical possibility is that the deflation overshoots significantly so that the currency can experience a mild inflation from that point onward somewhat on the lines of the Dornbusch overshooting model. But for that to work on a sustained basis, there would need to be periodic bouts of intense episodic deflation. The sharp appreciation of the bitcoin in the last few weeks in response to the Cyprus crisis suggests one way in which this could happen, but that would be a nightmare to model.