Please enter your email below to get MrMoneyHustler updates!!!

Thursday, February 14, 2013

A Tale of Two Currencies

     Throughout history humans have had two types of currency.  The purpose of the first type of currency is to provide a handy and available medium of exchange.  Cash is an example of this type of currency.  It is what we use everyday to buy stuff.  The purpose of the other type of currency is to be a safe store of value.  Silver coins are an example of this type of currency.  The buying power of this type of currency holds steady or even increases with time.   All matters concerning money are relative, but in general, there are two needs that money provides solutions for: a medium for exchange, and a store of value.

     In ancient times we might have seen this dynamic play out with gold and silver.  Silver was used for everyday purchases, and gold was used as a more desired form to store large quantities of value and for longer periods of time.  Today, many forms of investments are used to store value, or even appreciate value, over long periods of time.  For example, real estate could be seen as this second type of money I'm referring to.  Real-estate and many other forms of investment are sometimes used as a safe store of value, or a form of money that either preserves or gains in purchasing power.  Other examples of items that are used to store and appreciate value are gold, stocks, antiques, and diamonds.   These items often satisfy the need humans have for storing their efforts for production from one day, and reclaiming the value of their efforts on some day in the future.

     When we think about how to design money or a monetary system, we might like to have a single currency that satisfies both the need to store value, and the need to have a handy and available medium for exchange.  Because of human behavior however, this is not possible.  If we try to make the currency that is used for daily exchange also satisfy the need for safe value storage, the result is that it will be hoarded under certain economic conditions.  People will value the currency itself, and it will no longer be readily available to trade for goods and services as people begin to accumulate the currency and hold onto it.  In order for a healthy economic system to operate smoothly, there is a need for a slight disincentive to hoarding the type of money that is used for everyday purchases.

     The Federal Reserve System accomplishes this by slowly devaluing the purchasing power of the currency that is used for everyday trading.  This is done fairly simply by introducing currency, US dollars for example, into circulation at a slightly faster rate than economic activity increases, or slightly faster than goods and services are made available to the economy.  The result is mild but steady inflation, and that situation encourages people to seek to trade their dollars for assets that will not lose value.   Those assets might be gold, real-estate, stocks, or anything else.  The point is that it is not in the best interest of the average person to save dollars for a long period of time because they will slowly lose value.  It is better to accumulate assets that will appreciate in value relative to dollars.   This is the mechanism by which dollars become like a hot potato and people are eager to trade them for more tangible assets.  This arrangement keeps the dollars flowing around in circles through the economy, and it helps keeps them handy and available for everyday transactions.

     People have many choices as to what they want to use for the second type of currency, their "store of value".  The best choices for a currency that is to be used as a store of value are currencies which are made available at a slower rate than the growth of the overall economy.  The idea is to have demand for the currency outpace new supplies of the currency.  So, in this case, the purchasing power of the currency will hold steady or even increase with time.  Gold has been a good example of this over the last 10 years.  Because of limitations on mining, supply is limited.  The economies of the world have grown handily, and so the purchasing power of gold has grown also since supply is limited and demand increases.

     Our current system has some problems though.  Namely, people are in control of the system, and people have conflicts of interest.  People don't always do what is best for everyone when they have to option to do what is best for themselves, or their friends, or their family.  That's not to mention the potential for humans to screw up.  Also, our current system depends on an incredibly complicated system of accounting which is used to get information to the decision makers.  Error and delay are always possible along the way.  These issues may be short lived however, because we are standing on the brink of a revolutionary solution to these problems.  We now have the ability to design our two types of currency in a way that eliminates the human factor, and in a way that bases adjustments to money supply on real-time data from the economic conditions of the moment.

      Welcome to the era of electronic crypto-currency!   We have one, thus far, successful example of a crypto-currency.  It is a currency which is optimized to behave as a "store of value," and it is called Bitcoin.  Bitcoins are designed to appreciate in value by virtue of limitations on the introduction of new Bitcoins.   Demand is far outpacing supply, and as a result, the price for each Bitcoin is rising very rapidly.  The effect of this situation is clear; people tend to hoard Bitcoins rather than buy stuff with them because they are appreciating in value so rapidly.  As the world of crypto-currency matures, we will need another currency type that satisfies the need to have a handy, readily available medium for exchange ... ergo, a currency that people don't tend to hoard.

     We can accomplish that goal by copying the Federal Reserve system in the context of a computer program.  One cool feature of a crypto-currency is that every transaction is logged electronically.  That means that the volume and velocity of monetary movement is known in real time.  The actual amount of economic activity is known.  With that information readily available, a computer program can easily control the introduction of new currency at a rate that is slightly higher than the increase in economic activity.   A reduction in monetary supply could also be programmed to take effect as needed.  The key thought here is that the human element of the Federal Reserve system is now expendable.   We have better options at our fingertips.

2 comments: