Money is what money does! OK, it may be carrying things a bit far. But money does have some definition. As per Wikipedia, money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country.
Money does have many functions and they are to serve as (i) a medium of exchange; (ii) a unit of account; (iii) a store of value; and (iv) a standard of deferred payment.
Now we are clear about what money does. But what are the characteristics of money? They are: (i) durability, (ii) divisibility, (iii) portability, (iv) non-counterfeit-ability and (v) consistency.
All contemporary money systems are based on fiat money. Fiat money is without intrinsic use value as a physical commodity. It derives its value by being declared by a government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for “all debts, public and private”. Such laws in practice cause fiat money to acquire the value of any of the goods and services that it may be traded for within the nation that issues it.
Now we have seen what money does and what are its characteristics. You must have observed one interesting point here – there is no requirement that money or cash should be physical object! This gives rise to interesting possibilities.
Two recent developments are worth mentioning when we talk about money. The first one is the news report that Swedish banks are doing away with cash as Krona goes virtual and second one is emergence of Bitcoins.
Let us look at the first development. A report on Bloomberg on 11th April 2013 said that most of big banks in Sweden have stopped manual cash handling services in 65 percent to 75 percent of their local branches! They say cash is out as Swedes rely on credit cards, the Internet and mobile phones to make all their payments! Currency is used in only about 20% of shop transactions! Further, these banks say that only 5 percent of their clients make over-the-counter cash transactions. Here it is to be noted that the Nordic countries did away with the cheque about thirty years ago!
Swedish banks say that removing cash handling services is helping them to cut costs. It is also helping in raising income from their cards business! Removal of cash handling services have also helped in drastically reducing bank robberies in Sweden!
Incidentally banks in Sweden have performed better than many banks in rest of Europe! These banks are also among Europe’s best capitalized banks.
The second development is the excitement caused by Bitcoins. They’re a virtual currency invented in 2009 by a mysterious hacker who adopted the pseudonym Satoshi Nakamoto. Angered by the 2008 financial crash, Nakamoto wanted to create a currency that would be independent of government, so that a person’s money could be secure from the machinations of politicians and bankers. The Bitcoins themselves are all bit and no coin — there’s nothing solid to hold in your hand, just a series of letters and numbers that you keep in a virtual “wallet.” Once you have them, you can exchange them online for actual goods! Unlike U.S. dollars, euros, or other established currencies, Bitcoins are not backed by any government or central bank. With Bitcoins, the transactions are purely peer-to-peer, but the movement of every single Bitcoin is tracked and publicly recorded to avoid fraud and counterfeiting.
One can “mine” them by using highly sophisticated computers to compete against others to solve complex math problems and win the Bitcoins, released every 10 minutes in a sort of lottery. So far, around 11 million have been mined, and the lottery will stop when 21 million Bitcoins have been generated. A much simpler way to get your hands on a Bitcoin is to just buy one from someone who already has them — usually on a currency exchange website that allows you to swap dollars for Bitcoins. Then when you want to spend the Bitcoin, you send the agreed-on amount to the recipient’s online “wallet,” and off it goes.
Bitcoins do perform the functions which fiat money does i.e., to serve as (i) a medium of exchange; (ii) a unit of account; (iii) a store of value; and (iv) a standard of deferred payment. Further, it also has characteristics of fiat money i.e., (i) durability, (ii) divisibility, (iii) portability, (iv) non-counterfeit-ability and (v) consistency.
What is does not have is legal backing and a central bank. Recently, Bitcoin’s value plummeted 77 percent in just two days, due to technical problems with a Bitcoin exchange server, and it has experienced similar crashes in the past when servers or virtual wallets have been hacked. That volatility limits Bitcoins’ appeal: How can people depend on a currency whose value can halve from one day to the next?
There are also deeper problems over its legality. It’s only a matter of time before officials address two major issues: First, the fact that the Bitcoin effectively competes with the fiat currency, thereby violating law. Second, that because Bitcoin transactions are anonymous, criminals and money launderers see huge opportunity!
Now let us come to the very purpose of this article – Will virtual currency make paper currency redundant? Will virtual currency become more acceptable than fiat currency?
The most important requirement for a medium of exchange is acceptability. It is very difficult to see wide acceptance for any currency without legal backing and a regulator. However, use of cards, the Internet and mobile phones can increasingly do away with the paper currency but it is a bit difficult to visualize a future with a dominant virtual currency without any legal backing such as Bitcoins.
Bitcoins may be useful for making online payments for small value purchases on the internet but large ticket deals and investments in Bitcoins (or some other similar currency) is something which is very difficult to visualize now!
I will place my bets on a cashless world than on world with virtual cash!