How Bitcoin can become a true digital currency.

I've been putting some more thought into bitcoin.  In a previous post, I explain that bitcoins do not have intrinsic value nor do they represent someone's obligation.  Bitcoins are nothing more than speculative money.  Accordingly, their value depends entirely on trust, and the inflow of new bitcoin believers.

That is not to say that building a digital medium of exchange is bad idea.  Quite the contrary.  The bitcoin protocol provides the infrastructure that could enable the flow of true digital currency, which can have profound implications on our economic lives. I am not a technical expert and cannot speak to the design and efficiency of the protocol, but the idea itself has significant merit.
 
What a digital medium of exchange needs is a true digital currency.  As I discuss in the previous post, the source of intrinsic value is work which creates utility.  When people trade, they attempt to exchange equal amounts of intrinsic value.  This presents a problem for fiduciary money (such as bitcoin) because it has no intrinsic value of its own.  When  sellers accept bitcoins, they are basically making a bet that someone else will be willing to take those bitcoins from them.  Until this speculative nature persists, bitcoins will not fulfill the transformative potential of a peer-to-peer medium of exchange.


The modern solution to the intrinsic value problem comes in the form of fiat money, which represents an obligation by a credit-worthy third party such as a government or a bank.  There is a wide-spread misconception that fiat money is backed only by trust.  Nothing could be further from the truth.  Imagine Paul borrows $100 from Jack.  Jack then goes to Peter and buys $100 worth of goods and pays by transferring Paul's obligation to Peter.  The money used in the exchange between Jack and Peter has real value because it represents Paul's obligation to pay $100.  Just substitute the government or a bank for Paul, and you'll get the basic idea of how fiat money works.  Ultimately, fiat money is backed by the credit of the government, which is derived from our obligation as citizens to pay taxes.  If you place your trust in the US dollar, you are ultimately placing your trust in the productive capacity of the American people.

What a true digital currency needs is a credit-worthy party willing to take on liabilities that can be monetized in the form of bitcoin or any other digital token for that matter.  New bitcoins will no longer be issued when miners solve crypto-puzzles, but rather when such third party takes on new debt and issues bitcoins in exchange.  More importantly the value of the bitcoin will be equivalent to the value of the debt of the issuing party.  This will eliminate the wild price swings and transform the bitcoin into a true digital currency.

Such arrangement will put bitcoins in more direct competition with traditional financial markets.  Furthermore, it could represent a potential threat to bank monopoly on money creation.  Such competition will be healthy for consumers and the public at large.  The outcome will be based on which market can offer lower borrowing and transaction costs. This calls for a pretty dramatic change to the bitcoin protocol.  Specifically, bitcoin miners will no longer be compensated by mining new bitcoins, instead they will have to rely exclusively on transaction fees.  At this point, it is not at all clear whether the transaction fee alone provides sufficient incentive as to compel miners to continue to operate the peer-to-peer exchange.