A central proposition in economics is that competition is good. Free markets are typically the most efficient way to provide people with the goods and services they want and to allocate resources and organize economic activity throughout the economy. Despite the logic of the argument, there is one element of this economic activity that even ardent proponents of laissez-faire economics have been afraid to leave to the vicissitudes of the free interchange of supply and demand: money. Historically, the issuance and oversight of currency have been considered strictly the province of government, and the idea of currency competition has been associated with financial instability. Indeed, for 150 years, U.S. financial firms such as commercial banks had been prohibited from issuing currency. And even though financial deregulation in the past two decades has provided U.S. banks with the opportunity to issue electronic currency to compete with official money, banks have not ventured into the business of private currency issuance.

However, in the past few years, innovations in computer science have permitted entrepreneurs to create digital currencies, most notably Bitcoin. Proponents cite the ease of payments in a decentralized transaction system requiring no third-party clearinghouse, while regulators express concern that these transactions fall outside the current regulatory framework.1

To economists, this innovation raises intriguing questions. Is a private currency even sustainable as sound money? Does the proliferation of private currencies inevitably lead to unstable prices and hyperinflation? Or is the profit motive sufficient to cause a private issuer to limit how much virtual money it pumps into circulation? To answer these questions we need a basic understanding of how currencies—including cryptocurrencies—work. This discussion focuses on those aspects of cryptocurrencies that are key to understanding their role in monetary exchange, and so, glides over many technical details.

This article appeared in the Second Quarter 2018 edition of Economic Insights. Download and read the full issue.

[1]Regulators around the world are particularly concerned with certain criminal activities that can be facilitated by the introduction of digital currencies on a global scale. There is also a concern that cryptocurrencies can promote tax evasion.