Indeed, the technology underlying bitcoin could fundamentally change the way we think of money.
It is only a matter of time before paper money is phased out. Sweden, where about 2 percent of value of transactions are done in cash, may eliminate physical money within five years. Most central banks are working on technologies to power a future digital currency.
Bitcoin and other cryptocurrencies are based on a complicated technology known as blockchain, which acts like a digital ledger of all transactions completed with the currency. It's somewhat similar to the serial number that you can find on every dollar bill, but it actually means something because it makes bitcoin nearly impossible to counterfeit.
The exploding value of bitcoin has many observers predicting the launch of a U.S.-backed digital cryptocurrency, colloquially known as fedcoin. And there are many reasons beyond fighting counterfeiting to switch to a digital dollar.
When was the last time you paid for anything with a $100 bill? Or even a $50? Many retailers won't even take them. Most ATMs spit out twenties no matter how much you withdraw. And yet 79 percent of U.S. dollars in circulation are represented by $100 bills. Include the $50 notes, and it's 85 percent.
So where are all these bills? In black markets. When police first captured infamous drug lord Joaquín "El Chapo" Guzmán, they also discovered a cash hoard including more than $200 million, mainly in $100 notes.
Cash has the distinct advantage of being anonymous. You can put cash under your mattress or in a vault, and no one knows about it except you. A national cryptocurrency would make it far more difficult for criminals to hoard money because all transactions would be recorded in the government ledger. If a transaction was deemed illegal, the parties to the transaction could be identified. This is also true with bitcoin, whose ledger is viewable to anyone. Despite the negative press about bitcoin being used for illegal transactions, bitcoin is not anonymous, and criminals who use it often do not understand that their transactions are being recorded.
There is another reason for governments to like the idea of a national cryptocurrency: strengthening the power of monetary policy to help manage the economy.
Currently, the Federal Reserve lowers interest rates during tough economic times, but the Fed is practically limited at the zero bound because it is difficult to impose negative interest rates (regardless of whether that would be good policy). Suppose bonds were issued with a negative interest rate of 2 percent, making it expensive for investors to hold them. Who would buy them? Why not hold cash, which has a zero percent interest rate? With a national cryptocurrency, whose supply is controlled by the central bank, rates can be negative.
Worried about deflation in a recession? No longer. A national cryptocurrency such as fedcoin would be able to operationalize Milton Friedman's famous "helicopter cash" as an alternative strategy to stimulate the economy. A single line of code could instantly put $1,000 into every person's wallet.
We are seeing an important proof of concept in real time — the meteoric rise in the popularity of bitcoin. Today, the technology is a niche product akin to gold. It is controlled by no one (in contrast to a central bank cryptocurrency) and has limited ability to process large numbers of transactions.
Fedcoin, by contrast, would be decentralized to various Federal Reserve banks. There would be central control over the money supply, just as we have today, but meanwhile, the technology would offer vast improvements in transaction efficiency. Digital transactions are quick, cheap and potentially a lot more secure than the system we have today.
If the Federal Reserve does adopt its own cryptocurrency someday, it will become a major — and far less volatile — competitor to bitcoin and other digital currencies. In fact, it's not clear whether fedcoin would want that competition, and the Fed is in a position to impose a regulatory environment that tilts the playing field. So watch out, bitcoin.
As we increasingly move toward a cashless society, the idea of central banks taking advantage of cryptocurrency becomes far more plausible. While non-government-controlled cryptocurrencies will likely survive (gold is not centrally controlled, either), the big idea is blockchain technology. This innovation has applications that will likely soon affect every company and consumer.