There’s no substitute for real money

History is replete with schemes and approaches to create substitutes for real (that is, government-backed ) currency. And what they all have in common is that, eventually, they have all failed disastrously. Let’s review some of the more famous debacles that happened in the past and a couple that are playing themselves out presently.

In the 1600’s the Tulip Craze hit Holland. While the craze is usually cited as the stereotypical example of irrational exuberance leading to a market bubble that ultimately is unsustainable, it is also true that during that period the tulip actually acted as an informal currency. A large variety of real goods and services were exchanged for tulips.

Fast-forward now to the dot-com era, during which the online currencies Beenz and Flooz were introduced as alternatives to actual hard currencies. Both failed spectacularly in 2001, with Flooz even garnering the honor of being named one of the Top 10 Dot-Com Flops by CNet.

Even the most successful alternate currency systems, the myriad of loyalty points programs such as those run by the airlines, are fraught with problems. Frequent flier programs are seeing growing discontent from consumers, with industry analysts predicting a wholesale exodus from such programs in the near future.

Despite the failures of all these schemes in the past, new forms of alternate currencies continue to be introduced. For instance, in virtual worlds and massively multi-player games, the practice is common to create an in-world currency: Second Life has Linden Dollars, World of Warcraft has gold. So long as the virtual money remains confined to the systems with which they are associated and is used only to acquire virtual goods within those alternate worlds, these currencies are just “Monopoly Money” and little if any harm can be done. But, as we all know, these currencies are being exchanged for actual, real money.

Back in the real-world, the modern-day tulip is the mobile phone airtime minute, which has taken hold in places such as the Philippines and Africa as a form of cashless currency.

The problems with such informal currencies are many, which can be analyzed in terms of 3 overlapping categories: Trust, Fungibility, and Real-World Issues.

Ultimately the purpose of a currency is to protect the sanctity of a transaction. Back in the ages when bartering dominated commerce, the sanctity of the transaction was not an issue because there was no lag time between when you gave 3 chickens and received a bushel of apples. Introducing currency allowed you to drop off your chickens at the butcher shop and then go next door to the fruit stand to get your apples. But, if the currency can’t be trusted to retain its value for the short period of time between when you to conduct the two transactions, the currency is ultimately worthless. (I’m avoiding a discussion of the time value of money by keeping a focus on short time periods.)

Trust is broken when value is lost (note the currency crisis in Argentina a few years back). Real-world currencies protect trust through government backing, formal monetary and fiscal controls, and regulation. Governments ensure scarcity of the legal tender and act to control inflation, thereby ensuring a stable money supply and value preservation. Who is ensuring the trustworthiness of informal currencies? Do their incentives align with this goal?

Fungibility speaks to the usefulness of the currency. Real-world currencies are highly fungible because they are essentially universally accepted and also convertible into other currencies. Informal currencies are also convertible, to a point. But, the controls and the mechanisms for such conversion are akin to the black market exchanges in the former Communist states, much because informal currencies are not recognized as legal tender by any government. The effect is similar to what happened when the Soviet Union outlawed the possession of US Dollars: it drives the exchange market underground, which ultimately makes use of the currency inefficient.

Informal currencies lack fungibility because they are not universally accepted. The reason for this ties back to the Trust issue and the lack of formal backing. Concentrating on the currency of airtime minutes, obviously this currency lacks fungibility because it’s necessary to find someone willing to accept minutes as legal tender, which has a number of barriers: must be on the same network, must agree on the value of the minutes, must be on a prepaid airtime plan, must be able to further use the minutes as currency to make purchases, etc.

Real-world issues have a profound impact on informal currencies. How are transactions taxed? What are the property-rights implications? Who adjudicates and resolves disputes?

All these issues, and many more, have already been addressed for real currencies over a period of thousands of years. The banking industry and infrastructure that we see today is the culmination of these efforts. Until such time as informal currencies have the same amount of control, they will continue to be just a shadow of the real thing, and they will always eventually wilt, just like a tulip.