Currency is a means to an end. The end is growth, happiness, knowledge, complexity, diversity, etc...
Currency is a mean to those ends because it allows people to collectively trade goods, i.e. through the use of currency I don't need to trade my engineering services directly with farmers in order to eat breakfast, lunch and dinner everyday. I can trade my engineering services with companies, who pay me in $dollars, and somewhere down the line, farmers trade their food for $dollars.
This is the most important purpose of a currency: a respected Medium of Exchange.
The other major purpose of a currency is not really a function of the currency as it is really a function of the investor. The question is: can the currency be invested into companies and/or banks so that one's investment in terms of real goods increases with time. In order words, the money invested into companies and banks should not have rapid fluctuations and it should increase with time, i.e. it should be a stable Storage of Wealth. This means that all sorts of growing companies need to accept payment of the currency. This also means that the currency must be safe from theft and that you can purchase stocks/bonds/homes using the currency with near-zero transaction fees.
As of the end of 2013, Bitcoin appears to satisfy only one of the two purposes of a currency: Medium of Exchange. (For more details on Bitcoin, check out the following YouTube video. It's the best summary of Bitcoin I've seen so far.) As far as a stable Storage of Wealth, Bitcoin has failed miserably...due to theft, price fluctuations, and arbitrary rules for increasing the number of Bitcoins in circulation. But this is not a complete problem, as long as you realize that you shouldn't be holding onto Bitcoins, but rather you should be investing your savings into projects with real, positive rates of return on investment, such as stocks and bonds. Where are the stable and growing Bitcoin-friendly banks, stocks and bonds?
I think that there are some novel aspects to Bitcoin as a currency, such as the innovative way of having all of the currency transactions recorded by the public and without a central organizing agency. I would like to see a currency like Bitcoin take off and become a global medium of exchange with near-zero friction (i.e. with near zero transaction fees.)
However, people who purchase Bitcoins should realize that there are some underlying problems with Bitcoin:
(1) There is currently an arbitrary limit to the number of Bitcoins. This expected limit is around 21 Million Bitcoins. (See graph below) The problem is that it's not clear what will be the incentive to secure the transactions (i.e. to mine Bitcoins) if there are no more Bitcoins available to be generated.
(2) To continue along point 1, the amount of currency should track the growth in the capability to generate useful work. New currency should be generated when self-replicating power plants are built, and not due to some arbitrary limit and not when gold/silver are mined out of the ground. I'd like to see an alternative to Bitcoin in which new currency is generated only when new power plants are built and only when people democratically vote to allow more currency (i.e. not just when Ben Bernanke says so.)
(3) Right now, new Bitcoins are instead generated when transactions occur, but there is no connection between the amount traded in transactions and the growth rate in useful work.
So, here's how we solve the problem of too much inflation or deflation.
(1) We create an alternative to Bitcoin in which new currency can be created only when new power plants are created (or purchased from existing economy.) The new currency goes to those people who build the new power plants. The only problem here is to collectively and democratically decide on how much to pay the builders of new power plants and democratically vote on which new power plants to build.
(2) Those people who help in running the math problems are paid (not by creating new Bitcoins), but via a transaction fee payment from those people who trade in Bitcoins. One problem with Bitcoin is that those people who started mining early will become rich without having done anything of real value. This is one of the reasons that I'm skeptical of Bitcoin...that the early adopters have rigged the system so that they can become wealth at the expense of those who join later. In this sense, Bitcoin is very much like bubble waiting to burst. (Though, as I've said before, there are some really innovative aspects to Bitcoin that will be used, probably, in all future global currencies.)
So, my overall impression of Bitcoin is that it can't replace gov't backed currency, such as the U.S. dollar or the Euro, as a stable Storage of Wealth. Because of the arbitrary rules on the creation of new currency, I find Bitcoin currency to be as silly as gold and silver as currency. And just like gold and silver as currency, I predict that Bitcoin currency will fail to be an effective large-scale currency unless it changes its underlying method for generating new bitcoins. The failure of nearly every currency so far has been due to faulty rules for generating new currency. (The exception to this has been those currencies whose central banks are forced by law to maintain a constant average inflation rates. Though, as I've discussed in previous posts, the question for those currencies are: what set of goods to maintain a constant inflation rate? My choice is to maintain a near-zero, constant inflation rate in the yearly-average price of useful work...i.e. electricity and mechanical work.)
To generate new currency with Bitcoin, you can mine Bitcoins by using your computer help solve the encryption problems that allow the system to operate smoothly. The problem with Bitcoin is that there is always the question: how much new currency should allowed to generated each year? Worse, there is apparently no way to remove currency from circulation once it's been generated. This is a recipe for disaster because a currency needs to be able remove currency from circulation when people collectively made bad investment decisions.
The problem of inflation/deflation in Bitcoin is similar to problem faced by gold or silver currency. Unless you have an a trustworthy organization that can control inflation (i.e. control the increase and decrease of currency in order to maintain constant inflation), then you invite corruption and waste. For example, back when gold and silver were the main forms of currency, there was the continual incentive to find new sources of gold and silver. The Spanish Empire of the 1600s stole large quantities gold because it appeared to be valuable.
In the short run, this was good for the Spanish economy because it looked like they were generating wealth. However, in the long run, this was no different than a drug addiction. There is no wealth generation by moving gold and silver from one location to another. Wealth is only generated when there is a self-propagating increase in the amount of useful work. So, instead of learning how to generate real wealth, the Spanish Empire got addicted to the short-term gain of stealing gold from others and introducing it into the European markets.
As Milton Friedman stated in his Lecture "Inflation & Money", inflating a currency is like a drug addition because, in the short term, there is some gain as it appears that there is more business and more people are spending money. However, in the long run, if the rate of increase in the amount of currency grows faster than the underlying growth in useful work, then there will be inflation. The problem with inflation is that if inflation is large and/or not-constant, then it can actually decrease growth rates in society. (See actual data at the following post on how large and/or non-constant inflation rates correlates with lower growth rates.)
So, to end this post, I'd like to summarize the main point and I'd also state that I'd really like to see Google develop its own currency. I think that Google needs a way for people to increase their storage capability on its networks. We should be able to spend Google dollars (earned by filling out surveys or allowing ads on websites) to buy more storage space. (Right now, Google gives people real dollars for allowing ads on websites. There should be option for receiving Google dollars, which can be spent on Google products or converted into other currency.)
But ultimately, any currency needs to answer the following questions:
(1) Is it a universal medium of exchange? (i.e. can all goods and services be bought and sold using the currency?)
(2) Are transactions safe and secure?
(3) How are new coins generated? Who receives the newly created coins? Did the people who received the new coins do anything of value to earn the coins? Can coins be removed from circulation to prevent inflation?
(4) Who decides the rate of increase or decrease in the money supply?
My answer to the last two questions is: that power plant construction companies should receive the new currency to help build new power plants (perhaps the new coins cover 10% of the upfront expense per levelized kWh of electricity that consumers will purchase) and that the rate of new currency should be voted on democratically by those people who will use the electricity generated from the power plant. (This requires a secure way of voting over the internet which can hopefully be done in the same way that Bitcoin works with transactions. A record of your vote is saved forever. And perhaps the number of votes you get depends on how much electricity you consume.)
Let me know if you have any thoughts on improving such a currency, and let me know if such a currency already exists.