Is virtual money as good as gold ?
Virtual currencies have attracted the attention of both the media and policymakers around the world recently. Although virtual currencies aren’t especially new, the attention paid to them has been. Virtual currencies are those used in electronic, generally Webbased transactions. They are not issued by governments, which many view as positive at a time when confidence in governments is low.
Attention has focused on bitcoins, the supply of which is determined by an algorithm. Demand for the virtual currency grew with the media attention and the exchange value of a bitcoin reached a peak of more than $1,200, although the value has subsequently dropped nearly 30 percent as speculation in the virtual currency has decreased since policymakers have started paying more attention to it.
China recently banned financial institutions from trading bitcoins, and Norway has declared bitcoins to be an asset not a currency, which has important implications. Former US Federal Reserve chairman Alan Greenspan described bitcoins as a “bubble”, which also suggests that virtual currencies should be regarded as assets, because assets have bubbles, currencies become overvalued.
Bitcoins are not the only virtual currency; others have existed for some time. Computer games often have their own currency, with players earning units of the currency or tools or characters through their skill at playing the game. In some cases, a virtual currency can be purchased using real-world money, which enables the calculation of a virtual to realworld exchange rate. This trade has been going on for at least a decade, and several governments were quick to note that income earned from such transactions should be subject to tax.
So what are the key issues when it comes to a virtual currency? There are four questions to answer:
First, who controls the supply?
Matching the supply of any currency to the level of demand determines the value of the currency. This is what central banks try to do in the real world. The same principle applies for virtual currencies. If the supply is not controlled, the value of the currency is likely to disappear. If the creator of the currency ceases to exist, the computer game company goes bankrupt perhaps, the value of the currency is also likely to disappear. Similar risks apply in the real world — countries cease to exist, and their currencies may then cease to have value — Confederate dollars, anyone? However, as government systems collapse less frequently than companies, real-world currencies should be safer. Second, is it safe? Modern real-world currencies generally have some legal guarantees. Holders of a real-world currency in a banking system have partial protection from fraud or theft. Virtual currencies, not being issued by governments, have less protection. As virtual currencies are entirely electronic they could be considered more vulnerable to cybercrime than a real-world currency, although real-world bank accounts can be hacked too. Third, is it money? Anything accepted as a “medium of exchange” for goods and services is money in some sense. However, there is an important distinction when it comes to tax, as Norway has so obligingly highlighted. The tax treatment of money and assets differs. If a realworld currency appreciates, domestic sellers of that currency are rarely subject to tax. If an asset appreciates, domestic sellers of that currency will be subject to tax. If governments consider virtual currencies to be assets, not money, then holding virtual currencies will incur taxes not levied on holders of real-world money.
Fourth, what is a virtual currency worth?
For an economist, this is an easy question to answer. A virtual currency is worth what someone else is prepared to give in exchange. A virtual currency is of no value, unless someone else is prepared to accept it in exchange for goods or services that are of some use or value. If no one is prepared to give up something useful in exchange for a virtual currency, then the virtual currency is not worth the bytes it is written with.
There is no compulsion to accept virtual currencies. Real-world currencies have some compulsion. Creditors are — generally — legally obliged to accept a real-world currency in settlement of debts. Moreover, taxes are levied on real-world currencies. This creates an automatic demand for real-world currencies, which is lacking for virtual currencies. No one has to accept virtual currencies in settlement for anything, and governments are unlikely to react positively to any attempt to settle a tax bill with bitcoins.
There is an interesting comparison to make between virtual currencies and gold. On the most important question— as to what a currency is worth — the answer is the same for both virtual currency and gold. The value of gold is simply whatever anyone else is prepared to exchange it for. In real-world terms the value of gold has fallen 27 percent from its 2013 peak — a performance that is eerily similar to the fall in the value of the bitcoin. Gold is also generally treated as an asset not a currency, the exception being some gold coins, and subject to more tax than a real-world currency.
In a sense, therefore, gold was the first virtual currency — at least after 1971 when the tenuous link between realworld currencies and gold was severed. Given the wild fluctuations in the value of gold — what it can buy — over the past 40 years, that may not be terribly reassuring for those holding modern virtual currencies. The author is a senior global economist with UBS.