[Economy] Barter-Money-Bitcoin: Circular Flow of Income, Savings to Investment, Time Value of Money, Deferred Payments (Part 2)

circular-flow-of-income

[Economy] Barter-Money-Bitcoin: Circular Flow of Income, Savings to Investment, Time Value of Money, Deferred Payments (Part 2)

  1. Prologue
  2. #5: Difficult to store Value
  3. #6: Savings don’t turn into investment
  4. What is Circular flow of income?
  5. #7: Account-keeping = mission impossible
  6. #8: Lack product specialization
  7. #9: Future contracts and deferred payments
  8. Time value of money
  9. Bitcoins and Smart Contracts
  10. Mock Questions

Prologue

In the previous article (Part I), we evaluated Barter-Money-Bitcoin systems on four parameters:

features barter Fiat money (Rs./$) Bitcoin
#1: trade can happen without double coincidence of wants? No Yes Yes, if both parties agree.
#2: Promotes division of Labour? Hardly yes Yes, but limited @the moment.
#3: Divisible? Not always Yes but upto 10-2 Yes and more divisible than fiat money. 10-8
#4: Fungible? Not always Yes Yes, for now.

Let’s continue further, what are the limitation of bartering system? Why did people shift to money system and how does Bitcoin fare on those parameters?

#5: Difficult to store Value

UNDER MONEY SYSTEM UNDER BARTER SYSTEM
  • You earn money for providing goods and services to others. This is the ‘value’ of your labour.
  • You can and save / invest this value (money) in bank, Fixed deposit, shares, bonds, mutual funds etc. =possible to store the value of your ‘labour’ for a long period of time and become wealthy.
  • If the value of your labour is paid in Perishable commodities like milk, butter, rice, potato, fishes etc., it cannot be stored beyond a few weeks/months/years.
  • Same for livestock wealth -cows, bullocks, buffaloes, horse, camel, elephant etc. you may also need to pay their caretaker and veterinary doctor.
  • Even for a relatively non-perishable commodity like silk-it’s difficult to store value confidently: what if someone invents synthetic fibers and the demand for silk clothes suddenly falls down?
  • Stored value generates more income e.g. interest from savings account, dividend from shares.
  • Not always. E.g. dried fish will not generate more fishes.
  • Exception1: stored wine because its quality increases with time.
  • Exception2: Gold, diamond, real estate etc. things that are non-perishable and whose demand increases with rise in population.
  • Money is the most liquid asset- you can use it for buying almost anything immediately.
  • Even if you have 1 crore rupee in savings account, you can take out a few hundreds and dine in a restaurant.
  • With gold/diamond/real-estate this is difficult. They’re relatively less-liquid assets.

So far, money system is better than barter system, for storing the ‘value’ of your labour.

But the Main problem: Inflation erodes the value stored in money. For example:

  • within 2013, the onion prices have rose from Rs.20/kg to almost Rs.100/kg= 400% price rise
  • In a fixed deposit, you’ll barely get ~9% return in a year.
  • So even if you prudently store the value of your labour (salary) in money, your purchasing power declined.

Similarly, if government overprints currency notes for the sake of financing a war, bailouts of troubled PSUs or running populist welfare schemes =that also creates inflation, and erodes the purchasing power of money. Recall Rajiv Gandhi Suitcase Yojana.

What about Bitcoins?

Bitcoins are created by a mathematical algorithm, total amount of Bitcoins is finite (~21 million Bitcoins). Nobody can overprint Bitcoins beyond that.

It is possible to store value of your labour in Bitcoins e.g. IT Professional makes new software for American businessman and gets paid in Bitcoins. But…

  • Bitcoin itself cannot buy many goods and services at the moment, because Bitcon is not a fiat currency unlike Rupee, dollar or Euro.
  • At some point, you’ll have to exchange Bitcoins for a fiat currency- when you want to buy milk, vegetables or pay electricity bill.

And there comes the problem: the exchange rate between Bitcoin vs. fiat currency

year 2013 1 Bitcoin = ____ $
Last week of October ~190
first week of December ~1200
third week of December ~580
  • As you can see, Bitcoin exchange rate is way too volatile / fluctuating. Fortunes are made and lost in a matter of weeks.
  • A Botson Economics professor even predicts that by June 2014, one Bitcoin will be worth less than 10$, based on its current downfall!
  • Agreed that inflation (or overprinting) erodes the purchasing power of fiat currency such as dollars or rupees.
  • But you’ll never expect so much ‘erosion’ of value – in such a short period-like in first week of December you could buy two iphones in $1200, but in second week of December, inflation is so increased you cannot even buy one iphone!
  • In a separate article, we’ll see more about the connection between money supply vs inflation/deflation and how Bitcoin fits in that picture. but for the moment let’s just update the table
features barter Fiat money (Rs./$) Bitcoin
  1. trade can happen without double coincidence of wants
No Yes Yes, if both parties agree.
  1. Promotes division of Labour
Hardly yes Yes, but limited @the moment.
  1. Divisible?
Not always Yes but limitations Yes and less limitations than fiat money
  1. Fungible?
Not always Yes Yes, for now.
  1. Possible to store value/wealth for a long time?
Not always Yes Yes, but volatile at the moment.

Continuing with the original discussion: what were the limitations of barter system, that made people switch to money system?

#6: Savings don’t turn into investment

  • Under Barter system, there is no common storage for value (i.e. currency)=> difficult to operate banks, insurance companies and mutual funds.
  • As a result, people can save very less and often they just hide their gold, silver and jewelry under a tree or under their bed pillow.
  • This type of savings doesn’t help the entrepreneurs get loans to start new business, hire more people, produce more goods and service = not helpful for the economic growth.

Money system solves this problem through “Circular flow of Income”

What is Circular flow of income?

circular-flow-of-income

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