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

#3: Divisible?
#4: Fungible?

Yes, but limited @the

moment.
Yes but upto Yes and more divisible than
10-2
fiat money. 10-8

Not
always
Not
always

Yes

Yes, for now.

Lets 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

If the value of your labour is paid in
Perishable commodities like milk, butter,
You earn money for providing goods
rice, potato, fishes etc., it cannot be stored
and services to others. This is the
beyond a few weeks/months/years.
value of your labour.
Same for livestock wealth -cows, bullocks,
You can and save / invest this value
buffaloes, horse, camel, elephant etc. you
(money) in bank, Fixed deposit,
may also need to pay their caretaker and
shares, bonds, mutual funds etc.
veterinary doctor.
=possible to store the value of your
Even for a relatively non-perishable
labour for a long period of time and
commodity like silk-its difficult to store
become wealthy.
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.

Money is the most liquid asset- you

can use it for buying almost anything
immediately.

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.
With gold/diamond/real-estate this is
difficult. Theyre relatively less-liquid

Even if you have 1 crore rupee in

savings account, you can take out a
few hundreds and dine in a restaurant.

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, youll 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, youll 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 youll 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, well see more about the connection between money supply vs
inflation/deflation and how Bitcoin fits in that picture. but for the moment lets just
update the table

features
1. trade can happen without double
coincidence of wants
2. Promotes division of Labour
3. Divisible?
4. Fungible?
5. Possible to store value/wealth for a
long time?

barter

Fiat money
(Rs./$)

Bitcoin

No

Yes

Yes, if both parties agree.

Hardly

yes

Not
always
Not
always

Yes but
limitations

Yes, but limited @the

moment.
Yes and less limitations
than fiat money

Yes

Yes, for now.

Yes

Yes, but volatile at the

moment.

Not
always

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

#6: Savings dont 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 doesnt 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?

Money system creates two entities

HOUSEHOLDS
They buy goods and services from the firms.
they supply the factors services to the firms
1. land
2. labor
3. Capital (through their savings in banks,
mutual funds etc.)

FIRMS
They produce goods & services and sell it to
households.
they pay for those factor services in terms
of:
1. Rent (for using land)
2. Wages (for using labour)
3. Interest, dividends (for using capital

/ loans)

Firms profit = whatever money is left after paying the rent + wages + interest (+ tax +
bribes).
And firm can use that profit for buying additional factors (land, labour, capital) to
produce even more goods and services = even more income for the households (through
rent, wages and interest).this cycle of income continues.
Financial intermediaries such as bank, insurance companies and mutual funds, help
running this cycle by acting as a middleman between the households and firms.
On one hand they accept money from households and on the other, they help firms get
the necessary investment via debt (loans, bonds) or equity (IPOs, shares). For more on
Debt vs Equity, click me.

Thus the money system and circular flow of income leads to more jobs, more business, and more
economic growth. This is not possible under barter system.

What about Bitcoins?

In theory, Bitcoins savings can also turn into investment and thus the whole circular flow of
(Bitcoin) income =possible. But it is full of problem at the moment:

In recent times, many people have entered in the Bitcoin game out of speculative purpose
that in December 2013, one Bitcoin=1200$ so may be in 2014 one Bitcoin=worth 20003000$ and Ill become a crorepati in no time, if I somehow get hold of a few Bitcoins!
So they go to online Bitcoin exchange website, and give their fiat money savings (Rs. or
$) to buy Bitcoins and just wait-n-watch hoping that Bitcoin to Dollar exchange rate will
rise in future. In a way, this is same like hiding gold under your pillow and hoping that its
price will rise in future.
According to the critiques of Bitcoin, ^this is not turning savings into investment but
mostly speculative gambling.
For the circular flow of income, you need the savings of a household becoming
investments in business firms. And for that you need financial intermediaries like banks,
mutual funds and insurance companies.
but recently Peoples Bank of China (=Chinese RBI) has issued following notice:

Bitcoin is a specific virtual merchandise, which does not have the same legal status as
currency, and cannot and should not be used as currency in circulation in the market.

Meaning Chinese financial intermediaries and businessmen are officially prohibited from
accepting Bitcoins and thus circular flow of Bitcoins is stopped in real life.
Ofcourse some entrepreneurs have started companies with crowd funded Bitcoins, but
one or two Cinderella stories doesnt mean Circular flow of income.
Besides, even if an entrepreneur manages to get loan of Bitcoins to start a business,
hell have to convert some Bitcoins into fiat money (Rs/$) to pay for office-rent,
electricity bill, wages to laborers etc.

But since Bitcoin vs dollar exchange rate is so volatile, it is hard to determine a

reasonable interest rate that a businessman should pay back to the household or the
financial intermediary (who lent the Bitcoins.)

Recently Winklevoss Brothers (facebook fame; they claimed Mark Zukerberg stole their idea),
anyways these Winklevoss Brothers have launched a Bitcoin investment Trust. To put their
mechanism crudely:
1. Junta gives dollars to Winklevosse brothers, gets shares in return.
2. Brothers convert those dollars in Bitcoins, and invest in Bitcoin related startup
companies.
3. Those startup Companies make profit, return Bitcoins loans to Winklevosse brothers.
4. Brothers convert those Bitcoins in real dollars, and all the junta gets dividend according
to the number of shares owned by them. And if a person cannot wait for that long, he can
also sell those shares to others at the stock exchange.

A NewYork based company SecondMarket Inc. also launched similar Bitcoin investment
fund but aam-juntaa (retail investors) are not allowed. Only institutional investors (such
as pension funds) can invest in their fund.

Overall, these things are yet to pick up the momentum similar to a rupee or dollar based
sharemarket and mutual investment funds.
However in a futuristic society, there may be financial intermediaries owned and operated by
Artificial intelligence (AI) outside the control of government and if Bitcoin is accepted as global
currency, then perhaps Bitcoin savings could really turn into a decent investment.
Anyways, lets update our table:
features
1. trade can happen without double
coincidence of wants?
2. Promotes division of Labour?
3. Divisible?
4. Fungible?
5. Possible to store value/wealth for a
long time?
6. Circular flow of income? Can

barter

Fiat money
(Rs./$)

Bitcoin

No

Yes

Yes, if both parties agree.

Hardly

yes

Not
always
Not
always

Yes but
limitations

Yes, but limited @the

moment.
Yes and less limitations
than fiat money

Yes

Yes, for now.

Yes

Yes, but volatile @the

moment.

Not
always

Difficult easily possible

Possible but difficult@the

moment.

savings become investment?

Continuing with our original topic: what are the limitations of barter system, why did people
switch to money system and how does Bitcoin fare on those parameters?

#7: Account-keeping = mission impossible

In a barter economy, If there are 1,000 different goods and services in the market, then
the value of each would have to be stated in terms of 999 others. = no meaningful
accounting system is possible.
A farmer may be able to keep track of his income, expense, profit and land revenue
liability (Lagaan) because he uses very few inputs and produce only one or two crops per
year.
But imagine the plight of the Samsung company. They use so many inputs- screws of
various size and shapes, precious metals, circuit boards, plastic, glass, paint and produce
three dozen type of galaxy smartphones+ the cost of their marketing, transport, servicecenters...it is impossible to keep track of income, expenditure, profit and tax.
And account keeping is not just for tax calculation. It is essential to measure your assets,
liability and revenue stream to make future business strategies accordingly.
Another problem: If there are n tradable commodities products in a barter system, the
total number of MRPs will be [n(n-1)/2] (Think of the total handshake question under
permutation- combination.)
=difficult to run a kirana store in a Barter village because youve to remember so many
MRPs!

Money system solves these problems. You can express value of each and every item- no matter
how big or small -in terms of rupees/dollars/euros= thus, account keeping is easy as pie.

What about Bitcoins?

Account keeping easier in Bitcoin system than in Money system because,
Money system account keeping

Bitcoin Account Keeping (BTC)

All transactions are digital /
Manual records have to be kept= inefficient,
electronic in nature.
prone to errors.
Bitcoins= electronic transactions=
Even if you buy and sell everything using
no need to manually enter any
Credit card/netbanking still rickshaw fare,
records in the paper account books.
wages to petty laborers etc. will have to paid
And you can utilize softwares that
in paper currency=manual records need to be
automatically calculate income,
kept.
expense, profit etc.= more efficient,
less chances of mistakes, less harm
to environment than paper based

account keeping.

often youve to round off the figures e.g.

Rs15.40=>Rs.15/-. On a macro-scale it leads
to a considerable loss/gain.
For example, if a bank rounds off interest rate
of Rs.15.40 to Rs.15= every savings account
holder is paid 40 paisaa less, if bank had one
lakh account holders, it could save could save
Rs.40,000 by just rounding off=considerable
loss to customers as a whole.

No need to round off any figures.

You can even transfer 0.00006995
BTC. Recall smallest unit of
Bitcoin is Satoshi. 1 Satoshi=10-8
BTC
Thus, accurate calculation of
transfer of value, profit, loss, tax
liability, interest rate, depreciation
etc. possible.

#8: Lack product specialization

In the barter system, buying/selling/trade can happen only when two parties want each others
stuff. So, to increase the chances of this double coincidence of wants, people only produce
goods/services that are likely to be wanted by a larger population.

UNDER MONEY SYSTEM

UNDER BARTER SYSTEM
Procter & Gamble (P&G)- a FMCG
(Fast moving consumer goods) type
First of all, an MNC like Procter and Gamble
MNC.
cannot exist in barter system because account
keeping is a mission impossible.
so, there will be many small players but all selling
They produce Tide
just one variety of washing powder and that too
detergent for lower middle
with average quality because they cant afford
class and middle class
R&D for stain removal technologies, new
consumers.
fragrances etc.
They produce Ariel
detergent for the upper middle
and rich class.

Within Ariel: theyve separate

sub-brands for top-loading
washing machines and front
loading washing machines.

variety of toothpastes

Gel toothpastes for youth

(e.g.Closeup)
Special toothpastes for getting
your teeth whiter
Special toothpaste for cold
sensitive teeth
+Variety of mouthwashes and
so on.

Just plain white toothpaste. because the toothpaste

maker cannot risk to waste time in finding the
target audience who wants his special toothpaste
and who is ready to offer something in return that
toothpaste maker wants.

authors will produce many

genres of fiction: comedy,
crime, detective, mystery,
fantasy, horror, romance, scifi etc.

authors will only focus on comics, astrology, smsjokes-shaayari type of booklets.

Because those are more likely to be wanted by
majority of junta in exchange of rice, tomatoes and
milk.

What about Bitcoins?

Bitcoin will promote product specialization to a whole new level of smart products.

Imagine a futuristic laptop -if it stops working because of warranty covered defects, then
its blackbox will send automatic distress signal to Mother Company. And equivalent
amount of Bitcoins can be automatically refunded to your digital wallet. =No headache of
talking with service station employees.
Variety self-service products. Imagine a 3D printer-robot. You can email it product
design image, with a pre-payment of xyz Bitcoins. Itll automatically print the
customized product for you and ship it @your home.
Variety of pay and use products. Imagine a futuristic shopping mall, you walk in &
pickup xbox360 or playstation but instead of paying 30-40 thousand rupees upfront, you
bring it home, play as much as you like and return back. Only the Bitcoins equivalent of
playing hours will be cut from your digital wallet. Same for cars, bikes etc. with
microchips, thatll only function if you pay Bitcoins.

Possibilities are limitless but lets update our table.

features

barter

1. trade can happen without double coincidence No

Fiat money
(Rs./$)
Yes

Bitcoin
Yes, if both parties agree.

of wants?
2. Promotes division of Labour?
3. Divisible?
4. Fungible?
5. Possible to store value/wealth for a long
time?
6. Circular flow of income? Can savings
become investment?
7. Account keeping
8. Product specialization

Hardly

yes

Yes, but limited @the moment.

Not
always
Not
always

Yes but upto

10-2

Yes and more divisible than fiat

Satoshi=10-8 BTC

Yes

Yes, for now.

Yes

Yes, but volatile at the moment.

Not
always

Difficult easily possible Possible but difficult@the mome

difficult

easy

easier than fiat money.

hardly

yes

even better than Fiat money

Continuing with our original topic: what are the limitations of barter system, why did people
switch to money system and how does Bitcoin fare on those parameters?

#9: Future contracts and deferred payments

Deferred payment = you get the goods/ services right now, but pay for them in future. ExampleMonthly bill of newspaper, electricity, telephones.
This is difficult under Barter system.
Sonu
Nigam
Chaiwalla
Sonu
Nigam
Chaiwalla

Sonu
Nigam

(Orders a cup of tea)

Howll you pay?
Ill sing any song of your choice for two minutes.

Sounds like a fair exchange. But Im not in a mood of music at the moment. So, How about this: I give
right now but you perform that two minutes song, after two years, during my daughters wedding!
Sorry, I cant accept that contract because:

1. during the wedding season, I can perform @some rich mans reception and earn gold equivalen
2000 cups of tea.
2. After two years, my own reputation would have increased and at that time 1 cup of tea wont ev
ten seconds of my performance!

SECOND CASE
JK
Rowling
Chaiwalla
JK
Rowling

Chaiwalla

Orders a cup of tea, offers two pages from her Harry potter book.
well my son likes Harry potter series but two pages are useless, I want the entire book.
ok, How about you serve me one cup of tea every morning for next 300 days, and then
Ill give you the entire Harry Potter book!
Sorry madam, I cannot accept, because
1. Raw material- sugar, tea, milk, and kerosene- are becoming expensive every
month. Today, 1 tea=2 book pages but three months from now, 1 tea=3 pages
perhaps! So, I deserve the entire book, much before 300 days.
2. In 300 days, you might release second part of that Harry Potter book series and
in the meantime, my son would have read the first part borrowing book from a
friend.
3. Ultimately first part of novel will become useless. I cannot even sell it to others
because they will also want the latest part.

Similar problems when:

Farmer offers to give his bullock as payment, after 2 years but value of bullock declines
as it grows older and weaker.
Quality of wine improves with time. Value of art increases after the artists death and so
on.

Thus, it is very difficult to make deferred payments under barter system because:
1. Contracts can happen only when both parties agree on which specific commodity to use
for repayment. (double coincidence of wants)
2. Both parties face the risk that the commodity to be repaid would increase or decrease
seriously in value over the duration of the contract.
3. Either party will dispute the method of calculating the exact increase/decrease in the
value of a commodity over time.
All this makes credit / lending / borrowing / deferred payments =almost impossible in bartering
economy except a few basic contracts like farmer borrows from money lender and agrees to give
a part in the wheat produced.
But the advanced contracts on wages, salaries, interests, rents, and other prices extending over a
period of time= again mission impossible in a barter system.
Money system makes it possible because:

Household savings =>investment. And household earns interest on it (say ~4% in

savings account, ~9% in fixed deposit and ~11% in mutual funds per annum.)
These interest-rates or rate of return, help us determine the time value of money and
hence makes it easy to create future contracts and deferred payments.

Time value of money

Often youve seen the receptionist @coaching center say following:
1. Entire years fees is 10,000 rupees, you can pay it in five installments of two thousand
each.
2. But if you want to pay entire sum right now, well give you discount of Rs.500/So, why is she offering this loss making proposition. Why is she ready to accept 9500 right
now rather than waiting for 10000 at the end of one year? The answer is: time value of money.
1. If they accept payment in installment, there is always risk that you stop coming to
class after 5-6 months and dont pay the remaining fee installments.
2. You pay them 9500 right now, they put it in a fix deposit for 1 year @9% interest rate=>
get Rs.10384.29*. So even by accepting less than 10,000 right now, theyll earn more
than 10,000 in future.
*under fixed deposits, Indian banks usually give compound interest rate at each quarter i.e. 9% is
paid @every 3 months.
Same concept works in following cases:
1. In Gujarati dining halls, if you buy coupons for entire month, theyll either give you
discount or a 5-10 additional coupons for free.
2. Magazines offer higher discounts if you subscribe for more years.
3. In DishTV/Tata sky, if you pay 6-months or entire years subscription at once, theyll
give you discount / a few more channels for free.
Thus money system facilitates future contracts, deferred payments, debt obligations.

What about Bitcoins?

At present, it is difficult to estimate the time value of Bitcoin because
1. BTC to Dollar exchange rate is volatile and unpredictable. in First week of December
2013: 1BTC=~1200 USD but in Third week of December 1BTC=~580 USD.
2. Real life Banks dont accept Bitcoins in savings account or Fixed deposits. China has
imposed a specific ban.
3. Of course there are some random website claiming to give interest on Bitcoins, lending
out peer-to-peer loans to small business etc. But theyre not time tested (for a period of

10-20 years). No guarantee, hell shut down the server and run away to Nepal/Dubai after
exchanging the Bitcoins to dollars when exchange rate dramatically fluctuates.
But in a futuristic society, when more real-life trustworthy financial intermediaries accept
Bitcoins as a currency, then itll be possible to predict the time value of Bitcoins.

Bitcoins and Smart Contracts

As such, the Bitcoin system enables more smarter contracts because of computer programing.
You can have conditional-scripting capabilities. e.g. IF Event A happens, Pay B number of
Bitcoins to Mr.Cs digital wallet on D date at HH:MM:ss time...
Thus, it possible to create smart contracts and deferred payments based on Bitcoin transactions.
Future applications are numerous for example:
under conventional money (currency) system under Bitcoin system
Imagine a Tatasky set-top box with an
embedded microchip connected with your
digital Bitcoin wallet account.
You paid Rs.300 to Tatasky, and
This chip will monitor: what channels did
under the contract, company is obliged
you watch- and for how many hours,
to show you 150 channels for 30 days
minutes and seconds?
(=720 hours.)
Then only corresponding amount of
But in reality, you will not be
Bitcoins will be taken from your digital
watching TV for non-stop 720 hours.
wallet. (and not for entire 30 days or 720
most families just watch few specific
hours.)
shows between 7PM to 10PM.
The fact that you can pay any
denomination even 0.00884 Bitcoins
=makes this type of conditional TV usage
contract easy to implement.

Youre overpaying for the services.

Youll be paying only for the service that

you actually used.

Counter argument: what if a person hacks/tempers the set-top box so even if he watches for
100 hours, the chip will say on 10 hours watched? (Counter-counter argument: what if
someone puts a gun on his head and orders him to take out all money from ATM? Just because
there is a possibility of misuse doesnt mean technology shouldnt be used.)
under conventional money (currency)
system
You sit in a rickshaw/taxi. Driver
deliberately takes a longer route to

under Bitcoin system

Imagine vehicles have GPS-Bitcoin enabled

meter boxes. Itll suggest driver the most

destination. And / or he tempers the

meterbox in such way that youve to pay
more fare than what you actually travelled.

Petrol pump owner gives you adulterated

petrol mixed with kerosense OR he tempers
with instrument so even if meter says 1
liter while in reality only 950ml is
transferred.

economical route to destination (say 10kms

worth 0.05 Bitcoins.).
Even he takes longer route, still the
meterbox will only debit the 0.05 Bitcoins
from your digital wallet.

Vehicle fuel tank has Bitcoin enabled petrolanalyzer. Itll measure both the quantity and quality
of petrol and make payment accordingly from your
digital wallet. If less petrol is transferred then less
payment.

Anyways lets update our table:

features
barter
1. Trade can happen without
double coincidence of wants? No
2. Promotes division of Labour?

Hardly

Fiat money (Rs,$) Bitcoin (BTC)

Yes

Yes, if both parties agree.

Yes, but limited @the

moment.
Yes and more divisible than
Yes but limitations
fiat money (1Satoshi= 10-8
e.g. Rs14.05897
BTC)
yes

3. Divisible?

Not
always

4. Fungible?

Not
always

Yes

Yes, for now.

5. Possible to store value/wealth

Not
for a long time?
always

Yes

Yes, but volatile at the

moment.

6. Circular flow of income? Can

savings become investment? Difficult easily possible
7. Account keeping
8. Product specialization
9. Deferred Payment, Future
contracts

Possible but difficult@the

moment.

Difficult easy

Easier than Fiat money.

hardly

More possibilities than Fiat

money.

yes

Difficult easy

More possibilities than Fiat

money.

In the next articles, well see the functions of money, then evolution of money: from commodity
money, metallic money, fiduciary money, gold backed paper currency, fiat currency, bank
money; and then well see how Bitcoins system works.