It's not as complicated as it sounds. All you need is a system other people can understand and, most importantly, trust.
Here's a nightmare scenario shared by some mainstream investors, goldbugs and Ron Paul devotees: The year is 2013. Inflation has the U.S. economy in a stranglehold. International investors are fleeing to the far corners of the globe. The dollar is in a free fall, and Americans are scurrying to protect their wealth. What do you do?
Start your own currency.
It sounds complicated, but really it's as simple as three steps. First, amass a bank of stuff. Let's say gold. Second, decide on a sensible unit for your new currency. Let's say one "Derek Dollar" token is worth a gram of gold. Third, convince a critical mass of people to use it so that "Derek Dollars" are redeemable not just within my group of friends, but among shops and merchants around the world. Voila, we've got our own private currency.
No gold? No problem. The easiest way to start a currency is to draw up an I.O.U. system that allows your friends to trade hours of work. Hundreds of shops in Ithaca, NY, accept "Ithaca HOURs," a local currency backed, not by gold, but by man-hours. I spend an hour mowing an Ithaca lawn and receive a paper note for one HOUR. I walk to the barber's, hand him the piece of paper, and he cuts my hair. Now my neighbor's grass is shorter, my hair is kempt, and my barber is one HOUR richer. And it's all thanks to transactions that might not have happened were it not for a private currency.
The success of Ithaca HOURS shows you don't need to be a conspiracy theorist to see the virtue of private currencies. Maybe you want to create a new revenue stream that stays within your community (see right). Maybe you see a currency shortage and want a new way to grease exchanges. Maybe you want to buy goods in a virtual world like Second Life. Or maybe you want a fast, frictionless currency and you've found thousands of consumers who want the same thing.
U.S. dollars, like most modern money, are backed by a promise, not a metal. Rather than support the currency with towers of gold bricks, Washington issues the currency by "fiat," or by decree. The good news about fiat is it allows us to create more money -- trillions more --when the economy tanks. The bad news is that, like any promise, fiat currency relies on the faith of its users and investors. The history of fiat currencies is a mixed bag of century-long successes and infamous failures, from ancient China to modern Zimbabwe where inflation hit 90 sextillion percent in 2008. (Yes, that's sextillion. With 21 zeros.)
One clue to the answer lives in one of the most common words for money: credit. It comes from "credo," the Latin for "I believe." Money is all about trust. It's doesn't particularly matter whether your currency is backed by something concrete (like gold), something specific (like hours of labor) or something invisible (like a government's promise to accept that money as payment for taxes). What matters is that people agree to accept it in exchange for goods and services.
"Imagine that we are on a gold standard and a severe drought hits," economist Nick Blanchard explained to me in a useful example. "Suddenly water is in extremely high demand relative to gold, and everyone would be happy to rid themselves of bullion for water. Would you say that the dollar derives its value from gold, or the fact that people will accept it to buy water? The gold price of water is a floating exchange rate as much as is the dollar price of yen."
"The real value of any currency comes from the reasonable assumption that when you demand goods and services, the paper/metal/lint/whatever in your pocket will be accepted in exchange for that thing," he continued. "Currency loses all its value when people no longer want it in exchange for what you want."
Architects of private currencies face a chicken-egg challenge. To make a new currency popular among users, you have to sign up retailers. To make it popular among retailers, you have to sign up users.
The most interesting currency facing this existential crisis is BitCoin, a computer-generated currency that is famously traded among a couple hundred computer geeks and merchants. "The only thing valuable about BitCoin is that there are other nerdy internet denizens that will accept it for payment for things," Blanchard said.
BitCoin is backed by neither metals nor man-hours, yet each coin is worth nearly a dollar due to demand for the scarce BitCoins that have been released among the network of users. BitCoin is currently legal and active. But some worry it could face a fate like E-Gold, the bullion-backed online currency that quickly became a favorite of global crooks and money launderers. Its founder was sentenced to house arrest.
"Anything can serve as a currency and ultimately the winners will possess the characteristics that people demand: portable, fungible, easily divisible, and reasonably scarce," said John Matonis, editor of The Monetary Future blog and an outspoken advocate for private currencies. "Coins did serve that function, but a coin cannot be jammed through a broadband connection and molecularly transported. We must evolve now."
The excitement over private currencies -- whether from the goldbug fringe, the software geeks, or the econoblogger nerds -- boils down to an old-fashioned belief in competition. Currencies are like any other good or service. Monopolies can hurt the market. Government control can breed inefficiency. Maybe we should stop worrying and learn to love the BitCoin.