There's nothing new about creating money. Governments do it all the time but small communities and shops have often created their own currencies for local use. Sharks's teeth, cigarets, locally printed coupons. If it is distinct and in somewhat limited supply, it can be used as money. The only rule seems to be that a group of people need to consent and agree to the use whatever it is as money.
Adam Smith described money as the road, part of the infrastructure, that facilitates trade. The better the 'road' (the more trusted and widely accepted the currency is) the more trading takes place and, according to Smith, the more wealth is created. Creating a common currency to facilitate trade is the primary motivation for the existence of the Euro, making for lower transaction costs between traders. There are no currency buy and sell rates to nibble away at profits. But even with the euro, some trading costs are seen, credit card transaction charges make profits for the various financial institutions that help shift money around the world and these increase the cost to the buyer. They are a toll on the trading road and in a small way reduce the amount of trade.
Money is subject to the same sort of supply and demand forces that affect other items. Increased demand for currency raises its buying power while an increased money supply lowers its buying power. By manipulating the money supply the central banks claim to be managing the economy and conventional thinking has it that too tight a money supply can cause a recession while too large an increase in money supply is inflationary. But most central banks permit steady increases in money supply, which creates inflation. And, in times of inflation, cash savings tend to lose value. The British who've seen a steady inflation on the Pound for all of living memory have chosen to mainly invest in property, to the detriment, arguably of other parts of the economy than the house building sector. But now something new as come along, that just might be inflation proof - Bitcoins.
Bitcoins started to appear in 2009 and are a novel, virtual currency that appears to have come, almost from nowhere, and is making an impact. There are a few remarkable things about Bitcoins that should have prevented their existence:
1) They are designed to reduce international transaction costs, and bank profits.
2) They have no single issuing authority,
3) They are, unlike traditional currencies, not backed up by any real or imaginary collection of assets.
Bitcoins are convenient, it is easy to set up a Bitcoins account and buy Bitcoins using euros, pounds or dollars. You can buy a variety of goods and services with much reduced transaction costs It is also possible, if you have access to sufficient computing power, to generate new Bitcoins that can then be spent!
This is the cute bit, how can you 'mint' your own money? Of course, central banks do this kind of thing all the time. Euphemisms such as Quantative Easing, and Increasing the Money Supply disguise the fact that these acts put more and more bank notes into circulation. When the central banks are the issuing authority governments can do what they want with the new money, this gives access to an income stream in addition to taxation. Printing money was basically how the Bank of England got started in 1694, when William the 3rd needed to raise over a million pounds to rebuild the British Navy. A consortium of lenders came up with £1,200,00 worth of gold bullion and produced paper money to the same value. This generated a brand new supply of money that was used for trade and financed the new navy. Bitcoin miners have the same priveledge, but they can spend the new Bitcoins they mine on what they want.
The supply of Bitcoins is restricted by an Open Source mathematical algorithm which determines the rate of generation of new Bitcoins. In the early days of Bitcoins, in 2008, it was relatively easy to 'mine' a new Bitcoin but as more 'miners' have joined in the degree of difficulty of generating new Bitcoins has been increased. The Bitcoin foundation restricts the growth of the Bitcoin supply. Consequently, more and more computing power is needed to generate new Bitcoins. Bitcoin miners are now starting to use dedicated computer hardware, (ASIC technology) in order to keep Bitcoin production cost effective in the face of hardware and electricity costs.
In some senses Bitcoins are analogs to gold. In former times, when the supply of money was related to the amount of gold held by banks, or earlier when money itself was gold or silver coins, the money supply could only increase at a rate related to the efficiency of mining technology. National currencies abandoned the linkage between gold supply and money supply many years ago and the euro was never linked to it. Now central banks generate as much money as they see fit, but the anonymous creators of Bitcoins have introduced an artificial limit on the Bitcoin supply. This was probably neccessary to launch Bitcoins as a useful currency but may have interesting consequences if Bitcoins gain further usage.
At the time of writing (7th May 2013) 1 Bitcoin is worth 86.65 Euro, £73.09 and $113.57. The Bitcoin exchange rate can fluctuate dramatically in relation to demand. Recent events in Cyprus, where for a time it seemed that large savings in Euros might be subject to confiscation, seemingly led to a spike in the value of Bitcoins as people converted their savings from euros to Bitcoins. Some claim that in Argentina, where inflation is estimated to be running at over 25%, many people are moving their savings into Bitcoins. (Official government figures assert that inflation is more like 10%) Many will buy gold or other currencies instead but Bitcoins are more useable. They can be spent in fractional denominations as well as being easily transferred. Buying and selling in a conventional currency racks up bank charges.
The onset of Bitcoins is potentially very bad news for the Argentinian government who are using the time honored strategy of printing currency to keep their finances going. If people move widely to Bitcoins and begin to stop using the official currency this leaves government finances in an even more precarious position. They would then have to print extra money at a progressively faster rate to meet their outgoings. This would further encourage the switch to Bitcoins. Bitcoins enjoys the further advantage that a smart phone can be used as a Bitcoin wallet. This eliminates the need to involve the local banking system. This could makes tax collecting very problematic!
Now at the moment the big obstacle that is standing in the way of widspread adoption of Bitcoins is the lack of places that accept them. Of course, this is not a disadvantage if all you want to do is turn your money into Bitcoins rather than leave it in inflatonary conventional currency, but the range of places accepting Bitcoins IS increasing. Online shoppers come off best of course, although there are a number of communities dotted around the world where Bitcoins can be spent, over the counter as it were. And, most famous of all, the illicit on-line market place Silk Road where all transactions must take place using Bitcoins.
So what then might be the future for Bitcoins? If Bitcoins continue they will become more useful as increasing numbers of traders accept them. A virtuous circle, through increased demand, will cause any Bitcoin savings you may have to grow in value against other currencies and against the cost of goods. With classic economics this should eventually restrict trade because the Bitcoin supply will not keep up with growing demand as more people want to switch. However, this may not be the case with Bitcoins. They can be subdivided into tiny fractions, potentially you should never run out of currency to use, you just need succesively smaller denominations.
About the worst thing that could happen would be a competing currency to Bitcoins based on the same model. The current Bitcoin miners could switch their high performance hardware to the new currency and make an initial killing, if the new currency were to gain usage. But in order to do that it would need to be better than Bitcoins and offer some extra advantages and its hard to imagine what these might be. (see Litecoins)
Can governments legislate away Bitcoins? Again it's hard to see how. Most governments would struggle to rationalise legislation (not that they would need to) that would reduce trade, even when, as with Silk Road, much of the trade is in illegal products. After all dollars, pounds and euros are also used to buy illegal products.
It is all very interesting, and nobody really knows how it's going to turn out.