Imagine there is competition between two currencies. The two currencies are identical in every respect, except one is backed by assets and the other isn't. Which one would win the competition to become the preferred medium of exchange?
I think the one that is backed by assets would win. For two reasons:
1. The issuer of the backed coin could use those assets to help stabilise the value of the coins in response to fluctuations in demand. If demand falls, the issuer could use the assets to buy back some of the coins in circulation. If demand rises, the issuer could sell more coins in exchange for more assets. The issuer can make the supply curve of the coins more elastic, so that fluctuations in demand cause smaller fluctuations in price. Other things equal, people prefer a safer asset to a less safe asset.
2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return.
Other things equal, we would therefore expect to see competition between currencies lead to issuers of those currencies having assets backing those currencies, and paying out all the returns from those assets (minus administrative costs) to those who own those currencies. Free entry and competition drives down the profits from issuing currency to zero. Only currencies with 100% backing would survive.
But are other things equal?
There could be network externalities and a first mover advantage. Like Microsoft, VHS vs BetaMax, and the English language. If UnbackedCoin got on the market first, and if everyone wants to use the same coins as everyone else, and translation costs are high enough, it could survive against competition from BackedCoin. Customers cannot coordinate their simultaneous switch from UnbackedCoin to BackedCoin.
One more post in response to Brad Delong's email query and arguments about competition for Bitcoin.
I recommend Tyler Cowen's post.
[Update: I think JP Koning got there first.]
(Mike Sproul deserves all the blame for making me think this way.)