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Is Bitcoin a viable currency?

The media and blogosphere have been full of Bitcoin discussions recently and almost everyone has an opinion, but most of these opinions are tied to the technology of Bitcoin, that is, whether this new currency represents a major technological revolution in money.  So, most commentary has focused on questions about Bitcoin’s technological advantages: Is it really secure?  Is it truly anonymous?  Can it be counterfeited?  Are transaction costs actually lower?   Here, here and here are a few of examples and they contain comments like “Bitcoin is the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem.”  That is, they focus on the technology of Bitcoin.

But what of the finance and economics of Bitcoin?  Does it have the economic properties to be a viable currency?  I don’t think so.

Good money had three economic properties and uses.  It is a unit of account, used to measure and write contracts for things like income, wealth, and prices of goods.  It is a means of payment, used to avoid barter.  And it is a store of value, held to be able to make transactions in the future.  Of these three properties the third is the most important.  Unless money has a stable value, it does not serve the purposes that it should.  People will be wary of accepting something that might lose lots of value, and something with a volatile price makes a bad unit of account.

And my argument is not just that Bitcoin has had wild fluctuations in value that undermine its role as a viable currency, but deeper, that Bitcoin is destined to have wild fluctuations – it is poorly designed and conceived and so is likely to fail as a currency.  Why?

First, and primarily, Bitcoin lacks a mechanism for setting the supply of Bitcoin equal to the demand for Bitcoin to maintain its value.  History is replete with examples of governments that tied their hands in the supply of their currencies, much like Bitcoin has done.  What happens?  The value of the currency fluctuates.  Often a lot.  Before the founding of the Fed in the US, the dollar was backed by gold, and gold discoveries lead to inflations, and collapses in the price of gold to recessions and even financial crises.  Since the end of the Great Depression in the US, the Fed has actively managed the money supply to achieve price stability (at some times better than others).

Consider the example of the Y2K scare.  Before January 1, 2000, people were concerned that the change from the year 1999 to the year 2000 could lead to serious errors in computer systems, and in particular that it might become hard to use credit cards or get money out of a bank (or worse, bank deposits might even get lost).  As a result, people withdrew cash before New Year’s, lots of it. (These types of cautionary actions were widespread: governments grounded all airline flights overnight.).  These withdrawals were increased demand for cash that might have driven up the price of dollars – ie. led to deflation and changed interest rates.  But the large increase in the demand for cash did not cause any such real economic effects.  Why?  Because when demand increased the Fed simply expanded the amount of currency in circulation.  When New Year’s came and went without serious incident, people re-deposited their cash and the Fed reduced the money supply. The US price level remained stable.

Similar examples abound.  Prior to the founding of the Fed, the seasonal agricultural cycle lead to big seasonal swings in the demand for credit and currency which lead to seasonal swings in nominal interest rates (that is, the usual interest rate we think of which is the real interest rates plus changes in the value of money, that is, plus inflation).  If Bitcoin gains traction, will it have a seasonal fluctuations in its value that track the seasonal spending patterns of the world.  Will Bitcoins be more valuable in early December and comparably cheap in January?

Every day, central banks supply their currencies in proportion to the needs of the users of their currencies, so as to maintain a stable value for their currencies.  Bitcoin does not have a central bank.  It has a relatively inflexible supply mechanism (known as Bitcoin mining).  As a result, Bitcoin is destined not to have a stable value.  And a volatile price is bad for Bitcoin’s usefulness as a currency.  Central banks are an enormous competitive advantage for traditional currencies that the Bitcoin supply process completely lacks.

A second problem with maintaining a stable value is that digital currency is not really in limited supply. Its proponents will argue that it is.  The Bitcoin technology is carefully, maybe even brilliantly, designed to ensure that the supply grows slowly and it ultimately limited. But what happens when Bitcoin 2.0 comes out?  What if it has slightly better properties than the old technology?  Do people stop using Bitcoin 1.0 entirely leading it to become worthless?  Probably.  Is such a scenario likely?  Well,  think about the potential profits that one could make introducing Bitcoin 2.0, just by keeping a share of the initial number of coins.  These potential profits provide an incentive for the hi-tech business that comes up with a better Bitcoin to take over the digital currency market through advertising, lobbying, payments to businesses and so forth.  Or consider this alternative scenario.  Global banks start to provide currency transfers within their institutions but across borders that are as safe rapid, and low cost as Bitcoin payments.  There is no technological advantage to Bitcoin relative to a global bank with branches in many countries.  The point: while Bitcoin is in limited supply, digital currencies are not and neither are inexpensive ways to transfer money and make payments.

There are several other important cards stacked against Bitcoin.  But I will conclude with only one more., The “money supply” in the every country in the world is actually hard currency times the money multiplier – the ramping up of the hard currency into deposits in banks and lines of credit and gift cards and so forth.  In the US, the money supply – counting all of these money-like assets – is about twenty times the supply of hard currency.  And Bitcoin banking is developing and could go one of two ways.  First, it could be significantly private and unregulated.  The history of unregulated banking is that it is a disaster full of bank runs, volatile price levels currency collapses and so on.  The banking sector’s volatility becomes the volatility of the supply of Bitcoins which becomes price volatility.  Look just recently how the collapse of a single Bitcoin exchange affected the price of Bitcoins.  The second way Bitcoin banking could go would be as a regulated banking sector, becoming part of the tradition banking sector.  But then several claimed benefits of Bitcoin go out the window.  The true, large supply of Bitcoin is governed by banking regulation (but in every country in the world – what a mess!).  And while a Bitcoin is anonymous, a Bitcoin deposit is not anonymous. Once a bank gives you a credit for a Bitcoin and knows who you are, can it see in the Bitcoin chain how it was spent?  Not sure, but I would worry about it.

In sum, I am not worried about the technology – I have complete confidence that people at the other end of the MIT campus can solve almost all of the technological problems.  But the finance is suspect.  I am guessing that Bitcoin either remains small and volatile, with only transactions of suspect legality willing to accept the volatility as the price of true anonymity, or that Bitcoin goes down in history as a bubble, ultimately as worthless as the sequence of zeroes and ones that make up each coin.