There’s this new idea that plans to revolutionise money. It’s called bitcoin and aims to be an online currency to replace the real thing. Unlike printed money, it is not controlled by any central bank or government and prides itself on its lack of rules and regulations. Its proponents see it as a 21st century version of the gold standard and it has been enthusiastically endorsed by libertarians and anarchists around the globe as its price sky rockets. However, it is in reality a giant internet bubble based primarily on speculation that will inevitably crash. It is open to abuse, hacking and is no more trust worthy than the government. It is an economic calamity and trapped in hyper deflation death spiral. It can teach us a lot about how currencies work, and just as importantly, why some don’t.
Bitcoin is an online currency created by someone we know very little about. At its most basic it is an international currency, the same way Esperanto is an international language. Instead of people buying goods online with their individual currency, there would be one currency for online and it would be used globally. If that’s all it was then bitcoin would be a nice novelty, but get far less attention. This is because bitcoin is more than a handy way to pay for items online; it is political movement to challenge the power of the government.
The main feature of bitcoin is that they will have a fixed supply. While production continues at the moment (through ways too complicated for me to pretend to understand, it involves lots of powerful computers), this is being wound down until in a few years time, next to none will be produced. This fulfils the ancient libertarian dream of “sound” money, money that doesn’t devalue and cannot be printed. Bitcoin is unique in not having a central bank to manage it. This was done deliberatively so that money could never be printed as it is in America at the moment. It is unregulated and untaxed so that government can never control it. It is the libertarian ideology in practice, a privately run currency with no input from the government.
In this sense bitcoins are essentially a 21st century version of the gold standard. They remove a government’s ability to print more currency, instead keeping it fixed. Its proponents see it as a means of avoiding inflation and creating stability. Its creator argued that paper money is based on trusting the government, mainly that they will not devalue it. Bitcoins aim to remove this necessity. This is why it is so popular among libertarians and anarchists; it completely removes the government from the picture. The problem is that the gold standard was a disaster, it prolonged the Great Depression and one economist I know called it “the economic equivalent of creationism”.
Bitcoins suffer from several fatal flaws. The first and most obvious is its reliability. Despite their claims, bitcoins too are based on trust. You have to trust that the creators will not suddenly increase the supply of bitcoins and making themselves a fortune while devaluing everyone else’s stake. The creators have promised that they will never do this, but how much do you trust mostly anonymous internet users? The second problem comes from internet hackers. As bitcoins increase in value there will be more incentives for people to hack into the system. Bitcoins are not invulnerable and breaches have occurred. There are also fears that bitcoins could be used for money laundering, drug purchases and tax evasion. There are questions over whether or not bitcoins are even legal as it is illegal to mint your own coins.
Even if bitcoins succeed, they will fail. If everyone in the economy used bitcoins, the result would be an unmitigated disaster. The reason is that as the supply of bitcoins is fixed, the price will rise exponentially. Imagine bitcoins going for $10,000 or $50,000 each. We all know the dangers of hyperinflation, where prices constantly skyrocket making money worthless. Bitcoins are the same system, except in reverse. They suffer from the fatal flaw of hyper deflation (as far as I’m aware this is a new concept). Instead of prices exploding, it is the price of the currency. This means that the relative cost of everything else is constantly getting cheaper. Now that probably didn’t sound that bad, but it will destroy the economy. If the price of a good is $5 today, but if there is deflation is will be $4 tomorrow. The obvious response is to wait until tomorrow to buy it. The problem is that if there is constant deflation then people will be constantly waiting and never buying. If no one buys, then no business will survive and the economy collapses. A good example is the current state of the Irish housing market; deflation has caused the market to freeze.
So if hyperinflation leads to panicked buying of goods before their price rises again, then hyper deflation leads to hoarding of bitcoins and never buying anything. The worst thing about hyperinflation and hyper deflation is that it quickly builds up momentum and becomes self-sustaining. If everyone believes prices are going to rise then everyone will buy, which will cause prices to rise. Even if everyone knows it is a bubble or chaos, it still is more profitable to follow the herd. So the rise in the price of bitcoins will encourage more people to buy, which will cause the price to rise, which will increase expectations of a further price rise etc. Bitcoins are essentially caught in a deflation-death spiral. The constant price rises means that few will actually use it to buy anything; instead they will just hoard it. The rest will use it as a speculative casino and hope they can cash out before it all collapses.
Bitcoins are essentially a speculative bubble. In November they were worth $10, six weeks ago they were worth $30, now they are worth almost
$140 $150 $160 (its constantly rising as I write this and will have risen further by the time you read this). If you look at a chart of its price history, you can see this exponential growth. There is no good reason for this growth, it is pure speculation. As bitcoins have no intrinsic value and are not backed up or supported by any tangible good, there is no natural price. There are no economic fundamentals or foundations to support it. What we are watching in effect is the dot com bubble on steroids. There have been huge prices rises driven mostly by news reports (one blogger has found a correlation between the rise in price and the number of tweets mentioning bitcoins). It is a new technology that is associated with irrational exuberance and the animal spirits we saw during the housing boom. It is a ponzi scheme that will keep going so long as enough ideological libertarians keep putting their money into it. Eventually the novelty will wear off and it’ll run out of libertarians challenging the system. Then the price will plummet.
Another reason why bitcoins won’t take off is that it lacks stability. If the price of goods in bitcoins is constantly changing, how can anyone do business? For an economy to function there must be certainty and a constantly multiplying currency denies this. Bitcoins fluctuate far too much for any business to seriously consider using them. Again this problem is not temporary, but rather inherent in the design. By making the supply of bitcoins fixed, it will be the price that fluctuates in response to demand. This rigidity will inevitability cause volatility. Imagine if you owned a company whose share price was rapidly increasing in price. You could issue new shares to dampen the rise or conversely buy your shares to prevent them dropping too low. You could adjust the supply of shares to keep a stable price. This is contrary to the ideology of bitcoins and thus they will continue to wildly fluctuate.
The reasons bitcoins are so attractive are also the reasons why it will fail. Central banks can take actions to prevent the currency causing hyper deflation and prevent an asset bubble forming. Regulation can protect it from criminals, hackers and money launderers. However the whole point of bitcoins is that there is no central bank. The allure of it is that no one will intervene no matter what. The problem with this, and the reason why we have central banks, is that sometimes intervention is necessary. However, this ideological stubbornness will ensure the collapse of bitcoin.
(Monday 8th Update: When I wrote this yesterday, bitcoins were trading at $150. In the space of less than a day, they have jumped to almost $200. This has got to be one of the most obvious bubbles in history.
Wednesday 10th Update: Bitcoins peaked at $266 today before completely crashing. The market is in complete chaos and no one knows how much they’re worth. The bubble has burst. Best estimates are that prices are between $100 and $150.
Friday 12th Update: I have a new post detailing the bursting of the bitcoin bubble.)