Bitcoin is a solution in search of a problem. A bad one.
Last week the digital crypto-currency hit a record-breaking value of $4,000 per coin, and many market watchers expect it may keep soaring to $5,000 or even higher. This continues the trend of volatility which has defined bitcoins more or less since they were first introduced, with flash-crashes and spikes that have wiped out accounts one month while creating millionaires the next.
An awful lot of money moves through the Bitcoin universe. Buyers treat the project as something between a speculative investment opportunity and the borderless currency it was always intended to be, and it's terrible at both.
Let's start with Bitcoin as a currency, the role that inventor Satoshi Nakamoto always intended for his idea.
Nakaoto launched the Bitcoin project with a white paper published in 2008. The currency is designed, essentially, to be a form of online gold, with a fixed quantity in circulation and a slow "mining" process by which servers produce new bitcoins through complicated, energy-intense computational cycles. This mimics the supply and production caps of precious metals.
This design is central to Bitcoin's train wreck as a functional currency. As I have written in this space before gold-based currencies don't work. They are based on the disproven argument that currency works best when it's irreproducible and, frankly, on the emotional heft that a bar of gold has. Bitcoins, being made of ones and zeros, don't solve that problem with technology. Technology cannot solve the problems inherent to a fixed money supply.
"It's deflationary," said Rodney Garratt, an economist with the University of California who has studied the Bitcoin marketplace. "Eventually the stock of bitcoin would be exhausted, and as the economy grows there's more stuff. [So] prices have to fall, you can't control that."
"The Federal Reserve was in part founded on the principle of elastic currency supply, the idea being that you can mitigate some of the ill effects of economic downturns and temper the effects of big economic upturns by adjusting the money supply," he added. "It's a tool to help make the economy run better on average, and the idea of having a fixed money supply takes that all away."
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Broadly speaking, currencies can come in two different forms: fixed and elastic. A fixed money supply has a set volume of currency in circulation that can't increase beyond a certain point (think the amount of gold pulled out of the Earth, or Bitcoin's 21 million unit cap). An elastic money supply uses fiat currency, money that a central authority can produce at will. You can add or reduce the amount in circulation at any given time.
Advocates of a fixed money supply, like the supporters of Bitcoin, argue that allowing governments to make more money at will creates the risk of banking and financial instability. This, they say, de-tethers the amount of money in circulation from the value of the economy overall and allows careless (or, often in their thinking, nefarious) central banks to destabilize economies with a flood of cheap money.
What they miss is that while an elastic money supply can be unrelated to the value of the economy overall a fixed money supply has to be. As Garratt noted, modern economies grow. This is a feature of industrial nations, one that the world didn't have to consider until the last few hundred years. If the value of an economy grows faster than the supply of money in circulation (necessary to a fixed money supply), deflation sets in.
And if you think inflation is bad, which it isn't always, take deflation out for a spin.
All of which also ignores the role that fluctuating a money supply can play in mitigating economic downturns by encouraging spending with cheap money. (This is not to say that monetary policy is a successful or even desirable response to every situation, merely one which fixed-currencies do not offer under any situations.)
In other words, Bitcoin replicates all of the worst features of a gold-backed currency by design, while adding a few nasty wrinkle of its own in the form of costing approximately $25 per transaction.
On the other hand, it is also fair to say that these issues all apply to national currencies. Bitcoin isn't a national currency; it crosses borders, and no single economy is tied to it.
So perhaps that is the currency's true future, as a cross-border storage of value. Residents in a country with unstable or uncertain currencies could use it to supplement or replace their own currencies. In this way it would essentially act as an investment vehicle, a sort of digital bond, storing value in a safe space until needed. This idea of a trans-national store of value could have real value by helping people transfer loans and assets into a more reliable form.
"Remember," Garratt said, "we live in a country where our monetary policy has actually been pretty good, but look at Yugoslavia… or look at Cyprus, where the banks got into trouble and started seizing deposits."
Of course, all of that means nothing when the supply is so limited. A banker in Caracas might be able to offload his life savings into bitcoins, but there aren't enough in circulation to help ordinary citizens. Not to mention that stable investment vehicles don't ordinarily have value swings of plus-or-minus 40%.
"People have tried to value bitcoin a number of ways," Garratt said. "It is a currency, there aren't definitions of currency or money anywhere, but currency is anything that's commonly accepted a medium of exchange. Puka shells were currencies, lots of things were currencies throughout history."
But, he said, "the value of Bitcoin depends on beliefs, which are very hard to pin down. These things have value because people believe they're going to have value in the future, and how much value they have is based on how much value people think they're going to have. But these things can change."
This, in essence, is the problem.
Bitcoin was built as a currency but it doesn't have the backing or flexibility to act like one. While advocates like to argue that "Bitcoin has no intrinsic value and neither does a $1 bill," this misunderstands how money works.
A $1 bill has structural value. It has the power to pay your taxes and the authority that comes from its role as legal tender "for all debts public and private." It comes with a promise of careful economic stewardship and political stability, including that the Treasury will never allow a dollar to become so valuable that ordinary people can't afford to own one. In Pyongyang, that promise might not be worth much, but the word of Washington, Beijing or London is one on which people can and have built their lives for hundreds of years.
A single bitcoin has none of that. It has a limited supply and the enthusiasm of its investors. Its price waxes and wanes depending, essentially, on how excited people are about the project on any given day.
"If you buy Bitcoin today at $4,000, it's possible that tomorrow it's value will be zero," Garratt said. "There's no buildings to sell, there's no intellectual property. That thing can go to zero. I don't think it will… I think it or something that replaces it will be around forever, but it could become worthless tomorrow. "I'm not telling you I know what price of bitcoin is going to be tomorrow. I'm telling you it could be anything."
That's not investing; that's speculating. It's a gamble that the dice will keep showing sevens and hoping to cash out before the hot streak ends.
As I noted at the beginning of this piece, bitcoin is a solution in search of a problem. The project combines the worst of speculative investment and online, anarchist utopianism into something that has sucked up a lot of money and produced very little real value.
There's no denying the excitement that it has caused. People invest anywhere from dozens to millions of dollars building and operating its nodes, sometimes forming entire companies to do so. But for what? After all, the Dutch once built an economy on tulips. The pet rock made Gary Dahl a millionaire. Bad ideas can take off, and Bitcoin offers little more than a technical achievement and very dubious transaction privacy.
As an investment vehicle, bitcoins are all over the place, with little reliable pricing from day to day no less over a period of months or years. As a currency, it is built on provably flawed ideas about fixed and limited money supplies and undermined by its own erratic pricing.
Just try, after all, ordering a pizza with them today.
So what, exactly, do bitcoins do? As their price shoots ever higher it's a question that investors and inventors alike should really start asking.
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