Recently, Bitcoin has been highly publicized in the media — and most of it has not been positive exposure for the young currency, whether it is the mysterious disappearance of Bitcoin from the equally mysterious Mt. Gox Exchange, or the high-profile arrests related to the shutdown of (sketchy) black market sites. Bitcoin’s been taking a beating, and whether it’s fair or not cannot be determined without a thorough understanding of what it actually is.
Bitcoin is the “world’s first decentralized currency”, and is transacted over a peer-to-peer, user-controlled network. Its most useful quality lies in its decentralization. For as long as we’ve had money, governments have had some role in the regulation of currency, and for good reason. Currency plays three important roles in a society’s economy, first of which as a unit of account. Without government-regulated currency, we have no idea what anything is worth. Imagine going to the supermarket tomorrow and buying a dozen eggs; without money, those eggs can only be exchanged with something else that the seller deems of equal value. But here’s the caveat—every seller and buyer would deem different things to have “equal value”. For instance, I may be willing to sell a dozen eggs for a half pound of beef, but someone else may only be willing to sell for a carton of milk. This is highly inefficient and completely arbitrary—goods that people want won’t be allocated properly. Money solves this conundrum by being a legally uniform unit of account. Instead, if a dozen eggs are priced at $6, I’ll have to sell for $6 and the buyer will have to buy for $6, no questions asked.
On a similar note, money acts as a medium of exchange. Because governments back legal tender as money that must be legally accepted to exchange goods, there’s no need for bartering, which involves time and transaction costs. Finally, money acts as a store of value. If you open up a new bank account and deposit $1000 in it, depending on the interest rate offered, that money will grow as long as you save it. More importantly, the bank is now able to use that $1000 to invest or lend to borrowers, a huge component of growth in our modern economy.
So, the central question remains: is Bitcoin another step in the evolution of money—from commodity-based to fiat currency to Bitcoin? If so, could it potentially supplant the dollar or the Euro or the Yen as an official currency? In short, no.
Bitcoin lacks a fundamental characteristic that modern currencies, especially the US dollar, have: confidence in government backing. As fickle as it may seem, something intangible yet as significant as the US government’s word goes a long way. We’re a very credible country and we’ve never defaulted, so our government is able to borrow money at extremely low rates. Agencies like the Treasury and the Fed have the tools to weather economic shocks because of their control over the currency. Gone are the days of reckless currency printing as the Weimar Republic did post-WWI; the international monetary system is so stable today that major currencies move by less than +/- 1% a day.
The same can’t be said for Bitcoin. Here’s how it works. If I want to start “mining” Bitcoin, as they call it, I’d download a digital wallet and solve algorithms in increasing difficulty until I create new Bitcoins—pretty simple. Bitcoin users thus act as both “decentralized” central bankers by creating currency and financial institutions by facilitating the movement of this currency. The “decentralized” nature of Bitcoin is what draws its user base. It’s the “Internet’s currency”, a welcome sight for the younger generation in an era where the Internet and disenchantment with government are all the rage. The average Bitcoin user is 33, and most of its users are on the younger side of that mean. It’s a product of years of economic mishaps—deregulation, the financial crisis, bailouts—that has led people to reject the institutions already in place.
Without government backing, however, Bitcoin loses credibility and stability, essentially becomes a commodity. It lacks 2 out of the 3 characteristics of currency—something as susceptible to wild daily fluctuations as Bitcoin cannot be a store of value or a unit of account. In February, the Mt. Gox Exchange (where 70% of all Bitcoins are traded) mysteriously lost $350 million worth of Bitcoins, representing 6% of all Bitcoins in circulation. When news of the theft broke, Bitcoin plunged around 80% from almost $1000/Bitcoin at the beginning of the month to $200/Bitcoin 15 days later. A reliable currency could never experience these wild swings or sudden losses. Imagine waking up one day and hearing that the Chicago Mercantile Exchange (the largest commodities exchange) just happened to lose $2 billion (equivalent to 6% of its assets) of futures or commodities contracts. It’s unimaginable. And even if it were to happen, the government (most likely the Fed) would immediately step in to remedy the disaster. Bitcoin doesn’t have that luxury. Those $350 million are gone and will probably be gone forever.
Because Bitcoin still isn’t accepted for most transactions, a large number of Bitcoin buyers use it for speculation purposes precisely because it’s so volatile. Even so, does it have the potential to reach the critical mass necessary to replace conventional commodities like gold, silver, or copper? According to Goldman Sachs’ head of commodities research, Jeff Currie, commodities succeed more traditional ones when it solves a problem that the traditional ones have, analogous to steam engines replacing coal in the 19th century. In this case, there’s no blatant problem with gold that Bitcoin can solve—in fact, gold has a higher valuation and less volatility. With the state of Bitcoin now, it may be in an asset bubble that’s driven by irrational demand—and we all know that bubbles must one day burst. Hopefully, it’s small enough to have no real impact on a recovering economy that’s come a long way since 2008.
That being said, that’s not to say that Bitcoin will ultimately fail. As cybercurrency becomes more fine-tuned, currencies like Bitcoin have massive potential due to ease of handling and low transaction costs. We’re already so obsessed as a society with transferring money digitally—many of us would rather use our phones to handle money than have to make a trip to the bank. Whether we like it or not, the software age is definitely upon us, and Bitcoin could well be a major part of our lives in 5, 10, 15 years. But there are still so many questions that need to be answered before we can reach a conclusion on the viability of Bitcoin as a currency. As much as its supporters hail Bitcoin as “the Internet’s currency” free of government intervention, it has been proven time and time again that currency needs regulation and standardization in order to maximize efficiency. Color me skeptical, but I don’t see a private currency without government regulation as a step forward. Am I and are the people who share my view just old-fashioned, status quo-loving, change-averse establishment-philes? Perhaps. But only time will tell whether the young Bitcoin can survive a multitude of ever-increasing extant glitches.