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Saturday, 25 October 2014

The first five lessons of bitcoin

Edward Hadas: An early obituary for bitcoin

Bitcoin is not over yet. But the pseudo-currency is close enough to collapse to merit an early retrospective.

My prediction is controversial. Many fervent fans are persuaded that this government-free currency is for real. Their ardour may keep it going for a while, but equally bitcoin could disappear very quickly - that’s the way with speculative bubbles. So now is the moment to learn some economic lessons before the whole phenomenon is forgotten. Here are five.

Money without government appeals to people without law.

Legal tender has the backing of the issuing state. The government has a proprietary interest in maintaining a reliable currency. It also has the necessary powers to do so. It can regulate lending institutions, pursue fraud and create new money to keep the system afloat.

Bitcoin has none of that protection. On the contrary, governments are either hostile or hands-off. For anyone in the legal economy, the lack of official support is a significant negative. For anyone in the illegal economy, though, the extra-legal status is a positive. Unsurprisingly, the only real business actually to rely on bitcoin – not merely issue press releases about planning to accept the tokens – has been Silk Road, a now-closed electronic exchange for illegal drugs.

Speculative fever can alight on almost anything.

Bitcoin is a pretty unlikely target. After all, the more the value of the would-be currency changes, the less it looks like a real currency - so the more liable it is to lose all value whenever the speculators get tired or wise. David Yermack of New York University’s Stern School of Business explained in a recent paper that the unstable value of bitcoin – in the last three months, its dollar price has quadrupled, then almost halved and increased by about half – leaves it without two of the three basic attributes of a currency. Bitcoin is neither a relatable store of value nor a helpful unit of account.

Yermack kindly says bitcoin satisfies the third attribute – it can be, and occasionally has been, a medium of exchange. But if speculators were thinking clearly, they would stay away from any supposed money which banks don’t accept. After all, banks are involved in almost all exchanges in today’s economies.

The current monetary system is worth complaining about.

Bitcoin is the wrong answer to a good question: what can be done to make the monetary system less crazy? After so many banks needed to be rescued in 2008, and after five subsequent years of weird monetary policy, it’s clear that the question is legitimate. Something is badly wrong.

People can be excused for thinking that governments, including central banks, have run the money system so poorly that non-governmental money might be better, but that is the wrong answer. The only practical right answer is to improve the government-run monetary system.

Central banks seem to have learned how to reduce consumer price volatility, which was the scourge of the first decades of purely fiat money. Now the monetary authorities need to figure out how to reduce the volatility of asset prices, credit flows and foreign exchange rates. And the base interest rates should be high enough to give savers a real return.

Money is misunderstood.

Admittedly, money is complicated. It is a social token as well as an economic tool. It is a store of value, but its own value shifts constantly. It is considered a safe and solid asset - “like money in the bank” - but banks cannot really promise always to make good on legitimate demands to liquidate accounts.

I sympathise with anyone who does not want to try to understand how money works, but monetary ignorance can be dangerous. Many bitcoin investors will find that out, to their personal cost.

The whole economy paid dearly for similar misunderstandings by central bankers and regulators. They did not really consider the risks of speculation and wild credit creation by non-governmental financial institutions. If they had, there would have been no need afterwards to turn so many of them into quasi-governmental financial institutions.

Too much entrepreneurial energy is wasted.

Bitcoin is basically idle speculation, but it has inspired a great deal of skilled work. This small business – total value of a mere $100 million a year ago, now about $10 billion – has generated scores of websites and seemingly unlimited quantities of enthusiastic and evangelistic commentary. The original programmer, the producers of new bitcoins and the creators of a remarkable number of sophisticated bitcoin exchanges are all are very good.

A society in which no project ever attracted this sort of attention, intelligence and ambition would be moribund. The bitcoin mania shows that ours is still quite alive. But it is a bit discouraging to see so much of what is good in our economy directed to something so misguided. 

Readers' comments (1)

  • Perhaps someone could write a learned treatise as to how Bitcoin, at its most fundamental level, differs from a chain letter . . .

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The dollar price of bitcoin on July 1, 2013 was $87, according to bitcoincharts.com. The all-time high dollar price of bitcoin was $1,224 on Dec. 4, 2013. It fell to $640 on Dec. 14. On Jan. 8, the price was $965. 

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