Bitcoin has recently come into the news again because of the apparent collapse of its most important trading site "Mt. Gox".
I assume most people will know what Bitcoin is but in case you don't, it is supposed to be a kind of open source currency. It is neither backed nor controlled by any government or central bank, and it is supposedly untraceable, and apparently these features have made it very attractive to libertarians who are to varying degrees opposed to government regulation and taxation. And, one hears, also to other people who have even less wholesome reasons not to want their transactions traced.
Another feature of Bitcoin is that the maximum number of coins that can ever be generated is strictly limited. At the beginning it was very easy to "mine" additional coins, over time it gets harder, and at some point no more can be added to the system. This means that if Bitcoin gets used more and more, or even only if the economy grows, the value of this cyber currency will rise. In other words, Bitcoin has an in-built deflation mechanism, making all other goods cost less and less coins as time passes; the opposite of inflation. Of course this feature makes Bitcoin attractive to people with a somewhat gold bug-like psychology who believe that inflation is always bad if not downright evil.
With the problems of Mt. Gox news outlets have been discussing whether this will lead to the collapse of Bitcoin as a whole or whether the currency still has a bright future before it and is merely experiencing a hiccup. I am not an economist but I can imagine that it will recover; there surely appear to be enough True Believers out there to keep it going.
So it is well possible that Bitcoin will go on to be a success, the question is merely how you define success. Because it may well be a success as schmuck bait or an object of speculation, but it will never be a useful currency. And one does not have to be an economist to work that out.
If there are only two short items you ever want to read about Bitcoin, I suggest this blog post by professor of economics Paul Krugman and this comment from Hacker News. The first of these stresses how problematic the deflation issue is. Yes, at first it sounds very attractive to have a currency that always goes up in value if you have a good deal of it personally. But making you richer on paper is not actually the point of a currency; circulating around as a means of making the whole goods-producing economy work is. By incentivising people to hold on to their appreciating money instead of investing it into things that appreciate less quickly in value, a currency as sharply limited as gold or Bitcoin would bring an economy to a crawl.
The second, very short piece points out how easy it would be to manipulate the value of a currency that is not guaranteed by an impartial referee (the government in the widest sense) and backstopped as well as regulated by a central bank. One of the major jobs of a central bank is to interfere in the money markets to keep the value of a currency approximately stable, for example by injecting or removing money from the system as necessary. Bitcoin, on the other hand, by design does not have a central bank tasked with stabilising its value. This means that the value can fluctuate wildly through speculative attacks, bubbles or panic sales, often in very short time frames (and that does, of course, happen).
To understand why those fluctuations make Bitcoin a very bad idea as a currency one merely has to make one or two thought experiments. First, assume that you are an office worker with a monthly salary that is paid to you in Bitcoins. On 1 March, you are paid enough Bitcoins to see you through one month of grocery shopping. On 3 March, the value of Bitcoin drops 50%. On 4 March, you go shopping, and you realize that the supermarkets have marked all the prices up, and if you want to be able to buy enough food now you will not be able to pay rent and electricity at the end of the month. Oops. Perhaps you should ask to be paid in a less volatile currency.
Next, assume that you are running a trading company. You sign a contract with Canadian farming cooperatives for them to sell you, in six weeks, a certain amount of their grain in exchange for the sum of 5,000 Bitcoins. You search for people to sell the grain to in other countries, let's say Saudi Arabia, you organise shipping, etc, and come the day when the contract has to be fulfilled you realize that the value of Bitcoins has by now gone up 50%. Oops. Worse, it is likely that it is going to go down again by the time your ship has arrived in Saudi Arabia and your partners there have to pay you. Of course, you could try to get yourself insured against currency risk, but what insurer is going to offer you a reasonable premium if the risk is that high? Maybe you should find a less volatile currency to trade in.
So it seems as if Bitcoin could potentially work as a currency if it were tweaked a bit. Specifically, it would help if (a) Bitcoin had a central bank regulating it, with the mission to keep the value of the currency constant, and (b) Bitcoin had a mechanism of regularly increasing the number of coins in circulation to keep pace with the increased need for coins and to avoid deflation. Preferably, there should even be a slight degree of inflation to incentivise people to invest and spend their coins to keep the economy running.
Does that remind us of something? Oh yes, that is how real money already works.
And this is in my eyes the funny thing about Bitcoins: the pathological ideology of its most glowing proponents. Many of them see government-backed currency merely as a giant fraud, or a sinister instrument of control, and they visualise the world as consisting of a minority of evil oppressors manipulating a majority of passive and stupid sheeple.
Reality is not as simple as that. Our present fiat currency regimes are the results of centuries of trial and error. Instead of one single group of conspirators designing them as they saw fit, varied interest groups in each country have been and still are continually negotiating and fighting over them. If gold bugs gain the upper hand and a system becomes too deflationary, they will soon be faced with protests, riots and election losses as the economy freezes and people are suffering. If somebody throws on the printing presses to the degree that it pushes inflation continually higher than a few percent, they will antagonise especially the wealthy and pensioners, and likewise run into problems at the ballot box, protests and perhaps a reduced willingness of the rich to give campaign donations to them. If the system is not protected against speculative attacks, the value of the currency will oscillate wildly, and the economy will suffer as long term planning and contract security are lost.
Of course there is some corruption in governments, and of course there is some incompetence because the show is run by humans (and pace libertarian ideology, the same is equally true for any non-government sector). But we have government regulated currencies with an inflation target of around 2% because that is what works. I am fairly sure that if we were to start from scratch with the ideal utopian libertarian gold bug fantasy currency we would, after a few decades at most, end up in the same spot as we are today, as the same lessons are learned again. But would it not be awesome if learning them once would be enough?