What is Bitcoin?
The Planet Money podcast gives an overview of Bitcoin, but this video also provides a basic introduction.
Why I Believe Bitcoin will Fail as a Currency
Although I think that Bitcoin is ingenious and fascinating in many ways, I don’t believe that it will succeed as a currency. The problem is that a Bitcoin is unlikely to ever be a good store of value (a primary function of any widely accepted currency) because the (eventually) fixed money supply will cause the purchasing power of a Bitcoin to be extremely volatile.
Modern fiat currencies are able to control purchasing power (some better than others) because they have a central bank that can increase or decrease the money supply in response to economic growth and economic contractions. If the central bank does its job well, the inflation expectations of market participants will be well anchored, and the purchasing power of the currency will be relatively stable over time.
Historically, commodity based currencies have also been able to provide reasonably stable purchasing power, without a central bank, because the underlying commodities which were used as currency required labor and capital to grow, gather, or mine. The value of a unit of the commodity currency was related to the amount of labor and capital which went into producing it. This link to labor and capital helped to regulate the money supply and stabilize the purchasing power of the commodity currency.
For example, if the purchasing power of the commodity rose (deflation), there would be an increased incentive to deploy more resources to produce more of the commodity. This increase in production would increase the money supply and counteract the deflation. Alternatively, if the purchasing power fell (inflation) there would be a decreased incentive to continue investing the necessary labor and capital for additional production, and some of the existing stock of the commodity would likely be consumed for non-monetary purposes or used for trade with other groups. This would decrease the money supply and counteract the inflation. This production-based money supply response may have been rather crude, but in a slow growing economy it was likely sufficient to keep prices and expectations reasonably stable.
In contrast, the value of a Bitcoin has no similar link to labor and capital, and there is no central bank to control the money supply. Since the supply of Bitcoins will eventually be fixed, the purchasing power of a Bitcoin will depend on the size of the Bitcoin economy and, more importantly, on the expected future size of the Bitcoin economy.
In fact, the purchasing power of a Bitcoin today depends greatly on our expectations for the growth or contraction of the Bitcoin economy tomorrow. If market participants expect the deflation in the future due to a growing Bitcoin economy then they will want to hold large Bitcoin balances and the purchasing power will increase today. However, if they expect a decrease in the future size of the Bitcoin economy then they will want to hold minimal (or zero) balances and the purchasing power will fall today.
Similar to a speculative stock, the value of a Bitcoin will be very susceptible to swings in market confidence. However, with a speculative stock, the success of the underlying business is largely independent of the stock price volatility. In contrast, the adoption of a currency does depend on purchasing power stability. If purchasing power cannot be stabilized then widespread adoption by consumers and merchants is unlikely.
Although I’m convinced that Bitcoin will eventually fail, it is still a fascinating story to follow if you are interested in monetary economics. The online debate over Bitcoin’s viability is fierce. There is a lot of money currently invested in Bitcoins, and some individuals even claim to have invested all of their personal savings in the currency. In addition, new exchanges are being started to trade the currency, and Bitcoin enthusiasts are spending thousands to create “rigs” to “mine” the currency. Who knows? Perhaps a future iteration of a private digital currency will solve the problems that this initial version uncovers.