The trouble with bitcoins

Five years after the collapse of Lehman Brothers and the full onset of the global financial crisis, the search for plausible alternatives to conventional “fiat” currencies continues unabated. Gold prices have risen 200% since 2007, despite a dip of 40% in the last two years.

But while the gold bugs have suffered recently, the bitcoin has steadily gained interest both as an alternative currency and a speculative commodity. Built on distrust, the bitcoin promises complete transactional privacy and stability of value that no fiat currency has ever been able to provide.

So, in ten years, will we look back and see the bitcoin as just another irrational, speculative phenomenon, or will it become a viable challenger to the US dollar’s “exorbitant privilege”? The essential properties of the bitcoin mean it’s not particularly useful as a staple currency, and that is what will probably seal its fate more than anything.

Ultimately, the main reason for holding bitcoins – unless you use them for illegal purchases – is for their speculative value; this is protected because there is a fixed supply. For now, the value of bitcoins is almost entirely determined by demand, which, in turn, is a function of people believing that their value can continue to grow. The fact is that because some 78% of the currency is not in circulation, there’s a real risk that sales by just a few hoarders could trigger a big devaluation. A further factor is that the bitcoin is inherently illiquid: it’s not as though there are professional traders dealing it.

The bitcoin is an experiment in the sense that it is founded on distrust. Essentially, trust in bitcoins has to be relative to distrust in everything else. So, the question becomes: as we move away from the financial crisis, do we trust existing fiat currencies more or less? Just as importantly, do we retain the same amount of trust in a currency that’s based on distrust?

It’s important to separate distrust in fiat currency from distrust in authority. They are separate things. One is a belief that your store of value will be eroded over time; the other is a distrust of authority, period.

Of course, one of the features some people like about the bitcoin is that there is no regulatory protection; but you still have to believe you can protect your store of value. What good is a store of value if you can’t store it away?

In that context, the more popular the bitcoin becomes, the more resources will be devoted to stealing it. Because it has no regulatory backing and is not generally recognized as money (Germany being an exception), you can’t just call the police when it’s stolen.

The rise of the bitcoin introduces the more fundamental question of how much we are willing to pay for the security that’s offered in a fiat currency system controlled by democratically-elected governments. Democracies allow voters to punish their leaders for abuse of power, and that includes abuse of powers over currency provision. But thus far, voters seem to have had little success at the ballot box in protecting the value of their money. Such is the loss of purchasing power that US$ 100 today is equivalent to US$ 9.33 in 1929. The libertarian appeal of the bitcoin is accordingly immense. The flipside is that adherents of the bitcoin have no police to protect them or their savings, no armies to fight off invasions and no public safety net to fall back on in the event of bad times.

Ultimately, the bitcoin’s deflationary character is a reason in itself why it fails in its broader use. There is a mostly fixed supply of bitcoins and, as their value rises, the incentive will be to hold them rather than spend them, driving up value further and creating deflation. Even if you come up with some alternative, it’s not at all clear that a commodity standard type of system is beneficial to the global economy – unless you’re happy to undergo depreciations every so often. Some people would argue that this would not be bad for an economy, and I rather sympathize with that view, but I don’t think anyone is going to willingly choose to live in that world once they recognize what it entails. Certainly, they’re not going to vote for a system that protects the value of their currency at the cost of undermining their economic security

Read more blogs on finance and economics.

Ten things you should know about bitcoins by Ethan Huntington, Senior Associate, Global Agenda Councils, World Economic Forum.

Author: Gene Frieda is a global strategist for Moore Europe Capital Management and a Member of the Global Agenda Council on New Economic Thinking.

Image: Some of Bitcoin enthusiast Mike Caldwell’s coins in this photo illustration at his office in Sandy, Utah, September 17, 2013. REUTERS/Jim Urquhart