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Society, Politics & Law

Baffled by Bitcoin

Updated Friday 14th March 2014

The magic of the world’s first ‘crypto currency’ is still lost on most monetary experts, writes Alan Shipman.

A patient attempts to pay for an operation with Bitcoin Creative commons image Icon Catherine Pain under Creative-Commons license You can already buy a pint with itpay some tuition fees in it, even use it to book a spaceflight. It seems there’ll soon be nothing that Bitcoin cannot buy.

That’s a bit of a surprise to most financial observers, who don’t regard Bitcoin as a form of money. It’s still a long way from generally acceptance as a means of payment, and you can’t pay your taxes with it. Nor is it a reliable store of value: the price of a Bitcoin has gone under $100 and over $1000 in recent years. Because its ‘exchange rate’ with other currencies is so unpredictable, you’re unlikely to find commercial banks extending large loans in it, or investors treating it as anything more than a highly speculative asset.

Eliminating banks as an intermediary may save a few cents in transaction costs, but it can also leave luckless investors like James Howells rooting through the rubbish-tip when the hard drive goes missing.  Bitcoin’s entirely-online existence leaves out the back-ups that keep alive your savings when your bank’s computers crash. And as it isn’t issued by a central bank, no-one is likely to trust a private currency like Bitcoin as the core of their payments system – unless the algorithm behind it is reprogrammed with a lender-of-last-resort app.

All a Bit confusing

But economists have a hard time explaining to techno-enthusiasts why Bitcoin isn’t money. The reader reaction to finance-and-business professor David Yermack, writing in the MIT Technology Review, is typical. While some regard his explanation as straightforward and entirely reasonable, others clearly regard Bitcoin and other ‘crypto-currencies’ as an innovation that will transform our economies and political systems, and that commentators reared on traditional views of money still don’t understand.

To Bitcoin’s cheerleaders, the very things that set it apart from dollars and pounds – its private-sector origins, avoidance of bank intermediation, freedom from central bank influence – are destined to make online currencies into an alternative form of money (or an alternative to money). The virtues of virtual money will prevail even if governments try to regulate them out of existence. Russia’s and China’s attempts to do so prove, to the early-adopters, that online currency can beat autocracy in ways that offline protests never did.

Although convention would define Bitcoin as a commodity or asset – something bought with money – rather than money itself, this isn’t a rigid distinction. Exchange-based economies got going, legend has it, when conveniently portable and durable commodities (like silver and gold) began to be fashioned into coins. They took off when traders started swapping the receipts they’d been given for wealth stored in bank vaults, turning immobile stacks of bullion into cash.

However, while some experts (including former Federal Reserve chairman Ben Bernanke accept that crypto-currencies might have a valuable role alongside real money, most still doubt if that’s a positive development. A token that by-passes conventional banking channels will inevitably appeal to illegal traders and money-launderers, and one whose markets are unregulated is always vulnerable to fraudulent trade. Much bigger difficulties loom if households and mainstream businesses start earning and spending in ‘crypto-currency’ to avoid tax. Legally keeping recorded income and sales below the tax threshold, by switching most transactions to Bitcoins, is like standing up in a stadium to get a better view. If just a few do it, they gain. If everyone does, they’re in a grave new world of no public services, no national security and no-one to keep the networks repaired.

Too expensive? Or too free?

The internet’s visionaries tend to regard its decentralisation and lack of regulation as key strengths. Since even the most autocratic governments can’t always stop their citizens using the net, or dictate how they do so, online media are associated with free speech and new forms of peaceful political resistance. So it’s predictable that many internet enthusiasts will hail Bitcoin and its progeny as a big new step on the road to digital liberation. Its private issuance, invisibility of transactions, immunity to taxation and state control will all be viewed as positive attributes, especially in a world recovering from disaster wrought by big banks on centralised credit and payment systems.

Unfortunately, the financial crisis showed how monetary worlds can collapse when there is too much decentralised, uncoordinated activity, and too little central supervision. Bitcoins and modern money share one feature – both have no inherent value, and are safe for transaction and saving only if people continue to accept them in exchange. Governments are trusted to issue money because they want people to use it (so as to tax them), and they want to be able to repay public debt with it. These give them a powerful incentive not to inflate its value away too quickly. Private currency issuers don’t have these incentives; historically, they’ve put too much into circulation, made its value plunge, and caused a flight into ‘harder’ currency.

Bitcoin’s creators have cleverly avoided this trap by strictly fixing the amount in issue. As more people buy into it, and put large stashes aside (or into the rubbish-dump), its resale value has soared. But that fixed supply means that if the whole economy converted to Bitcoins, and experienced any growth, prices and wages would continually fall, in order to stretch those few coins further . Deflation – falling prices – has always been bad for business, and currently threatens the Eurozone’s already fragile recovery. If Bitcoin’s the answer to our financial woes, we may have got the question wrong.

This blog post is part of Society Matters. The blog seeks to inform, stimulate and challenge our understanding of this changing world and of our humbling role within it. Find out more about the blog and the team.
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