The Economist carried a nice piece on Bitcoin that many may already have read. They conclude that the explosion in the price of Bitcoins (recently breaking the $1000 barrier) looks bubbly. I agree.
Most people with things to sell don’t accept Bitcoin in exchange. So most choosing to hold Bitcoin do so knowing that they are holding something they will one day exchange for cash, before exchanging that cash for something they really want [I’m assuming we can forget about currency hobbiests here, though you can find a lot of those around Charing Cross market stalls on a weekend]. In this sense, if Bitcoin is a bubble, it’s a bubble resting on another bubble. Cash is also worthless intrinsically. But we accept it because we know everyone else will. And we know they will because they are making the same calculation. It’s a bubble that can burst if you try hard enough. Witness countries that ‘dollarized’ in the face of decades of sporadic hyperinflation. Although the cash bubble can sometimes prove surprisingly resilient. For example, in this speech, Mervyn King describes how in Sadaam Hussein-controlled Iraq, when the Kurdish region was protected by the no-fly zone, pre-no-fly-zone Sadaam-issued banknotes continued to circulate, even though Sadaam himself first debased them [partly to plug gaps in his own finances] and then renounced them. Users no doubt calculated that at some point in the future Sadaam would be deposed, and the deposers would recognise these notes and exchange them [for another intrinsically worthless bit of paper] and they were proved right.
You might often hear the argument that money is accepted because the law states that creditors must accept cash as final settlement [in this sense cash is ‘legal tender’]. But this has always struck me and no doubt others as superficial. Laws are costly to enforce. If conditions changed such that accepting cash was not wise, people would not accept it. [Short of changing the penalties for breaking it: Sargent and Velde describe how the Jacobins made it a capital offence to use wine and cheese to store wealth, as they debased their Assignats, claims exchangeable at future auctions of expropriated church lands]. So cash is a bubble, which might or might not burst under different pressures. And Bitcoin is a bubble blowing on a bubble, and holders are calculating that they might or might not be able to exchange for cash at some point, and might or might not (probably will) be able to exchange the cash they get for their Bitcoins for something they really want.
Bitcoin seems like a solution to a problem that doesn’t exist, or, if it does exist, is slowly being solved over time. One problem with currency is that it’s inconvenient to cart it around. But electronic payments are slowly taking over. Except [as Paul Flowers’ secretly filmed consumer transactions recently reminded UK TV viewers] for illegal goods. Another is that people can steal it from you. But Bitcoin also seems exposed to theft. Another is that it gets eroded by inflation. But societies around the world have slowly got on top of that problem too. Looking far out into the future, I recall that people used to speculate about a world in which we could engage in real-time wealth exchange. Perhaps swapping claims on indexed mutual funds. This world advances too, with the odd hicupp in financial markets. [OK, quite a big cough].
Bernanke reportedly said that Bitcoin may hold ‘long term promise’. But, if I’m wrong about it, and people do switch to using it, then it will cause a problem for central banks, depriving it of a lever. Those who think that using monetary policy for the purposes of trying to iron out booms and busts does more harm than good may think that losing this lever would be a good thing. Personally, I would worry about it. Imagine the world economy without the loosening of the Fed, ECB, BoJ? Not even John Taylor would advocate policy that tight.
Could Bitcoin be a kind of hedge against other monies? I doubt it. A world where all public monies are being debased feels more like a world that is facing catastrophe, and it doesn’t seem right to conjecture that virtual computer based monies would feel safe. If all the cash bubbles burst, surely the Bitcoin bubble would too. A world in which just one public money was being debased would be one in which investors could protect against by holding multiple currencies. So Bitcoin doesn’t seem to help here either.
Bitcoin’s hard-wired inflation rate is currently set to flatten out at zero. Not good either. Presuming that global supply continues to grow, and velocity stabilises [in this hypothetical world where we settle on Bitcoin as the medium of exchange], that will mean deflation. Deflation, for anyone who reads Paul Krugman’s blog, or anyone knows sticky price models, is a bad thing. If you plot GDP in the major economies over the life of the gold and other metallic standards, the episodes of deflation following inflations are not usually remembered as happy periods.
Private monies like this may have a beneficial effect. Hayek imagined a world where private monies would compete and discipline issuers not to debase their currency. Perhaps Bitcoin and other competitors that emerge might do the same. But then, as just mentioned above, this could have its downsides if it forces central banks to generate inflation rates that are too low, or to avoid using monetary policy to stabilise booms and busts.
The Economist report that the German finance ministry recognise Bitcoin as a ‘unit of account’. But that doesn’t amount to much. I’m pleased to announce that anyone who wants to deal with me can count whatever they like in olives or marshmallows, provided they don’t expect me to take them as final settlement. [I don’t like either].