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BITCOINS: Boom and Coming Bust

BitCoin OfficialYesterday Dr. Jia Liu, AIER Research Fellow, and I attended a Bitcoin presentation at Boston University’s Center for Finance, Law & Policy. The lead speaker was Jeremy Allaire, founder and CEO of Circle Internet Financial. Circle will offer transactions software and systems for merchants to deal with bitcoins, as well as services for consumers to buy, sell, and store bitcoins. This makes Circle a major competitor with BitPay and Coinbase. So far the new venture has raised $9 million in venture capital from Jim Breyer, Accel Partners, and General Catalyst Partners.

Advocates like Allaire call bitcoins a form of digital currency. The currency is completely virtual—it exists only on the internet—and is independent of any government. Thus, they like to say, it is a global currency.

But is it a currency? Or is it a security? Or is it just PayPal with a weird back-story? There are really two separate aspects to bitcoins. First, advocates argue that bitcoins are more secure, stable, and private than government-issued currencies. Second, that the use of bitcoins facilitates transactions and transactions processing.

Currencies—money—work because people trust in them. One way to engender trust is to establish a high-demand commodity as the basis for the currency. Promising to exchange the currency on demand for a fixed measure of gold very quickly makes a currency viable. This is the basis of gold standards and similar commodity-based currencies. The other way to create trust is for the political entity to declare that, by law, the public has to accept the currency of the land in exchange for real goods and services. It helps a lot if the government has a track record of maintaining a stable currency, but weight is also provided by tax-levying power and a substantial tax base.

If you are one of those people who does not trust the government, bitcoins offer an alternative. But bitcoins offer neither commodity nor government backing. To believe in bitcoins, you have to believe in mathematical algorithms that release money into the bitcoin economy when and only when certain math problems are solved. You have to believe that the internet cannot be hacked. You also have to believe in the mysterious creator of the bitcoin, an untraceable, possibly nonexistent person or group of persons going by the invented name Satoshi Nakamoto. Are we feeling warm and fuzzy about this yet?

Of course, bitcoin accounts have been hacked. Often. Accounts have been wiped out. More generally, the system has been compromised. In fact, in the news yesterday was a story that researchers from Cornell University have demonstrated that a group of self-interested individuals could co-op the bitcoin system for profit, affecting the flow of bitcoins into the system. The system does not appear particularly safe.

Advocates also promote the idea that bitcoins are anonymous and untraceable. This has led to fairly widespread usage of bitcoins for illegal transactions and money laundering. Bitcoins seem the way to go for drug trafficking and online gambling. It is also a way to move money and make transactions so as to avoid taxation. Not surprising, the Department of Justice (DoJ) and the Department of the Treasury have jumped on this as fast as you can say “Nakamoto.”

This year, the FBI shut down Silk Road, a service using bitcoins to deal illegal drugs. Seizing their virtual assets, the FBI now owns about 1.5% of all bitcoins in circulation.

Oh, and that anonymity. It turns out that by tracing the trail of transactions, it appears that it is possible to track down the owners of bitcoins and identify their transactions. Put together DoJ and traceability, and it is starting to look like the bitcoin may not survive in its current form much longer. The federal government may just choose to make holding bitcoins illegal as a way of clamping down on illegal activity.

If bitcoins form a currency, is it a more stable currency than national currencies? The short answer is no.

The value of bitcoins has fluctuated wildly, leading many to criticize its use as a currency. The design of the bitcoin slows the growth of the bitcoin money supply and limits the number of bitcoins to 21 million. Thus, scarcity in the face of rising demand has increased the market value of bitcoins, encouraging hoarding as speculative vehicles. Moreover, there is nothing real underlying the currency. And the more people get involved in bitcoins, the higher their value, leading some to charge that it is a Ponzi scheme.

This makes bitcoins look like securities being promoted in a Ponzi scheme, something that raised the interest of the U.S. Securities and Exchange Commission.

Trading the coins is also problematic. In a study by computer scientists Tyler Moore at Southern Methodist University and Nicolas Christin at Carnegie Mellon University, 45 percent of Bitcoin exchanges end up closing, with their customers losing their money. Many close without warning, some suffering security breaches that forced them to close. Even so, speculation has reached such a frenzy that speculative bubbles have arisen and burst, most recently in April of this year.

To the extent that it is a currency, bitcoins should be, and will eventually be, regulated under banking laws. If being unregulated and anonymous is the big selling point for bitcoins, it appears that it will not last. Governments are moving aggressively to police and regulate the market, and prosecute tax evaders.

In fact, bitcoin companies are facing lawsuits, legal actions, and investigations by private interests and government agencies including the Secret Service, the Department of Justice, the Securities and Exchange Commission, and the Department of the Treasury, to name a few.

But what about bitcoins as a means to make transactions easier? This has promise, but appears to be separable from the “bitcoin as a currency” argument. In fact, this makes bitcoins remarkably similar in practice to PayPal—a wildly popular internet transactions system.

All in all, this leaves us with a notion that bitcoins may go the route of Napster. The elements that facilitate anonymity and illegal commerce will be removed by federal enforcement agencies, and the transactions payment system that remains will become a competitor to PayPal. Since bitcoin uses the currency activity to finance lower transactions costs for the payment system, this leaves bitcoin with no cost advantage over PayPal and similar services.

In other words, it may just all blow over.

10 Comments Post a comment
  1. Kyler Donlan #

    I think that Bitcoin is another bubble that will eventually pop, just as all the others have. Furthermore, no currency can possibly swing in value as much as it does to be reliable, especially one that has no guarantee that it is worth anything! For example, in the last matter of months it has risen from about $80 to $245! Over time people will realize it is worthless and move on.

    Like

    November 6, 2013
  2. Keith Hocter #

    I think these are all interesting and mostly accurate observations about the Bitcoin. The observations may argue that the Bitcoin is a bad currency, an ineffective currency, or an immoral currency — but I don’t see any argument that the Bitcoin is not a currency. And, many of the observations apply equally to the US dollar, gold, or other more storied currencies. For example, Bitcoins have been used to purchase illegal drugs over Silk Road and probably through other venues — but the amount of illegal drugs purchased with Bitcoins is dwarfed by purchases made with US greenbacks, which are also untraceable.

    Bitcoin is at the very least an interesting experiment in virtual currency. Like most experiments, it has a high probability of practical failure. But I’m amazed at how urgently the monetary establishment wants to dismiss the phenomenon entirely, without honestly studying it.

    Like

    November 6, 2013
  3. Very interesting discussion. Bitcoin serves us an opportunity to re-examine and explain currencies.

    Dr Cunningham’s survey of Bitcoin highlights serious shortcomings, some of which Mr. Hocter astutely points out are characteristics of other currencies. However, the point Bitcoin backers seem to highlight most is the mathematical limit to the ability to create more Bitcoins. This inherent rarity and slow growth of the number of Bitcoins is cited as the inherent value of the currency.

    Whereas dollars can be churned out as fast as printing presses can print (faster really in our digital age), Bitcoins can only come into existence via bit-crunching algorithms – “Bitcoin mining.” This makes the Bitcoin process sound like a metal-based currency, such as a gold standard. I think, therein lies the fallacy.

    Currency is supposed to simply be an expedient way to exchange value: My labor for your product, for instance. The need for the currency to have a value of its own is to avoid the ability to claim something of value without providing something of value in exchange. Hence, in a gold standard that includes sound commercial banking, a unit of currency must represent a fixed amount of gold, my processing effort of equal value, or a product of equal value.

    Bitcoins, in spite of their limited number, have no significant inherent value: they are immaterial, computer processing creates them as long as someone pays the electric bill, and they represent no product. Minus a government’s say so, this is similar to a Dollar, Euro, or Yen. On the other hand, gold, silver, copper, and perhaps other commodities, are material, are created with significant effort, and can be various products – all things of inherent value.

    Hence, Bitcoins are not the next sound currency, just as the dollar (at less than 5% of it’s value in 50 years or so) is not sound, no matter what it trusts in.

    I am very interested to read other opinions.

    Like

    November 7, 2013
  4. Keith Hocter #

    I’m largely sold on the notion that the Bitcoin won’t be the next “sound” currency, if for no other reason then because it’s the first large-scale experiment in a new class of currencies. Early experiments usually fail. Gold is a “hard” currency in that it is linked to a commodity, but it is not the first such currency. Ancient cultures used all sorts of commodities for currency, from beads to clam shells. Those currencies turned out to be unsound, or at least they became unsound as better alternatives emerged … but they were the predecessors of gold, and performed a very valuable function in their societies. To dismiss them as “non-currencies” doesn’t seem right.

    Gold functions (functioned?) as a currency because people accepted it as such and used it for trade and value storage. People settled on gold because it turns out to have certain characteristics that make it more useful as money than most other commodities — e.g., scarcity but not excessive scarcity, durability, divisibility, and lack of higher and better uses. It would be interesting to enumerate the desirable characteristics of a currency, and apply those criteria to Bitcoins, US dollars, Zimbabwe dollars, and gold.

    Like

    November 7, 2013
    • A comparative analysis of various currencies, as you suggested Keith, would be very interesting. AIER once had/has a book on the history of money that was interesting, but I don’t recall it comparing the qualities inherent to them or over time. Maybe AIER should consider such a book…

      Like

      November 7, 2013
  5. Steven R. Cunningham, PhD, Chief Economist #

    There are some issues with bitcoins being considered a currency, but that was not the purpose of my blog post. One of the most basic requirements for a currency is that it is widely used and accepted as a means of exchange. Bitcoin is not. In fact, nobody I do business with accepts bitcoins. Government will not accept tax payments in bitcoins.

    As an economist, I also evaluate money in terms of money supply and money demand. The supply process is obviously artificial, and has recently been shown to be easily capable of being undermined. It is also totally inelastic. The demand for bitcoins seems to be primarily as a speculative asset and a means of conducting black market activity. So bitcoins do not have the kind of supply and demand structure of a normal money asset.

    There are plenty of examples of successful currencies issued by private interests. The US had a “free banking period” that ran through the middle of the 1800s in which banks issued their own notes (currency). It can be done.

    And, by the way, bitcoins have not been dismissed out of hand. There has been a lot of consideration and analysis given to the subject. For the most part, a lot of leading economic researchers have argued against bitcoins based on their shortcomings.

    Like

    November 8, 2013
    • Sorry to hi-jack your blog post… I liked it, but my interest was piqued by the currency thought. For a list of businesses accepting Bitcoins, I found the following Website: https://www.spendbitcoins.com/places/ The list is long and amusing but a tiny fraction all merchants, surely. “Widely used and accepted” is a relative term, so if it is widely used by shady characters, perhaps it does meet the criteria as a currency for shady deals. At about $350 per Bitcoin there does seem to be a demand for shady transactions that outstrips supply.

      Like

      November 9, 2013
  6. Keith Hocter #

    It was a good article to introduce the subject, and certainly not intended to be complete or scholarly research. I’ve read a number of scholarly articles on the technology involved in Bitcoins, and don’t doubt there has been proper economic research done on the subject as well, but I haven’t come across the latter — admittedly without much of a search effort on my part. In the financial lay-press the discussion around Bitcoin technology tends to be mixed and fair, but any discussion on the financial application of Bitcoins tends to rapidly decay into innuendo. That I do find frustrating, it’s a topic which deserves serious attention.

    Widespread use is a high threshold to impose; clearly only currencies issued by large governments or blocks would qualify under that standard today. But I suspect we’re just using different words to say the same thing; I would just say that widespread use is a characteristic of an effective or successful currency. Gold, Bitcoins, and other alternative currencies are currently used much more for speculation than transactions, but they do establish a benchmark against which other currencies can be compared and evaluated.

    Like

    November 8, 2013
  7. Tim Eddy #

    I wonder if bitcoins were invented late at night in a college dorm. I can imagine someone saying “if the Federal Reserve can create $85 billion a month out of thin air, I will bet that I can do the same on a smaller scale”. When all of this comes unraveled, let’s hope that it does not destroy the faith that people have in fiat money.

    Like

    November 20, 2013

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  1. Bit-heist: Over $1mn in bitcoins stolen from Australian online bank | Global Clarity

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