Why Bitcoin Is Doomed as a Currency

Over the past year, pretty much all consumers of financial journalism have been inundated with an endless stream of opinions on the viability of Bitcoin. It's a wearying task for non-journalists to sort through the heap of formulaic bull and bear pitches just to hone in on an honest argument. But rest assured, clarity can be found. Before I get to my thoughts on the subject, here are both sides of the debate summed up as clearly as I could manage:

In favor
Bitcoin fans use a variation of these three arguments:

1. Transaction use - Digital currencies allow people and businesses to make payments cheaper and quicker than with traditional money. Without the hassle of bank fees and processing times, we essentially cut out the middle men of finance and smooth out those wrinkles in the decision-making process.

2. No inflation - The supply of money is limited. There is no central authority and no printing press, making the currency "inflation proof."

3. Past performance - In 2013 its value grew fifty-fold, 'nuff said. (OK, maybe I made the last part up.)

As more vendors accept Bitcoin to save on transaction costs, so too will demand for the currency rise.

Not in favor
Dissenting arguments in the Bitcoin debate tend to be a bit more muddled. Nobel Laureate Robert Shiller once said, "A bubble is a time of expected future dramatic price increases that is brought on by psychological extrapolation of past price increases." In many ways, this has become central to the Bitcoin story. It's tough to see that a $1,000-valuation of Bitcoin (at the time of writing this article) is based on real expected demand for transaction use, because that would require near universal adoption of Bitcoin.

For example, like many other successful entrepreneurs with Libertarian sympathies, Richard Branson is on the Bitcoin train. Branson's space exploration company, Virgin Galactic, is now accepting the digital currency as payment, but what happens next? Will Virgin Galactic pay their fuel costs with Bitcoin? Or funnel it to suppliers who also accept Bitcoins? In order for that to work, those suppliers would need to pay their employees in Bitcoins, who would have to pay their taxes in Bitcoin. In economics, we call it a medium of exchange. A currency is only useful when it can be exchanged for other goods or services.

But let's just assume that somewhere down the road Bitcoin does become a successful medium of exchange. It would effectively account for its huge gains in 2013, but it also means that the growth is already priced in. As much as investors would like to believe it, nothing goes up forever. So if we believe that a new payments system can eventually seduce a majority of firms and that explains why it grew 6,000% in one year, it's logically inconsistent to believe that price will continue to rise.

My thoughts
Contrary to popular belief, the debate about Bitcoin's viability is not new. It's really just an old argument between economists over the nature of money. 

For decades, economists from two rival schools of thought have disputed the nature that money plays in an economic system. Those in favor of Bitcoin believe that recessions, stock market crashes, inflation, deflation, unemployment, vampires, zombies -- basically anything bad -- is the product of poor mismanagement of the money supply. Libertarians who rail against the Federal Reserve have their intellectual roots in Milton Friedman, who once said "Inflation is always and everywhere a monetary phenomenon." It's true that unrestrained printing of more money has induced hyperinflation by diluting the value of that currency (see Austria post WWI), but that's not a slam dunk case.

Knowing that a link exists between changes in the money supply and the real economy – unemployment, inflation, interest rates – is crucial to understanding why Bitcoin is doomed as a currency. I mean, 2008 showed us how real stock market bubbles can be, but the effects can be softened through smart central banking. If you disagree, just look at the difference in post-crisis recoveries of the US and the UK.

US GDP Chart

US GDP data by YCharts

United Kingdom Real GDP Growth Chart

United Kingdom Real GDP Growth data by YCharts

The Federal Reserve embarked on a quantitative easing program that vastly expanded the supply of money in the United States; Britain's central bank did not. As a result, GDP growth bounced back quicker on this side of the pond. Now all this is by way of saying that good central banking is key to good governance, and it becomes pretty toothless with a fixed money supply. 

The Foolish bottom line
Assume that Bitcoin is compelling enough to become a universal payments system. That in itself is crazy, but just assume it's true. Ignore all the familiar signs of a bubble waiting to burst. The part where you run in to trouble is getting governments to accept tax revenue as Bitcoin, because it undermines the national currency, making monetary policy irrelevant. And why would a country do that exactly? Why would they surrender the ability to heal their economy? Sorry to all the believers, but it's a Libertarian pipe dream that makes absolutely no sense. 

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  • Report this Comment On January 08, 2014, at 4:31 PM, mckmuze wrote:

    While it may be true bitcoin is not in a position to displant any centrally issued currency. It will not go away. If you hold bitcoin, you quickly realize that most arguments are irrelevant when you hold it as insurance. Every financial crisis in the world will push bitcoin higher and higher. Additionally, encroachment on the worlds citizens becomes a consistent and persistent insurance for the individual. If you hold it and it goes up, you don't sell all of it. Its a hedge against injustice. Additionally, its merely the first application developed on a globally distributed operating system (for lack of a better term) money was just the first application deployed. The network is already more secure than most other systems of comparable computing power. While I agree its not a currency. I do think it is an extremely valuable commodity capable of going to astronomical values with every injustice committed to the worlds people. An ever increasing gap between rich and poor is fueling this trend (so bitcoin prices are following the income gap, close the gap and you destroy bitcoin, allow the gap to increase and watch the price of bitcoin increase. Like it or not, it will never go away, until a better system is developed that addresses the problems it hedges against.

  • Report this Comment On January 08, 2014, at 4:32 PM, mckmuze wrote:

    Correction* Additionally, encroachment on the worlds citizens makes bitcoin a consistent and persistent insurance for the individual.

  • Report this Comment On January 09, 2014, at 7:56 AM, tinytiger wrote:

    What I don't like about your article: you compare Annual GDP with Real GDP Growth. It would be nice to see both charts for the US and the UK.

    Also, doesn't it make you scared when you look on the US short when you see such an enormous increase in money supply over a relative short period of time? Do you really think that there will be no substantial negative side effect?

    This money politic which you call "intelligent" seems to me like the desperate action of the driver of a breakless speeding down a mountain whoch pushes down the gas even more hoping to surivive with the aid centrifugal force.

    Disclaimer: I am not a libertarian

  • Report this Comment On January 09, 2014, at 10:16 AM, pondee619 wrote:

    "poor mismanagement"

    What is "poor mismanagement"? Is it the opposite of good mismanagement? Is poor mismanagement good management?

    "Virgin Galactic, is now accepting the digital currency as payment, but what happens next?"

    What did Branson do with his bitcoins? Is he holding them or did he trade them for dollars or another currency?

  • Report this Comment On January 09, 2014, at 2:40 PM, VikingBear wrote:

    Whatever the medium of exchange is, it is an abstraction of an honest person's promise to pay something of value to another person, now or in the future, for some goods or services.

    There is an element of trust that must be tacitly agreed upon by both persons that the medium of exchange has a determinable value. The more stable this determined value is, the more likely there is to be expansion of trade.

    Bitcoins, or Zombie Money, lack a generally accepted value; it is, at heart, a belief about a hope. The demonstrated value has fluctuated so widely so fast that the transfer time--theoretically infinitismal--has in actual process taken long enough for the value given to rise or fall significantly before the value received can be used.

    I will give the creators of Bitcoin the benefit of the doubt; I do not think they deliberately set out to defraud anyone, It's just gonna work out that way.

  • Report this Comment On January 22, 2014, at 8:48 PM, slightlywonkish wrote:

    @TinyTiger Hi, this is Gaurav, the author of this post. Thanks for the feedback! Your point on annual GDP vs. real GDP is reasonable, but it was the easiest data to get my hands on and since inflation has been negligible in both countries, I didn't think it mattered all that much. The conclusion still holds water.

    And I'll only get scared when Treasury yields aren't at historic lows and the US is functioning at full employment. Sure, fiscal tightening in recent years has prompted monetary authorities to take a bigger role in battling unemployment, but hey, they should do whatever it takes to close that output gap.

    Cheers,

    Gaurav Seetharam

  • Report this Comment On January 28, 2014, at 9:22 PM, iaminfidel wrote:

    Bitcoin is more than just a digital currency; it is a revolution in in computer science. Just as internet protocol code revolutionized the dissemination of information, so too will Bitcoin revolutionize finance and financial transactions. The elimination of financial third parties has commenced! Now you can safely store your wealth without a bank or broker. But I digress, to focus only on Bitcoin’s use as a digital currency, as the author of the article does, is missing the full scope of its potential. Bitcoin’s hope, promise, potential, its power lies in its code, which by the way is open source for all to inspect.

    The author of this article brags about the Federal Reserve’s success managing the economy is something to behold and herald whist examining said success from the perspective of a two dimensional creature. After all, why worry about legacy and the impact on the future when we can party today, or at least feel good about the day. Today, quantitative easing is all the rage! Borrow from our great-grandchildren; why should we care, we will be dead or demented by then. Twenty trillion dollars in debt will be child’s play when the centrally-controlled dollar is inflated so the federal government can more easily pay-off the largess of our generations’ hubris.

    Bitcoin’s code is the foundation of something that is and will be revolutionary. It will be the disruptive technology of note because it will put control of the fruit of labor back into the individuals’ hand, not just in the developed world but the WHOLE world.

  • Report this Comment On February 16, 2014, at 6:37 PM, wasmick wrote:

    All currency is faith. If bitcoin (or any other perceived currency) can solve that, it will succeed. It ain't impossible, gold did it; bitcoin could.

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