The Problem with Bitcoin


One purpose of writing this piece is a vague hope of being proven wrong by some economist who knows better than me. That would be nice. Because what I have come to think about Bitcoin is not nice. Before writing this piece, I presented my common-sense critique to Bitcoin proponents, and so far nobody has provided answers. Perhaps I asked the wrong people. So make my day—prove me wrong. Here goes.

Bitcoin is not a currency. It is a virtual commodity. You can place money in a commodity, like gold. But gold isn’t money, and neither is Bitcoin. It is not issued by a government. It is not backed by an economy using it as the standard medium of exchange. It is not governed by a central bank that keeps it from going nuts. And, indeed, Bitcoin has gone nuts. Or, rather, it’s gone tulips. That’s a pun, I’ll come back to that.

People trade in commodities that they don’t use, like gold. So why should you not trade in Bitcoin? After all, we know for sure, based on some solid (we think) cryptology, that the supply of available Bitcoins is predictably exact. With gold, someone can find a new mine, flooding the market and lowering the price. Not with Bitcoin. With gold, you need a third party to carry out a secure transaction. Not with Bitcoin.

So Bitcoin is better, right? Wrong! Bitcoin might be a robust technology. But the Bitcoin market is crazy. Either that, or I am.

You see, gold is like an air raid shelter. If investors lose trust in cash as an investment, they can’t shift to bonds or shares, because they too depend on cash. At that point it’s a good idea to invest in a commodity—something that is less volatile than cash. Like gold. Investing in gold means protecting yourself against a loss of trust in the dollar. So after the financial crash of 2008, the dollar price of gold went up. Now trust in the dollar is coming back. Gold has dropped in price against the dollar by 25 percent since 2012.

But Bitcoin investors seem to be living on a different planet. While gold has gone down since 2012, Bitcoin has soared from $5 to $1,000 (it had dropped back to $879 at the time of publication). If this is about distrusting cash, if Bitcoin-buyers are securing themselves against a currency crash, if $1,000 will have the buying power of less than $5 before long, well, that currency crash will be such a horrible crisis that owning Bitcoins won’t be much help. Better, then, to dig a hole in the ground and fill it with canned beans, warm clothes, and shotguns. Some people do that, too. They might just be the levelheaded ones in this comparison.

Is there anything other than a weakening dollar that can bolster Bitcoin? Well, yes. If there were a strong economy backing up the Bitcoin, exchanging products and services in Bitcoin and outcompeting products and services from other economies, including the US economy, then Bitcoin would do well. If the Bitcoin economy GDP goes up, so will the exchange rate for the Bitcoin. I’ve never heard of any Bitcoin economy like that, but let’s talk about it anyway.

Let’s say a new coffee chain opened in 2012, StarBits. They proudly belong to the economic zone of Bitcoinia, meaning they do all their financials in Bitcoin, write contracts in Bitcoin, pay wages in Bitcoin, sell their products in Bitcoin and so on. Now, they sell totally mind-blowing cafe lattes, and they sell them for only 0.20 Bitcoin each. I went there a year ago and bought a divine latte. It cost me only $1 (I paid seamlessly with my smartphone Bitcoin exchange app.) Well, today, with the appreciation of Bitcoin, that latte will cost me almost $200. Will I buy the world’s best latte for $200 a pop? Do I have a hole in my head? StarBits would have been out of business by now! No customers!

This is one reason to why real currencies, like the dollar, have central banks. The central bank keeps the currency in check so that people can rely on it for doing business, pricing their products, paying their employees and contractors, and so on. It does what it can to keep the currency stable. Bitcoin does not have a central bank, so it’s technically not a currency. If it were, it would be failing miserably.

Hyperinflation is bad enough. Germany, Argentina, Iceland, and others—anybody who has experienced hyperinflation never wants to see inflation again. But hyperdeflation, as Bitcoin regularly experiences, is even worse. Central banks will do everything they can to avoid deflation because it means that people will avoid buying things and drag their feet on paying. They will do business just by keeping their cash under the mattress. No business! Latte, anyone?

If Bitcoin doesn’t qualify as a currency, perhaps you could think of it as a service—an intermediary for certain kinds of transactions. That would make sense. With Bitcoin I can execute risk-free transactions with someone on the other side of the world without involving banks or credit card companies. That’s value! There are probably a number of people who are willing to pay for that. After all, I pay the credit card company several percent on each purchase I make.

But why should the value of this intermediary currency fluctuate so wildly against all real currencies? Say you’re a startup trying to build a transaction management service, a kind of Skype for Bitcoin. It’s not at all helpful when the proprietary, underlying currency goes haywire. The nuisance of doing exchanges via a wildly fluctuating Bitcoin outweighs the cost of going through banks and credit card companies. If Bitcoin is a transaction service, then the rollercoaster Bitcoin exchange rate is a bug in the architecture. And now with so many people stockpiling Bitcoins, betting on a rise in exchange rates, it’s going to be hard to fix.

The only other reason I can think of for the dizzying ups and downs in the value of Bitcoin is tulip mania. Bitcoin has gone tulips!

In Netherlands in the 1600s, people started trading rare, fancy tulip bulbs and the prices went up. Bulb buyers would buy and stockpile bulbs, creating scarcity, driving up the prices. Soon prices skyrocketed, attracting even more buyers. Economists call it market froth: the beginning of unsustainable rates of asset price inflation. A few tulip bulbs could buy an estate. A single bulb cost more than a craftsman would earn in several years. The market escalated for years and crashed in weeks. This sounds like my best Bitcoin theory so far. Did I miss something? Someone, give me a better explanation!

Now, Bitcoin has some really neat, useful, advanced technology that might break new ground in finance. But I fear that a crash of Bitcoin will leave such a stink behind that nobody will want to touch it for a while. Just like we did with Internet companies after 2001. And that’s an outcome no innovator could wish for. Let’s treat Bitcoin as what it is—an impressive technology, a financial experiment, a social phenomenon, but hardly the basis for a new digital economy.

David Nordfors is the CEO and Co-founder of IIIJ. Follow @dnordfors

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