Much has been made of Bitcoins and other so-called digital cryptocurrencies. I remember how, in the early days, Bitcoin was supposed to be the cure for all the woes of modern fiat currencies and the central banking system. Even at the time, I failed to see the logic in that claim. I should mention that I have profitted some from Bitcoins, mostly by the fluke of having mined some when it was trivial to do so.
Before I get into Bitcoins, however, I should define a few terms. First, a fiat currency whose tokens have no real intrinsic value, or a negligible one. The only reason a fiat currency has value is because there is some authority that mandates its use for some process that is not optional. In other words, its value exists by fiat. The dollar (take your pick which one) has no intrinsic value – the coins and notes used to represent dollars and cents merely score keeping tokens made of base metals or paper or what have you. Furthermore, most of the dollars that circulate never actually physically exist in this day of digital transactions.
Central banks, on the other hand, are more complicated and simple at the same time. Wikipedia has a reasonable write-up on central banks over here. It’s easy to get bogged down in the details, though. Roughly, the central bank usually oversees the operation of commercial banks, manages interest rates (whatever that means, really), and often is responsible for producing the national currency.
Neither fiat currency nor central banks are problematic on their own, regardless what many fear mongers would have you believe. A fiat currency is arguably better than a commodity currency (gold, silver, copper, leaves, etc.) as long as there are sensible controls on how much is circulating. Central banks serve an important mediation role between commercial banks and also as a banker for the government.
Where the problem comes in is fractional reserve banking. I do not use the term “lending” because you cannot lend what you do not have. Basically, the fractional reserve system is an institutionalized fraud which allows commercial banks to “lend” money they do not have so long as they have a sufficient reserve level. This has the side effect of multiplying the money supply well beyond the amount put in circulation by the central bank. This sounds wonderful – more money is good, right? Wrong. For a good description of what is wrong with this system, head on over to Positive Money. Their take is UK centric but their illustration of the problem applies everywhere.
The practical upshot of the current money system is that without continual inflation, the economy will completely fall over dead because there will not be enough money to pay the interest on loans and therefore borrowers will default. As borrowers default, eventually the money supply starts shrinking making it harder and harder for the remaining borrowers to pay their obligations. You end up with a downward spiral of defaults leading to reduced money supplies, deflation, hoarding, and other problematic situations. In other words, the economy becomes illiquid and stalls. By continually increasing the supply of money circulating, this default spiral can be staved off. Positive Money notes how this is problematic in the current system in which the commercial banks are chiefly responsible for the total money supply.
The problem with inflation, however, is that it is basically stealing from the future to pay for the present. The dollar I put in a safe today will be forth far less in real value when I take it out in thirty years. At an annual inflation rate of two percent, that dollar will lose nearly half its real value over thirty years. Put another way, what you could buy today for $1.00 will cost you $1.81 in thirty years if inflation stays constant at two percent. If you start playing around with the mathematics and plug in the underlying cost of interest owed to the commercial banks, the implications become frighteningly clear. The current system is not sustainable and it is amazing it has not totally collapsed previously.
Enter Bitcoin. The creators of Bitcoin looked at the current situation and observed that inflation is bad and that we clearly need a currency with some sort of built in hedge against inflation. What if we create a currency that has an absolute upper bound to the number of currency units that will ever be created and prevent any central agency from having any control of the system.
That particular notion would make perfect sense in a steady state economy. A steady state economy is one where economic activity is neither growing nor declining. This is, of course, the only economic state that is actually sustainable, but that’s not the point of this discussion.
In the real world, economic activity is growing, on average, and it will continue to do so as long as the population continues to increase and demand for “stuff” continues. That means, if you have a fixed currency supply, there will always be more and more stuff being chased by the same number of currency units. As the level of activity increases, the average prices must decrease if the currency available does not also increase. In other words, this situation ultimately has deflation built into it. While this is not necessarily bad in itself, it does cause some behaviour that is less helpful. Hoarding currency becomes profitable as it becomes more valuable over time, which, in turn, further reduces the currency supply, leading to further deflation. In short, even without a shrinking money supply (such as in the case of the default cycle mentioned above), the economy will eventually become illiquid.
The situation just described is exactly the situation with Bitcoin. What the designers of Bitcoin have created is not a currency but a scarce commodity akin to gold or silver. The same reason we abandoned gold and silver as currency units makes Bitcoin unsuitable as a general purpose currency. However, like gold or silver, it is useful for single transactions at a specifc moment in time, and, potentially, as an inflation hedge.
In other words, while I do hold a small number of Bitcoins, I do not believe they should ever become a mainstream currency. That would be more deleterious to the overall economic health of the world than the current central bank based fractional reserve system of fiat currencies. And that is saying something because the current system is so horribly broken that its ultimate collapse is almost certainly looming large on the horizon.