why bitcoin is not doomed, but not it’s not the next global currency either

When an investment loses half its value in about six hours, people notice and people worry. So as the virtual bitcoin currency fell from about $260 per BTC to $130 per BTC during what had to be a really scary day for bitcoin investors, articles all over the web started questioning bitcoin as a viable currency all over again. Now the price is back up to the $160 per BTC range and things seem to have stabilized. They might even pick up a bit as aggressive investors see opportunity for scooping up a valuable asset at a discount. But the question remains. Is bitcoin a viable and solid investment, or is it just a virtual casino which will one day crumble? Last time I wrote about the currency, everyone was wondering what’s next for bitcoin. And after all this time, there’s still no clear strategy for what bitcoin could be other than something to buy and hold on to until it will gain value, and use it for anonymous transactions on the web. Since it does have uses, it’s not going anywhere soon, but it’s a little unnerving to think about its long term viability.

Here’s the dilemma. Money is worth something when a) we say that it is, and b) it’s adopted with enough enthusiasm to be widespread and useful. Dollars are used around the world because a common understanding across the planet is that dollars are valuable and they’re backed by the world’s largest economy and dominant military superpower. This is why everybody will take your green bills as a valid payment, and should your dollars be exchanged, there’s a big international network of markets that figure out exchange rates with other established currencies. This is very basic Econ 101 stuff, right? Well, bitcoin has some of the same things going for it. We agree that bitcoins have value and there are international exchanges to figure out what it’s worth when we compare it to other currencies. And there are adopters who take it as valid payment. But are the adopters enthusiastic enough and are there enough of them out there? After all, who stands by the value and strength of the bitcoin? Who secures its worth as a currency? Right now, it’s a few major exchanges and a large online community. That’s a start, but it may not be enough.

Rather than spending bitcoins around the world to pay for things on a regular basis, bitcoins sit in virtual lockers on hard drives in safe deposit boxes. Instead of mining and spending, most of the inertia seems to be mining and hoarding. There are something like 11 million bitcoins being circulated and another 10 million left to mine. What then? Is that when people will finally start to spend it and mainstream businesses adopt it as a valid form of payment? And will people deal with a finite supply of bitcoins by taking advantage of the fact that bitcoins can be split into very, very small decimal values, creating artificial inflation as the bitcoin floodgates are opened? And let’s not even get started with alternative block chains that could split bitcoin into two, or three, or hundreds of different currencies, negating the original libertarian idealism behind it. The way the bitcoin economy has been originally meant to work basically caps its size, which means that as every bitcoin to be mined has been mined, the economy will no longer grow, the prices will only deflate to allow an increase in the volume of trade, and produce very bizarre PPP ratios.

Interestingly, this is somewhat reminiscent of what we saw in the ancient world, in which a fixed supply of gold had to be broken down further and further into more and more complex currency to allow transactions to keep happening, so there is precedent for this. However, there were no international exchanges to figure out what currencies are worth back then and minting gold and silver and bronze coins was pretty much the safest way to go for many official transactions. Now we have such exchanges so we don’t need to price our currencies solely on commodities. In fact we’re doing it the other way around and using commodities as a useful hedge against a fall in a currency’s value. But of course all this is predicated on the simple fact that these currencies are being used in enough transactions to be truly valuable, otherwise, they fall out of use and much of the country’s debts have to go unpaid or be repaid in commodities that can be made liquid on international markets. (Well, that’s the idea, the practice is way more complicated.) Who would stand behind bitcoin? Who would repay all those left holding the bag if bitcoin crashes?

It’s that anxiety about what will happen when the bitcoins are all mined and all the complexities of using a currency with no central bank behind it that keep a whole lot of people from using it in a mainstream environment. And this is very likely what caused the massive, massive correction we just saw. Those who were not True Believers™ in the power of virtual currencies with no central bank or regulators attached, decided they made enough and cashed out. More speculators will return and new ones will buy the now discounted bitcoins, so we could see $260 or $300+ BTC rates in no time at all. But if all they’re doing is hoarding a currency with very limited use (and an uncomfortable deal of it quite unsavory, such as paying cybercrime tools and illegal goods), the value of the bitcoin is limited as a novelty that’s ripe for aggressive speculation and little else. At the same time though, bitcoin shows that you can do an awful lot with virtual cash and we might want to adopt its design to phase out paper money and coins for established currencies.

All in all, it looks like bitcoin is an interesting experiment ripe for some fun speculation to make a little, or a lot of, quick cash (relevant aside: I have no investment in bitcoins), and with things to teach us when it comes to modifying modern, existing currencies for the wired world. But it really doesn’t look like it could rise to become the next franc, or dollar, or yen. It will have its uses, but it’s going to stay more or less a novelty for the foreseeable future. That is unless bitcoin finds a new way to open up and instead of hoarding it in virtual wallets on encrypted hard drives buried deep in a remote mountain, locked in safe deposit boxes designed to survive a thermonuclear blast and the inevitable zombie apocalypse that will follow, bitcoin holders go out and spend the currency out in the real world. Maybe then the lack of a central issuing authority might not be an absolute deal breaker and if it stays small enough, people might not want regulators to sort out particularly rough price changes and the Fed will just let it keep flying under the radar…