Rico's rants: Bitcoins

Every once in awhile, stuff shows up on the Internet that Rico never heard of, and Bitcoins are one of them. Time has provided a nice series of articles on the subject:

Peter Svensson has a primer:

Bitcoin, the virtual currency composed of digital bits, is based on cutting-edge mathematical schemes that guard against counterfeiting. But it’s also based on an old idea, now dismissed by mainstream economists, about how a currency should operate, an idea that could be setting bitcoins up for an abrupt plunge.
Bitcoin was started in 2009 as a currency free from government controls, an entirely digital means of exchange for a digital age. It’s a rapidly growing phenomenon that has taken root as a payment method on some websites for both legal and illegal goods.
Each “coin” has been worth less than ten dollars for most of the currency’s history, but this week the value surged past two hundred dollars, with the recent bailout crisis in Cyprus seen by many as one of the triggers of the surge. It recently saw a “flash crash,” as the value dipped close to a hundred dollars before recovering.
The meteoric rise in value is also linked to what some economists say is the biggest problem with the currency: that the supply of bitcoins increases only slowly, at a rate that’s coded into the system.
That’s a contrast to a regular paper currency like the dollar, whose supply is managed by a central bank like the Federal Reserve. The Fed engineers the dollar supply to increase slightly faster than the growth of the economy, which means that the value of the dollar falls slightly every year, in the phenomenon known as inflation.
New bitcoins are “mined” or generated by computers. They get harder to generate all the time, which means the inflow of fresh bitcoins keeps falling. There are about eight million bitcoins in circulation today, and the maximum that can be generated is 21 million. By 2032, ninety-nine percent of those will have been created.
Since the supply of bitcoins grows so slowly, any increase in demand leads to higher prices. That’s known as deflation, and it’s widely seen as a disaster when it happens to a real-world currency. As money becomes more valuable, our incentive is to hold onto the money instead of spending it, slowing down the economy.
“What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin,” Nobel Prize-winning economist Paul Krugman wrote in 2011.
When the supply of money is fixed or increasing only slowly, deflation can feed on itself. Investors will look at the rising price of the coins, and conclude that they’re set to rise further. So they buy more, sending the price even higher. This goes on until the market is sated. In the ideal outcome, the value of the currency then stabilizes at the new high level. In the worst case, the value plunges.
This boom-bust cycle has already happened once before for Bitcoin It hit nearly $31 in June of 2011, then crashed, hitting two dollars five months later.
In essence, Bitcoin is similar to the “gold standard”, the monetary system in force before modern central banking started to take root in the 1930s. Under the gold standard, each unit of currency was worth a certain amount of gold, leaving governments few means to increase the amount of currency in circulation.
No country uses the gold standard today, but some libertarians want to revive it, and see Bitcoin as a modern-day alternative or complement. “If you wipe away the misguided economics courses that we have, deflation doesn’t have to be a negative,” says Jon Matonis, a board member of the non-profit Bitcoin Foundation, created last year to foster and protect the system. “It’s not a bad thing when a citizen’s purchasing power increases.”

Raphael Satter has an article on their boom and bust:

It’s a promising form of electronic cash free from central bankers and beloved by hackers. Bitcoin may also be in deep trouble, registering catastrophic losses that have sent speculators scrambling.
Although the cybercurrency has existed for years as a kind of Internet oddity, a perfect storm of developments have brought it to the cusp of mainstream use. As currency crises in Europe piqued investors’ interest, a growing number of businesses announced they were accepting bitcoins for an ever-wider range of goods and services. The value of a single bitcoin began racing upward amid growing media attention, smashing past the hundred-dollar mark last week before more than doubling again in just a few days.
Then came the crash.
The price of Bitcoin has imploded, falling from $266 recently to roughly $55 on the following day. The best-known bitcoin exchange, the Tokyo-based Mt. Gox, has suspended trading for what it described as a twelve-hour “market cooldown”.
Nicholas Colas, chief market strategist for the ConvergEx Group, said it was a “great question” whether the currency could survive the wrenching up-and-down. “At this point I would say yes, since it has before,” Colas wrote in an email. But he noted that, unlike previous oscillations, this collapse was taking place in the full glare of international media attention. “A lot more people know about Bitcoin than during the prior problems,” he said.
To its supporters, Bitcoin has enormous promise. They describe it as the foundation stone of a Utopian economy: no borders, no change fees, no closing hours, and no one to tell you what you can and can’t do with your money.
Some of that promise is being delivered: when Bitcoin first got its start in 2009, the currency could buy almost nothing. Now, there’s almost nothing that bitcoins can’t buy.
From hard drugs to hard currency, songs to survival gear, cars to consumer goods, retailers are rushing to welcome the virtual currency whose unofficial symbol is a dollar-like, double-barred B.
Just days ago the total value of bitcoins in circulation hit two billion dollars, up from a tiny fraction of that last year. But Bitcoin collapsed, shedding roughly 75 percent of its value in a series of stop-and-start crashes that left many enthusiasts anxious and many skeptics saying “I told you so.”
“Trading tulips in real time,” is how longtime UBS stockbroker Art Cashin described Bitcoin’s vertiginous rise, comparing it to the now-unfathomable craze that saw seventeenth-century Dutch speculators trade spectacular sums of money for a single flower bulb. “It is rare that we get to see a bubble-like phenomenon trade tick for tick in real time,” he said in a note to clients.
Colas seemed to reject the idea that the suspension of trading at Mt. Gox was a sign that Bitcoin was coming apart at the seams. “For the average user, losing Mt. Gox for twelve hours is like going to an ATM and finding that it is out of money,” he said. But he prefaced the statement by noting that bitcoins suffered from the same weakness of any other form of money. If people increasingly believe they’re not worth anything, then they’re not worth anything, no matter how clever the currency’s design is. “The future of bitcoin is, like all currencies, going to come down to trust,” he said.
One Bitcoin supporter with a unique perspective on the boom-turned-to-bust might be Mike Caldwell, a 35-year-old software engineer based in suburban Utah. Caldwell mints physical versions of bitcoins at his residence, cranking out thousands of homemade tokens with codes protected by tamper-proof holographic seals, a retro-futuristic kind of prepaid cash. His coins are stamped with the words Vires in Numeris— Latin for Strength in Numbers. Some may wonder whether Caldwell’s coins will one day be among the few physical reminders of an expensive fad that evaporated into the ether. When asked, Caldwell acknowledged that Bitcoin might be in for a bumpy ride. But he drew the analogy between the peer-to-peer currency enthusiasts who hope to shake the finance world in the next decade with the generation of peer-to-peer movie swappers who challenged the entertainment industry’s business model in the 2000s. “Movie pirates always win the long game against Hollywood,” he said. “Bitcoin works the same way.”

Michael Sivy has an article on their significance:

The volatile rise and fall of Bitcoin has prompted lots of stories explaining why the online virtual currency is a classic bubble. Many compare it with Tulipmania in seventeenth century Holland, where the prices of rare tulip bulbs soared to absurd heights and then crashed, ruining the speculative investors who had bought them. But the Bitcoin phenomenon is more than a bubble. It says something important about the current and future state of the global economy.
The scale of the recent boom and bust has been staggering indeed. At the start of the year, a Bitcoin was worth $13.51. Earlier this week, it traded as high as $266. But, on Thursday, it plummeted to less than $100, as one of the exchanges where Bitcoins are traded closed temporarily. This would be comparable to the exchange rate for the British pound soaring from $1.62 (where it was on 1 January) to $31.90 and then falling back to $12.
Such monumental appreciation and volatility is clearly the result of speculation; people buying the online currency just because they think its value will rise, not because they want to use it to purchase goods and services. But Bitcoins' gains are not the result of speculation alone. They partly reflect the fact that the Bitcoin system is much better designed than previous online currencies. And more significantly, the runup also reflects anxiety about the safety of the global banking system and the stability of major international currencies.
The technicalities of the Bitcoin system are complex, but to make this online currency more successful than previous versions, the designers overcame two key challenges. First, to prevent counterfeiting, they attached a history of transactions to each currency unit, but allowed users to keep their transactions nearly anonymous. Counterfeiting is hard because fake Bitcoins would need an authenticated history to pass muster.
Second, they strictly controlled the supply of Bitcoins outstanding, thereby saving it from the disastrous fate of, for example, the paper currency known as assignats that were issued during the later stages of the French Revolution. Initially, assignats were backed by land and buildings that had been seized from the Catholic Church. If the French government had issued only enough assignats for that property, there would have been plenty of assignats to spend until the property was disposed of. But the government liked having extra money, and didn’t cancel the assignats as the property was sold. In fact, France kept printing more, and within five years there was very serious inflation.
Unlike assignats, Bitcoins have no backing at all. What they do have, however, and what has turned out to be more important, is a formula limiting the growth of the supply outstanding. Over time the formula for the Bitcoin supply actually reduces the amount of new currency added to the system. And the new Bitcoins are not created by fiat, but in exchange for valuable labor: they are paid to computer hobbyists who monitor the Bitcoin system to keep it running and prevent counterfeiting.
Critics have argued that a currency like Bitcoins would be inherently deflationary because the supply can’t be adjusted in reponse to economic conditions. The same argument could be made about a gold standard, of course, or an extremely hard currency like the Swiss franc. Moreover, the relatively small supply of such hard currencies means that the inflow and outflow of hot money can make them highly volatile. The price of gold, for example, climbed from less than $300 an ounce eleven years ago to almost $1,800 late last year before dropping to $1,564 today, and the Swiss franc rose from $0.82 in 2008 to $1.38 three years later, before settling back to $1.07.
But there’s a strong argument that the appreciation and volatility of all these currencies reflects reasonable concerns about the global economy and banking system. The economic debacle in Cyprus keeps getting worse, after all; in fact, the losses there figure to be far greater than any that have occurred in the Bitcoin universe. In addition, the Federal Reserve, the European Central Bank, and the Bank of Japan are pumping out money like French assignats.
Of course, real countries do have massive wealth backing their currencies and their bonds, as well as the police power to arrest counterfeiters. And as I’ve argued in an earlier article, the US dollar appears to be in better shape for the near term than most other major currencies. But the Bitcoin is doubtless only the first well-designed online virtual currency, and is sure to be followed by Bitcoin 2.0 and other even more sophisticated successors.
Could these online currencies ever reach a level at which they altered or obstructed government policy? President Clinton’s adviser James Carville famously joked that if he were reincarnated, he would want to come back as the bond market because “you can intimidate everyone”. Just as the so-called bond vigilantes acted as a brake on Washington’s fiscal policy in the 1990s, one day “currency vigilantes” could act as a similar brake on monetary policy.
The Internet will almost certainly offer access to a growing number of currencies in one form or another that are beyond national control. If a future Fed Chairman tries to repeat Ben Bernanke’s policy of Quantitative Easing (effectively printing money), worried investors could start pulling their savings out of the dollar and send it streaming into the Cloud so fast that the Fed would be forced to change course.
Governments will fight back, no doubt. But virtual currencies will be no easier to control than Facebook. Stopping the movement of capital will be possible only if countries are willing to impose harsh taxes and capital controls. Once alternative currencies are frictionlessly available on the Internet, every laptop will become its own Cayman Island. However the current boom-and-bust plays out, Bitcoin is the beginning of something, not the end.