Here’s a piece of redundant advice: don’t buy Bitcoins. I heard about them this morning on NPR in a fascinating story. My advice is redundant because at the end of the piece, NPR mentions that Bitcoin’s biggest bank was robbed, so I don’t think anyone is going to buy anyway. However, if that robbery hadn’t occurred, let’s see if I’ve read enough Krugman and Galbraith to explain competently why not to jump in the Bitcoin market.
In the beginning of the story, a Bitcoin proponent mentions how: (1) there’s a fixed supply of Bitcoin, and (2) there’s no Bitcoin “Fed.” The proponent loves Bitcoin because there’s no Fed to “screw it up.” However, the lack of a monetary authority is actually a huge problem, and makes Bitcoin more akin to a pyramid scheme (or, perhaps more accurately, Dutch tulip mania) than a currency.
The Bitcoin early adopters got in when Bitcoins were cheap and started to generate buzz about Bitcoin. The fact that there’s a limited supply no doubt helped raise initial demand. So did the Gawker story about how you could buy drugs with Bitcoin. Demand skyrocketed.
What happens next–a crash–is nearly inevitable and can happen in a few ways. Endogenous catalysts include: early adopters cashing out and reaping the rewards, big retailers not wanting to buy Bitcoins at high prices so they stop accepting them. Exogenous events could be: government raids of accounts used for illicit purposes, bank robberies, runs on a bank, negative (or lack of) publicity.
When enough of the above happen, the price of Bitcoin drops below the price the late-adopters paid for it. These late-comers don’t want to take a loss so they don’t sell/use their Bitcoins. Since no one is using Bitcoins, stores stop taking them (even though they might not mind buying Bitcoins cheaply) because of transaction costs or negative associations with the currency. If no one accepts Bitcoins, there’s no point in buying them. Demand, and the price of a Bitcoin, plummets…just as fast as it skyrocketed initially.
In essence, the Bitcoin economy experiences a recession/depression. When a recession occurs in the real economy, the government or Fed steps in with expansionary fiscal and/or monetary policy. If Bitcoin had a Fed, the Fed would give everyone more Bitcoins at a cheap price so people would have an incentive to use them and get the economy rolling again. That’s why we need a government and a central bank.
And if you don’t believe that hypothetical, think about the recent Bitcoin bank robberies. I bet the Bitcoin customers who lost their shirts would have loved a little help from FDIC.
As usual, government serves a useful role, and libertarian fantasies are nothing more than Ponzi schemes.