Don’t Buy Bitcoins

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.

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2 Responses to Don’t Buy Bitcoins

  1. Nathan says:

    You’re saying that the price of bitcoin will fall due to lack of demand, causing a recession.

    So how would a controlling body fix the recession by decreasing the value, if that was what caused the recession in this scenario?

    I kind of like the idea of the Fed not being able to print a ton of money to decrease the value of the currency I hold.

    On another note, until the value of bitcoin stabilizes, it will not be a safe medium to store value long-term. But it is still a great method of transferring value between individuals securely over the internet.

  2. mindless says:

    I’m not an economist, but I believe the standard answer is to print more Bitcoin so that people have enough Bitcoin that they feel comfortable spending some. And by keeping inflation at a somewhat predictable low, but positive, rate people have the incentive to spend Bitcoin *now* rather than waiting.

    Even with Fed we get manias and panics sometimes (less frequently than before The Fed) — I see taking the Fed out of the equation as exacerbating that mania/panic, not helping it.

    Bitcoin might be a great way to pass money between people over the Internet….if it had a fixed (or even stable) value. If you receive money in Bitcoin from a person over the Internet, you should probably cash out right away — and that seems like a pain. Looking at charts, Bitcoins are at one-third (!) of their value from 60 days ago. Yikes.

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