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Will the Bitcoin Have Byte?

Can It Really Become Shadow Money?

The Bitcoin

The Bitcoin

A cult has developed around the Bitcoin. This is because it is a medium of exchange that is not issued by a government entity and is not controlled by a central bank. Bitcoin.org describes the Bitcoin as follows:

Bitcoin is a digital currency, a protocol, and a software that enables
• Instant peer to peer transactions
• Worldwide payments
• Low or zero processing fees

This concept has led to a variety of reactions. Simon Black of Sovereignman.com touts the benefits of the new currency. He notes the privacy of the transactions and the lack of traceability. He shows an example of how an Argentine Car rental agency charges less for rentals if the customer pays via Bitcoin. It doesn’t get reported to the state that way, and transactions costs go down for business off the official books.

The 1-day rental rate for a basic car was 380 Argentine pesos. At the government’s official rate, that works out to be $74 USD. In Bitcoins, the same car rents for 1.13 BTC… which is approximately $54 USD. This is nearly 30% cheaper! The benefit for the rental agency is the privacy; they can avoid all the costly fees, bureaucracy, and debilitating capital controls associated with a normal transaction. Plus, they can hold Bitcoins instead of the rapidly depreciating Argentine peso.

What Simon Black sees as a benefit, others see as a drawback. Bloomberg.com goes as far as to describe the Bitcoin as an existential threat to the modern liberal state.

Electronic payments aren’t new. Bitcoin’s only innovations are its status as an independent currency and its decentralized network design. But those differences might make Bitcoin — or rather, crypto-currency in general — an existential threat to the modern liberal state. If widely adopted, crypto-currencies would cripple government in three central functions: taxation, police and macroeconomic stabilization.

Business Insider describes a less far-reaching and more believable threat posed by Bitcoins in conjunction with the “Black Internet”. They describe the Bitcoin as a currency for criminal transactions to include child porn, gun-running, drug smuggling, and violent crime for hire. This is the downside to a decentralized, untraceable currency.

For Bitcoin to truly qualify as a money, it has to serve the three classical roles of money. It has to be a store of value, a medium of exchange and a unit of accountancy. This suggests that Bitcoin will not be a suitable currency at present for several reasons. Not everyone accepts Bitcoin. Megan McCardle explains that they are unable to compete against the USD because of illiquidity. If people don’t accept them, they are not an inviscid medium of exchange.

The reason I think that bitcoins will ultimately go away is that I think they will, like other virtual currencies before them, ultimately prove to be too illiquid. A dollar is one of the world’s most liquid assets: it can be turned into virtually anything I want, at least if I put enough of them together. But bitcoins are not so liquid. Mostly, to buy things, I need to trade them for dollars or another currency. And that is the fatal weakness of bitcoins: at some point, to compete with dollars, it needs to enter the real economy.

The fluctuating value of the Bitcoin undermines its viability as a unit of measure and as a store of value. When sell side activity forces trading to halt for ten hours, it cannot store value. Volatile currencies complicate rather than facilitate economic transactions. Another Bloomberg.com story describes the volatility in Bitcoin prices.

According to Mt. Gox, the largest Bitcoin exchange, the currency started out at $230, spiked to $266, touched a low of $105 and then settled at just above $170 (it’s now $123). That’s, in the course of the day, a 15 percent jump followed by a 60 percent plunge off the day’s high and ending with a substantial loss.

Thus, the Bitcoin has a potential role as a competitive, non-government currency, but cannot reach this level yet. It is not universally accepted, and it fluctuates too wildly to serve as a store of value. However, the Bitcoin does offer a potential haven for black market transactions and for investors from nations with badly managed currencies in search of a hedge. The Bitcoin is far, far away from being the next USD. However, it will be an instrument to quietly hide wealth and hedge against unreliable national currencies. In places like Cyprus or Greece, the Bitcoin could truly have Byte.

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