Bitcoins: Does an Internet Currency Mean the Doom of the Dollar

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Monetary utopia will have to wait.

In mid-June, Bitcoin, a virtual currency many lauded as a model for the future of money, plunged in value after a hacker nearly stole $9 million of the digital dollars. The exchange rate had reached $30 per Bitcoin, up from $5 as recently as April. After the hack, the value dove to penny, but has rebounded to $16.

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The lure of Bitcoins, beside their anonymity, is that the tender is not run by a government or central bank. No quantitative easing here. The number of Bitcoins increase at a constant rate, much like legendary economist Milton Friedman proscribed for a stable currency. At a time when a rising number of countries are in financial trouble that seems sensible. And yet silly at the same time. Here’s why:

Since the financial crisis, many economists have been calling for the creation of a new global reserve currency to replace the dollar. The problem is that all currency systems have their flaws. The dollar’s is that it is tied to a country that is in a prolong economic recession, and likely won’t be the powerhouse it once was. But if you picked a currency that was tied to an overheated economy with much higher inflation than ours, you would run into issues as well. Which is why Bitcoins or something like it seems nice. By decoupling the currency from an economy, you don’t have to worry about economic growth, or the lack of it, driving the value of the currency up, or down. And yet, as we see in the Bitcoin example, that doesn’t really make a currency any more stable. Bitcoin valuations have been all over the place. The dollar, on the other hand, despite the Japan tsunami, Middle East unrest, unemployment and now the reemergence of the European debt crisis, has barely moved this year – down just $0.05 against the Euro. While an alterative reserve system like that proposed by the IMF couldnt’ be hacked, there are sure to other issues, perhaps the credit quality of the IMF or whatever international body would back said multi-national currency.

Some U.S. politicians – including a few running for President, namely Ron Paul and Tim Pawlenty, think getting rid of the Federal Reserve and returning to a gold standard is the answer.  That would fix the number of dollars in the economy, and, they believe, insulate it against the U.S.’s growing debt woes. But the experience of Bitcoins, which is also a fixed currency system, argues the opposite. Yes, under a gold standard you could redeem your dollars for gold, hopefully pegging your bucks to some hard asset. But what’s to stop the value of gold from dropping. What’s more, gold gets found all the time, so it’s not really fixed. What’s more, economist John Wright of John Hopkins University, who studies monetary policy, says there were many examples of “price level instability” during the days of the gold standard. If anything, Wright says removing the Fed would make our currency less stable, not more.

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What’s clear is that moving away from the dollar alone will not cure what’s ailing the global economy, and it could potentially makes things worse.

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