The Real Significance of the Bitcoin Boom (and Bust)

Online currencies like the Bitcoin are one day likely to alter government policy, just as the bond market did in the 1990s

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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 to tulip mania in 17th century Holland, where 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. And 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 Jan. 1) to $31.90 and then falling back to $12.

Such monumental appreciation and volatility are 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 run-up also reflects anxiety about the safety of the global banking system and the stability of major international currencies.

(MORE: No Money, No Problems: Canada Considers Completely Digital Currency)

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 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 response 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 11 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 reflect 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 U.S. 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 alter or obstruct government policy? Former President Bill 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 Islands. However the current boom-and-bust plays out, Bitcoin is the beginning of something, not the end.

63 comments
felipeclement
felipeclement

Nowadays, exchange of ideas and transactions are so simple. One best example here is Bitcoin, in which peer-to-peer transaction have its control and ease. Base on Bitcoin Daily News, we should see bitcoin in its different applications and learn to maximize its worth.

ListentoJohnMar
ListentoJohnMar

@KarlvanDecker Hey Karl I've read it over at Goodreads and it really is doing famously. Saw that even the ex VP of JP Morgan found it was a refreshing read! Hey is it true that he once had a contest for the book? do you know any online source where i could buy? btw saw the article, as expected of Vivek he shed some light on it.

StibYobs
StibYobs

Great article. Another good explanation of bitcoins is www.biticoin.com

KarlvanDecker
KarlvanDecker

Will BitCoin ever amount to anything more than a bit? That is the question. Is it really a boom or a bust?  The interrogatory sentence is actually a title of the article written by Vivek Sood, author of  The 5-star business network that is all over Goodreads.com He argued a different point on his article http://tinyurl.com/bitcoinVivek

MarkTTT
MarkTTT

I wanted to buy Bitcoins here, in the UK, directly without intermediators on ebay or other middle men (because fees are huge), and I found it very difficult, so I made this guide with the cheapest way:


http://howtogetbitcoinsuk.blogspot.co.uk

WilfTarquin
WilfTarquin

The main factor driving the bitcoin bubble is not quite speculation, but manipulation and money laundering. This is a currency where anyone with a couple of millions of, let's say drug money, can easily, anonymously, untraceably _and legally_ laundry their money while at the same time making money off minor players.

If they're ambitious they can even set up their own -still anonymous, still legal- exchange, where they -legally- can freely manipulate the exchange rate.

The bitcoin pool is filled with sharks. Caveat emptor.

Mindless
Mindless

Flawed in Many ways, sorry to say.  Anyone with any wisdom can see this clearly.

MarkHolland
MarkHolland

There's some pretty good evidence that Bitcoin was designed by the US government to track people making illicit purchases of narcotics and other "bads" and 'services' of a questionable nature. Expect a midnight knock any time now.

debianhelp1
debianhelp1

This is about DDOS vulnerabilities and only having one major exchange running for billions of transactions. This isn't about a real crash in currency or financials. You guys need to get your heads out of your buttholes.

taxkilla
taxkilla

It's just lazy analysis to jump to the bubble conclusion, but seemingly the  first conclusion for most economists (and the press).    more coverage should be given to merchants who accept btc,  who are now the key influencers increasing bitcoin legitimacy. http://littlebiggy.org/4713627

VictorColeiro
VictorColeiro

Bitcoin is the definitely the beginning of something. The beginning of countless copycat digital currencies that will be developed and flood the market with alternative digital currencies . All of which will have the affect of printing more money as the french did way back.

It's already happening with Litecoin etc etc etc.  All these alternatives promising quicker transaction times, easier accessability , security, lower transaction costs etc.  ie Let the Digital Tech currency war begin with a new better currency coming out each year.

That's the  problem with making a currency out of nothing  , so can others


jankowitts
jankowitts

This is a good article. It gives bit Coin a chance. EyesOpenReport.com also had a good bitcoin article up.

JohnDavidDeatherage
JohnDavidDeatherage

Pressure from BitCoin and other non-government issued currencies may put pressure on governments to limit growth in national money supplies.

attenuator
attenuator

Bitcoins are deflationary only in proportion to their DEMAND. Only if their demand goes up over time does deflation occur!! These articles make everything so complex. Bitcoins may aspire to be a currency, but they are not used as a currency today. We must treat them for what they ARE, not what they might someday be. so, do YOU believe Bitcoins will be in increased demand? For how long? It is as simple as that.

BCanuck
BCanuck

From the article,

'course, real countries do have massive wealth backing their currencies and their bonds, as well as the police power to arrest counterfeiters.'

... well, sort of.

Hardly any countries have massive wealth backing their currencies, that's why they're called fiat currencies. The US dollar is a fiat currency. The US govt debt far, far, far exceeds the value of it's gold reserves. FDR killed the Gold Standard when he annouced that citizens could no exchange US dollars for gold. Nixon killed the Bretton Woods gold exchange standard where other central banks could redeem US dollars for gold.

Fiat currencies can't be officially exchanged for anything (like gold or silver). People use them because ... other people use them. They're held up by confidence alone. Most of the time this works. Most of the time.

Rob_____
Rob_____

if anyone wants to give a poor father of 2 a bitcoin penny so I can send my kids to college: 1HgD3VfqET7KhngHyxg8gakuRdFXhTprST

DavidSpencer
DavidSpencer

Increasingly scarce-by-design currencies tend to reduce the velocity of transfers within the system itself, resulting in deflation. How do you re-inflate the Bitcoin economy when that happens? 

jankowitts
jankowitts

 Eyesopenreport.com did a story like this one. I think the bitcoin will find its place very soon. Give it some time, we will see another run into the bitcoin.

copscub
copscub

People need to understand that bitcoin serves a very useful purpose as a transaction medium regardless of its value in relation to the dollar. You can make transactions for FREE across the internet. A merchant can accept bitcoins through many payment processors and instantly have them converted back to the currency of their choice. If I want to buy a product that is $100, I can go on an exchange buy the required bitcoins and immediately make the purchase. If bitcoin is at $1 per BTC I need to buy 100 of them. If bitcoin is at $50 per BTC I need to buy only 2 of them. No matter what, bitcoin will still serve the purpose.

There is a large online "infrastructure" that is currently being developed to support bitcoin. The beauty of bitcoin is that it is a world-wide medium of exchange for the internet. Unless another crypto-currency is developed that has a significant improvement over bitcoin, there will be little interest in adopting that alternative as a replacement.

time-lifer
time-lifer

Save or Destroy?

If you want to save bitcoins, send to this address: 15z9kzobncmrB1fqkvtWDpDSKwRwvtnSvx

If you want to destroy bitcoins, send to this address: 1FiZ9KiJDT19qdXpA5jZvhPtJ2g7QpNpY1

GoranRanGo
GoranRanGo

Other than creating momentary scarcity I don't understand the value of bitcoin. What's to stop flooding the marketplace with thousands of currencies based on the same model?

mockworld
mockworld

@MarkHolland Do you have a source? Bitcoin is a peer-to-peer technology preventing a third-party from monitoring transactions. And people have been using for real-world transactions since 2009 - with no knocks on doors. 

jeremyyeo
jeremyyeo

Suppose 1 billion people already use Twitter, would you now use App.net? The network effect of having a large number of users are being ignored here. There have already been copycat digital currencies (forks) of Bitcoins that have failed. 

econhub1
econhub1

@attenuator Yes, exactly. And where would the demand for Bitcoin come from in the long run? They don't have any use value except as stores of value and for exchange, but that requires consistent demand for them.

econhub1
econhub1

@BCanuck Dollars used because you have to use them to pay your taxes, at least here in the US. Euros are used in the eurozone...because you have to pay your taxes in euros.

Ozlanthos
Ozlanthos

@jankowitts If the title reads anything other than "Bitcoin: the new FIAT-currency canary", it is most likely bs, and either meant to stimulate a run or a bubble...

 -Oz

vstillwell
vstillwell

@Dunois Yeah, and silver's going to be $100 an ounce in 2012. Heard it all before. 

vstillwell
vstillwell

@copscub Nothing's free. You'll have to pay a transaction fee or a premium to buy these things. Why? Because they want your old-school green money, that's why. 

stevebebber9194
stevebebber9194

@GoranRanGo 


Yep just like Ebay, Google, Amazon...... Get it?  not too many competitors in giants like these!  Same will be with Bitcoin !

mcreadyblue
mcreadyblue

Like fiat currencies, absolutely nothing.

VictorColeiro
VictorColeiro

@jeremyyeo

Suppose 100-200 million already use Myspace and Facebook comes along, surely Facebook would fail.  Oh wait..


mockworld
mockworld

@MarkHolland @VictorColeiroBecause he's wrong. Without critical mass nothing will replace Bitcoin. I could create a new social network to compete with Facebook, but no-one will use it because their friends are not using it. The only way I could beat Facebook is by somehow offering a better user experience. So far none of the competing digital currencies offer any advantage over Bitcoin. 

jankowitts
jankowitts

It's picking up again. I guess the speculation took over, making the price drop like that.

It's going up now, I think that's showing there's still intrest.

VictorColeiro
VictorColeiro

@jeremyyeo

Bitcoins has it's weakness , especially transaction verification times etc . And there is nothing stopping someone like Google coming along with a Zero transaction/exchange fee currency with revenues based on side ads on the exchange.  Lets not forget the major dramas that have happened with the major Bitcoin exchange this week , someone who even offered a stable exchange with an alt currency would have an advantage .

Look I'm not saying being first isn't an advantage, but history has shown time and time again that this is no guarantee.


jeremyyeo
jeremyyeo

Facebook was able to catch up and surpass MySpace because it provided a much better platform, tools and apps, and more options, whereas MySpace diverted its attention to serving eyeballs to advertisers and fell ever more behind on facilitating the “social” part of social networking.Litecoins and the like only serve to satisfy the wants of those who got in late with Bitcoins. Watch this video to see what the Bitcoin protocol can already do:https://www.google.co.nz/url?sa=t&source=web&cd=2&ved=0CDQQtwIwAQ&url=http%3A%2F%2Fwww.youtube.com%2Fwatch%3Fv%3DmD4L7xDNCmA&ei=lGFqUZGSBNCYiAelnoHQBw&usg=AFQjCNFEGzg9YGblkDXocMO3QEBUWzNeAA&sig2=Amkc8aX00HVWusrLoUTiiw

jeremyyeo
jeremyyeo

Facebook was able to catch up and surpass MySpace because it provided a much better platform, tools and apps, and more options, whereas MySpace diverted its attention to serving eyeballs to advertisers and fell ever more behind on facilitating the “social” part of social networking.

Litecoins and the like only serve to satisfy the wants of those who got in late with Bitcoins. Watch this video to see what the Bitcoin protocol can already do:https://www.google.co.nz/url?sa=t&source=web&cd=2&ved=0CDQQtwIwAQ&url=http%3A%2F%2Fwww.youtube.com%2Fwatch%3Fv%3DmD4L7xDNCmA&ei=lGFqUZGSBNCYiAelnoHQBw&usg=AFQjCNFEGzg9YGblkDXocMO3QEBUWzNeAA&sig2=Amkc8aX00HVWusrLoUTiiw

MarkHolland
MarkHolland

@mockworld @MarkHolland @VictorColeiro The "network effect". It's real to be sure. But facebook is well-capitalized company with strong leadership that can deftly and instantly respond to challenge. Bitcoin (the name) is neither capitalized nor a company. In fact, as an open source software software scheme it encourages usurpation.

Ozlanthos
Ozlanthos

@jankowitts Misreading misreads doesn't make the data they misread any clearer. None of you have any fricken clue why Bitcoin is really appreciating! You hear and assimilated gigabytes worth of media telling you the answers, and because you have a conceptual wall built between that news, and the value of the currency in your pocket, you can look at what is going on with Bitcoin, and think stupid thoughts like "it's just a bubble"., "there is still some interest there". Yeah there is interest there! You know why? Because the Burnabanky is authorizing the distribution of another 85 BILLION IN LIQUIDITY EVERY MONTH! Why would you stay in dollars if the people printing them are disregarding actual demand as the primary motivator behind creating additional supply?

As to the speculation? That is profit-taking. They probably did a pump and dump in attempts to reflate some of the value back into their dollars. They are doing it to gold and silver too....What out for your stock portfolio! It's most likely next!