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.