Bitcoin’s Design Flaw

In 2013, Bitcoin, a peer-to-peer “crypto-currency,” transcended its status as an intellectual curiosity of libertarians and money-laundering tool for black marketeers by entering common discourse and even common use. Moreover, its price rose dramatically–almost overnight.

The Bitcoin phenomenon is not closely comparable to any previous one: it is the only somewhat-accepted non-state currency in recent decades and it provides a lesson in monetary theory for onlookers.

There is no intention to use Bitcoin as an investment or asset. Instead, its creators intended for consumers to use it as an acceptable currency. However, what is the difference between assets and money?

In economies without money, people could only trade their goods and services for someone else’s goods and services. An employee of a local gun factory, for example, may receive rifles in exchange for his labour in lieu of money. If this employee really wanted to spend his wages on butter, however, he has to barter with someone who not only has butter, but also wants to accept his guns in exchange for it. Economists refer to this as the “coincidence of wants” and it implies temporal and pecuniary transaction costs for all seeking to trade in order to improve their welfare. To reduce these costs, money must be valued universally. If not, sellers will not accept it in exchange for real goods and services.

The value of money should also remain roughly constant over time. If it does not, its buying power is unclear and those who have access to it will use it as an investment, as opposed to a medium of exchange.

Most asset markets are inherently volatile. When consumers purchase stocks, for instance, they accept the possibility of the market crashing because their expected returns are favourable.

Yet, both risk of collapse in value and the expectation of an increase in value doom currencies. Holding money with the expectation that its value will increase, however, is erroneous: when people hold their dollars rather than exchanging them–typically in anticipation of its rising value–money no longer serves as a medium of exchange. Furthermore, if there is a significant chance that the value of said money could collapse, it will no longer appeal to consumers as a medium of exchange and they are unlikely to hold large sums of their wealth in that particular currency.

Bitcoin’s exchange rates with established currencies are volatile for two main reasons. First, they have no underlying value that does not come from the expectation that others will accept them in exchange. Precious metals, for instance, are durable, malleable, hard, and pretty and individuals can use fiat money issued by central banks to pay taxes. Bitcoin, however, has no inherent value.

Second, Bitcoin lacks a governing institution capable of controlling its value. Central banks control fiat currencies by adjusting interest rates and the money supply to keep inflation at a roughly constant rate. With no governing institution and a hard cap on the possible quantity of Bitcoin, there can be no coordinated response to changes in the demand for the currency to regulate its value.

Bitcoin’s market history reflects theory that suggests its volatility. Between 2 October 2013 and 30 November 2013, its market exchange rate with the American dollar increased from less than $100 to about $1,125–an eleven-fold increase. By 18 December of that year, however, this exchange rate had plummeted to $522. Technical issues have exacerbated the currency’s volatility. The collapse of Mt. Gox–a popular Bitcoin exchange–after a software glitch raised doubts about the reliability of the virtual currency’s peer-to-peer payment network.

Herein lies Bitcoin’s critical problem: because its value does not regress to anything independent of others’ valuations of the currencies, its exchange rate is highly volatile. Moreover, because its exchange rate is highly volatile, people have little reason to expect it to function as currency in the future.

Ultimately, Bitcoin’s experience reveals a vicious cycle that currencies lacking a governing institution and an underlying value will face. Although risk-loving speculators may enjoy betting on or against its success, those looking for viable non-state money should look elsewhere.

Michael Sullivan is a 2013-2014 Atlantic Institute for Market Studies’ Student Fellow. The views expressed are the opinion of the author and not necessarily the Institute

2 thoughts on “Bitcoin’s Design Flaw

  1. This is certainly a factual account of bitcoin, but I think that bitcoin isn’t INTENDED to serve the same purposes that fiat currency do.

    Its function follows its form. It is anonymous, independent of a nation, not controlled by gov. regulations, and can be sent easily to another for a good or service, as well as being highly secure.

    Bitcoin has and will retain value as long as those points apply.

  2. Like all those before you, you only have one argument, it’s volatile. Overtime volatility will pass either because it bottoms out because of lack of interest or because exchanges mature and market makers enter the scene. So instead of saying what others report try adding value by offering an insight into the future.

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