A Bit of a Con

Bitcoin – the so-called crypto-currency that has sent financial journalists into a blogging frenzy recently – sits in the spectrum between a commodity and a currency. The only reason it has any of the characteristics of the latter is that it is accepted in exchange for (a limited number of) goods and services. But it definitely has the characteristics of a speculative commodity, even more so than gold, and can never make it as a fully-blown currency.

If more goods and services were denominated in BTC (the short code that bitcoin has adopted) the massive swings in the price relative to the US Dollar (USD) this week would be less noteworthy. Prices of “foreign” goods – those not denominated in BTC – would, of course, be impacted in relative terms. But even for those goods that have prices quoted in BTC, the vendor is more interested in how the amount received would convert into USD. So, without widespread acceptance, every transaction involving BTC brings with it a great deal of foreign exchange risk.

Monetary stability is something that those who control official (fiat-based) currencies strive to achieve. Bitcoin can never have this so long as it exhibits the characteristics of a speculative commodity. We witnessed a large scale deflation as the price of BTC in USD went up and then a bout of inflation as the opposite happened. These sorts of moves would be devastating to anyone relying solely on bitcoins as a means of trade or investment.

Estimates of the expected return on an investment implicitly take into account the risk that the real value of the currency unit will change. Denominating an investment opportunity in BTC would warrant a very high cost of capital and therefore be prohibitively expensive for the borrower. There is no reason to think that this can change.

Bitcoin’s popularity, however, seems not to rely on its capacity to offer monetary stability or a credible alternative to prevailing means of exchange. Most holders of bitcoin do so not because they believe in anarchic monetary policy and are rebelling against the inexorable debasement of official currencies by those in authority. Rather, they are hoping to make a quick buck by selling to a greater fool.

The emergence of numerous bitcoin-millionaires is enough to capture the imagination of the lottery-playing types. There is no reason to be sure that something else won’t steal the collective imagination at some point – and that threat is already emerging.

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