Bitcoins and Bubbles

It was only about a month ago from a friend that I had learned about this new, electronic form of currency known as Bitcoin, and now it’s in the news. Unfortunately, it’s in the news for the reason that there is bad news. So, what is this stuff, why does anyone care, and why is it scaring some people?

First off, Bitcoin has a murky history. It was formed by an anonymous hacker among hackers, and it has several purposes that many libertarian- or anarchist-minded folks wanted, and the way it came together is rather clever. First off, the programmer and his or her crowd wanted a currency that would not have the problem of inflation: the value of the currency could not be lowered by simply making more of that currency. This is something that gold is useful for, since extracting more gold is very difficult, while printing paper dollars is easy. Second, they wanted to make transactions anonymously; it should not be possible to track who is the person that made purchase X. This is important for those that don’t want the limitations of purchases that governments may enforce, from drugs to certain toys. Third, they wanted to make it effectively impossible to fake a transaction, so unless you have a stupid-easy password then your money is safe and you can’t make up money out of nowhere. Lastly, they wanted to create market forces to make it so transactions are as a cheaply administered as possible. When you use a debit or credit card, while you do not incur a cost, the merchant can be paying as much or more than the profits made from the sale. That’s why you will often see at various locations that you must spend so much to use a credit card; otherwise they will loose money selling you things.

When it comes to these goals, Bitcoin is very impressive. When it comes to the first goal, there is a certain number of Bitcoins out there, and slowly does that amount grow over years; finally after a few decades, the number of Bitcoins in the world stops growing, and inflation is not possible. A simple algorithm will regulate this initial growth in the amount of coin in the world, enough to try and entice people to get interested, and then inflation ends. If you don’t understand why that is desirable, look at Weimar Germany, in which the inflation had gotten so bad that it took a 3 billion Mark. In such a situation, the costs of what you need to buy goes up, but your wages will be delayed; too much inflation, and it’s basically the same as getting a pay cut.

On the point of anonymity and authenticity of transactions, this is where the programmers shine. In order to hack and fake a transaction, you have to insert into the stream of past transactions that other people on their computers have stored, and it requires some amazing computing power. As it was explained to me (see also here and here), you don’t have to worry about someone decoding the system until someone builds a Dyson sphere to get the needed energy for all the computations. In other words, the NSA, CIA, FBI, or whatever shadowy organization you can think of simply cannot break the system unless that have computers that exist in time and space and made of matter. That makes things pretty safe. So long as you don’t do anything stupid, like give people access to your account. So basically, you need a TARDIS.

As for transactions, this is where markets come into play. For someone to exchange money with another person from a distance, you need someone in the middle, and they won’t do it for free. As mentioned above, this is one way that credit card companies make money, my taking a bit from one party for the cost of the transaction. But with Bitcoin, a transaction is facilitated by going out and finding those transaction chains out in the Internet and verifying them. For a cost, but then it can be competitive  If just about anyone can devote their laptop to the process, then that means there are lots of competitors vying to carry out transactions. With lots of potential folks doing that, it means there are lots of opportunities to have the transaction completed quickly and to find the lowest bidder. This is going to be the big scare for companies like Visa and PayPal, as now they can have many, many new competitors in the market.

There is a fair amount of this that can only be appreciated from a programming level, and unfortunately that is not my specialty. But when my friend who is in that category described it to me, I could see how clever it was. It is certainly admirable, and given it’s security it would potentially make one’s currency exchanges even better than if done with real green-backs; paper money can be forged, after all, but Bitcoins cannot in any reasonable sense.

Oh, and there is one other feature to consider: it’s legality. As best as I understand, the use of this item as a medium of exchange is allowed under the law, so long as no one is claiming that the currency is backed by the faith of the Federal Reserve. And that’s fine to many of the hackers out there that probably want an end to that government institution.

But what has been making this digital currency so news-worthy? What is all the hubbub, bub?

While Bitcoin will not suffer the problem of inflation in the digital world, there has been quite a lot of issues when it comes to its value in the real world. A currency is simply a medium of transaction, and in a transaction you depart with something you value for something else you value. For example, I depart with a dollar (which I value) for a Coke (which I also value). I make the transaction because I want the Coke more than the one dollar. So even if we existed in a world were there were only 1 million Cokes, the trade still requires something that isn’t so necessarily fixed (the number of dollars). And people may change how much they value Coke (perhaps people end up wanting Pepsi or RC Cola or no soda at all), and others may buy up Coke hoping the value will change with time and they can sell them back for cash.

This sort of thing happens with oil, and many have blamed oil price spikes on speculation. And you will get the same market forces acting on a currency like Bitcoin. And that is exactly what has been happening. The value of Bitcoin has shot up and down with blazing speed, and many different commentators have stated how Bitcoin is acting like a speculator bubble. In particular, comparison is made to the tulip mania in the Netherlands a few centuries ago. Basically, all of the insanity of people in the market will come to force in making major over-estimations in the value of something and then the massive market correction that takes with it a lot of people’s money. This is what happened in 2008 with the housing market; the value of house loans in a particular area, sub-prime mortgages, was over-estimated, in part so that way the sub-prime mortgages could continue to increase and value. Then the bubble popped, and since then the US economy has been struggling to dig itself out. The large, privately-held debt of the people (not the government) has also made it difficult to get new lines of credit and bring up spending to help grow the economy.

The key point is that Bitcoin is suffering the same issues, and there no way the computer program can avoid that. It’s the nature of the economic beast when you have non-rational actors.

Paul Krugman already noted almost two years ago that with the stability of the US dollar and the increased value of Bitcoins meant that there was actually a situation of deflation, which can be just as much a problem as inflation (elsewhere he notes the philosophical problems with Bitcoin). The problem here with this deflation is that people are hoarding Bitcoins, so that means spending isn’t happening. The very thing a currency is supposed to facilitate. The way to avoid this deflation would be to make more Bitcoins, but that is expressly not allowed in the system. The printing of money by governments isn’t simply so they can spend as much as they want (though you should still not necessarily trust all they do), but also to minimize the run-away problems in an economy. Ben Bernanke printed a lot of money, but it didn’t cause any significant inflation, and he did this to respond to an economic crisis. So not only does Bitcoin have significant issues, it does not have the ability to fix them, including the ability to fix national or global economic problems.

Krugman also notes that Adam Smith had a point against gold and silver as standards of money which is all the more true for Bitcoin (and gold has had its world year in decades, so same goes for those pushing for a return to the gold standard). Smith argued against using real resources to gain something that has only symbolic value. Now, gold has real-world uses, including in electronics (not to mention jewelry). The same cannot be said of Bitcoins, and it takes computers built-up to run the operations efficiently; that means using resources for something that has no actual utility outside of the digital realm. Money is, as the Onion got right, ultimately a social construct, and spending resources to get more of a social construct isn’t going to do much good. This makes Bitcoin a “pure bubble”.

But even besides, economic theory, there are a few things in its electronic form that scare me. For one thing, there are many exchanges of Bitcoin, and they are currently giving wildly different values. I see some values as low as $60 for one Bitcoin and as high as $32,000. Imagine being able with one Bitcoin being able to only pay for a dinner for two in one place, yet go down the road and buy a new car. Some of these exchanges are also shutting down for various reasons. Imagine if the NASDAQ just ended, with all the information of transactions and the like left to everyone else to figure out.

However, there is another fear that comes, and that is what hackers can do. Even though it is effectively impossible to break the codes to make fake transactions. a little bit of coding can disrupt the market and lead to huge profits. The spiking and then death plunge of the value of Bitcoin on one exchange may have been due to a DDoS attack. Basically, the hackers made it impossible for others to access the website and conduct trades. So, what the hackers can do is wait until the value of Bitcoin gets sufficiently high, they sell their shares and run a DDoS attack, wait for the panic to set in which brings costs down, and then buy up Bitcoins when their value has plunged so far. It’s speculation with some extra computer savvy. In the process, some get rich, and others lose a lot and can literally do nothing about it (hence the panic). It’s a whole lot harder to do that with paper money; a DDoS attack can be done with several computers and a bit of hacker knowledge (though I don’t know how to do it myself).

So, while Bitcoin has some amazing qualities, it brings with it some particularly notable issues, including how it is the purest fiat currency. It seems to be highly susceptible to bubble-making, and it is currently suffering for significant deflation. Some of the issues it has may become less troublesome if it grows in use, but at its heart Bitcoin cannot act as some sort of superior currency divorced from the problems of government-backed exchange mediums. So, I think I’ll stick to green-backs for now.

In other economic news, apparently the study that made many nations try to reduce their spending and debt, which has caused the economic woes in Cyprus and Greece and the Euro-zone in general, has been shown to be multiply-erroneous and shows that having a large debt to GDP does not mean the economy is hurt necessarily. So, another example of government spending not being the problem to everything, as it seems to be for many of the libertarian folks supporting Bitcoin. Again, that doesn’t mean spending is necessarily good or that there is nothing wrong with debt, just that this study has it all wrong, and it probably has lead to far more harm that good.


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