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A bit of foolishness

Written by Richard Barrington - 7 Comments

This post is from staff writer Richard Barrington.

I almost sprained my neck last week from shaking my head while reading stories about wild fluctuations in the value of the Bitcoin, an electronic currency.

Bitcoins began 2013 with an exchange value of less than $20. Their value started to climb, and that climb accelerated until they reached a peak of $266 on April 10. Then the bottom fell out, and within two days the Bitcoin exchange rate was down to $61.11. I’ve seen my fair share of crazy investor behavior over the past 30 years, but this was really one for the record books.

Of course, plenty of investments have gone through boom-and-bust cycles in recent years, so what was it about this story that particularly drew my curmudgeonly ire? Let’s examine a few details of the story:

  • One analyst explained that the Bitcoin might yet rally in the future because “(e)ven assets that have no underlying value have people willing to trade in it.” Too true, but hardly reassuring.
  • An exchange which handles Bitcoin trading attributed the precipitous decline in price to a rush of new customers trying to buy into the currency. If that’s true, it’s got to be the first time in financial history that surging demand has caused prices to plummet.
  • Bitcoin was developed by an anonymous hacker. Is that really good enough to earn people’s trust? A person who participates in illegal computer activities and won’t be identified wants your money. Any takers? Well, apparently yes.

The Bitcoin has an appeal to both liberals and conservatives who don’t like Big Brother monitoring their money, or using their currency (via monetary policy) for political purposes. On a more sinister level, this online exchange system also appeals to people pursuing illegal objectives such as tax evasion or money laundering.

Bitcoins strive to be free from monetary policy manipulations by limiting the amount of the currency in existence. Unfortunately, any number of decisions about managing distribution of the Bitcoin constitute a de facto monetary policy, including the decision to let new participants buy into the currency, how many are allowed to buy in, and on what terms the currency can be exchanged for other currencies. Even the decision to limit the supply of Bitcoins is a form of default monetary policy, and unfortunately one that threatened to turn this currency into more of a Ponzi scheme than a stable exchange medium.

This doesn’t mean that the Bitcoin or an idea like it can’t succeed, but it does mean that so far, this specifics of this concept are badly flawed.

What’s to like about the Bitcoin?

Like many attempts at innovation, the Bitcoin may prove to be learning experience that leads to better things later on. After all, there are things to admire about the idea:

  1. It is easy to imagine major currencies becoming available globally. The assorted troubles of the euro have provided a cautionary tale about trying to coordinate a currency backed by several nations. However, the idea that in the future technology will allow consumers and merchants to choose from a variety of major currencies and have the digital means to make exchanges seamless is both readily conceivable and desirable.
  2. Payment systems are already becoming increasingly electronic. Money itself has long been a symbol rather than anything carrying intrinsic value, and more and more that symbol is expressed in electronic rather than in physical form. So, the idea of a fully online currency doesn’t seem very far-fetched.
  3. Frustration with the conventional banking system is understandable. The whole “too big to fail” concept continues to leave a sour taste in many people’s mouths. It’s like an abusive relationship, where one person continually behaves badly but then keeps telling the other one “you can’t live without me.” I agree that the banking system has done a lot to lose our trust; I just don’t think the Bitcoin has done anything to gain that trust.
  4. Frustration with central bankers is also understandable. Central banks use money to try to manage complex economies, which can make people holding that money feel like a pawn in a chess match. Recent examples are the near elimination of savings account interest by the U.S. Federal Reserve in an attempt to stimulate the economy, and the threat (which they later backed down from) by the European Central Bank not to honor the insurance on Cypriot deposits. Our money would feel much more secure if it were not being used as a tool for managing economies and financial systems, though I’m not sure it is possible to isolate any form of currency from those realities.

Unfortunately, recent events demonstrate that the Bitcoin is a long way from becoming a stable, universal currency free of supply-and-demand issues and of speculative manipulation.

If you choose to support the Bitcoin because of what it represents, then by all means do so. Just understand that it is still an experiment, so limit your investment in it accordingly, because experiments sometimes blow up.

Published on April 29th, 2013
Modified on April 26th, 2013 - 7 Comments
Filed under: Saving & Investing

About the author: Richard Barrington is a personal finance expert for MoneyRates.com. He has earned the CFA designation and is a 20-year veteran of the financial industry.

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7 Responses to “A bit of foolishness”

  1. 1
    Jenny @ Frugal Guru Guide Says:

    People trust the technology because they understand it. Bitcoins are safer from fraud than really any other currency. But they have a number of flaws, and the fact that they are a currency that trades like a commodity that itself has no real-world use is foremost among them.

    Something like Bitcoins will probably be the currency of the future. Bitcoins themselves might not end up working–and if they do, then their untraceable usefulness for crime might be a big chunk of their eventual stability–but they are a kind of proof of concept that I don’t think anyone should ignore.

  2. 2
    Kurt @ Money Counselor Says:

    I agree with Jenny. Like many first attempts at a better mousetrap, the Bitcoin may fail, but surely exposes a huge unmet demand. I think the Bitcoin may well portend the future of currency.

  3. 3
    Steve Says:

    “Bitcoin was developed by an anonymous hacker. Is that really good enough to earn people’s trust? A person who participates in illegal computer activities and won’t be identified wants your money. Any takers? Well, apparently yes.”

    No, that’s not what earns people’s trust. The code is visible for everyone to see. There’s no part that’s hidden. It’s like someone hands you a math problem with solution. You don’t have to “trust” their solution; you have all the pieces to check their work with your very own calculator.

  4. 4
    William Cowie Says:

    The authorities and big banks fear the bitcoin, but for a reason that’s not obvious at first: there’s no multiplier.

    When I deposit $100 in my bank account, the bank goes and lends $80 to someone else, who deposits it into her bank account. That bank then lends $64 to someone else. And so on.

    My deposit of $100 turned into overall deposits of $100+80+64+…..

    That’s called the multiplier. It’s what’s both beautiful and scary about the current system.

    Bitcoin precludes that, because whoever holds your money can’t use it to go lending to someone else.

    Philosophically you might think that’s great. The reality is our current financial system runs on the multiplier. Take it away and (like it or not) choose your flavor of Armageddon.

    Of course, it seems the money running through Bitcoin is already outside of the money-laundering-police-run banking system, so that part of the multiplier is already gone… :)

  5. 5
    BG Says:

    William) Its not a multiplier per-se, but you did hit the nail on the head: our money is backed by debt — we have a debt based currency.

    Using your 20% rate (though that is not accurate, because it is practically infinite in the US) — your $100 is able to create $400 worth of extra money supply via debts. Though you must realize that your original $100 is also backed by debt too.

    As loans are created, the money supply increases — as debts are repaid, the money supply decreases (“money” is destroyed as loans are paid off).

    Now back to bitcoin — it isn’t backed by anything. At least the US$ is backed by something (debt).

  6. 6
    Anton Ivanov | Dreams Cash True Says:

    I would also like to point out that Bitcoins are currently more viewed as a speculative investment, rather than a real currency. Remember – the main purpose of our currency system is to facilitate product and service trade. Since Bitcoins are not generally accepted as a currency, they are not viewed as such. It is too early to tell what the future holds, but global acceptance is a must for Bitcoins to succeed.

  7. 7
    Tony Lovasco Says:

    “Bitcoin was developed by an anonymous hacker. Is that really good enough to earn people’s trust? A person who participates in illegal computer activities and won’t be identified wants your money.”

    If the anonymous person who developed the Bitcoin system hasn’t yet been discovered (and from what I can tell, he/she hasn’t), how do you know they participate in illegal computer activities?

    Lots of people refer to themselves as “hackers” that operate entirely within the law. I don’t know if this particular person was such a person or not, but I think it’s rather unfair to jump to the conclusion that he or she is a criminal without citing your sources.

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