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April 10, 2013 3:01 PM Without a Central Bank, Cryptocurrencies Like Bitcoin Will Remain on the Economic Fringe

By Ryan Cooper

The big news in cryptocurrency today is a huge collapse in Bitcoin price, down from $226 to $130 at one point just while I was watching—half its value gone in the space of hours. It’s now gyrating wildly between that and $180 or so. (Apparently this is driven by huge bid-ask spreads and a lack of liquidity.) Aside from the sheer spectacle of it all, this is an important reminder of the inherent limitations of non state-backed currency.

Because, as Evan Soltas pointed out the other day, there are strong reasons for modern governments to be suspicious of alternative crypto-currencies. They enable tax evasion, illegal transaction, and could potentially cripple the central bank. Being basically untraceable and traded on a peer-to-peer basis, Bitcoin is largely immune to police scrutiny, but only because of their strange origin:

Like gold, bitcoins are mined; but unlike gold, no one can stumble over some large seam and make a fortune. Mining for bitcoins involves an enormous amount of computer power, and very little luck, and the global rate at which new bitcoins will be mined is both predetermined and slowing down. There were about 3 million coins outstanding at the beginning of 2010, there are about 11 million coins outstanding today, and we’ll get to 14 million in early 2014. Come 2021 or so, assuming bitcoins are still used then, the rate of growth of bitcoins will be so low that to a first approximation the money supply will be constant.

Therefore, there is no human judgment whatsoever on the size of the bitcoin money supply, because it is all determined by prearranged mathematical formulas. This solves the problem of the currency being destroyed by the government, but at the cost of an inherent vulnerability to deflation and boom-and-bust panics, as we’re seeing today. (I strongly suspect some Wall Street types are making out like bandits at this very moment.) The only way to solve the panic problem is with a trusted central bank that credibly promises to intervene to prevent excessive inflation or deflation, thereby short-circuiting the self-fulfilling cycle. Again, this is impossible with Bitcoin.

A new cryptocurrency with a known central bank could be based on an island somewhere, like in Cryptonomicon, though again all extant nation-states would have a strong self-interest in banding together to destroy it. It might be arranged anonymously, though again there would be trust issues due to the whole system coming down by a single slip-up in security. Might a central bank function be programmed into the currency itself? I don’t have the math chops to even speculate, but it’d be worth thinking about.

In any case, there are centuries of trust built up behind the current state-backed fiat currency system. Bitcoin is right now recapitulating all the economic history that led to that system in warp speed. Seems likely to me it will lead to the same place.

Ryan Cooper is a National Correspondent at The Week, and a former web editor of the Washington Monthly. Find him on Twitter: @ryanlcooper

Comments

  • Jim Eckland on April 10, 2013 10:35 PM:

    Central Banks? Let's get rid of them !! Every nation can put Debt-Free Currency into circulation. The cost is only the price to Print it if it's :"Fiat". The world's Central Banks are destroying The economies and lives of the world's nations and people !!

  • toowearyforoutrage on April 11, 2013 10:47 AM:

    Intriguing!
    I liked the idea of Bitcoin until I heard about the tamping down of supply and came to the same conclusion. It would fall to deflation.

    Inserting algorithms to maintain a range of money velocity and inflation couldn't be hard compared with the existing model.

    There may even be factors that would measure Bitcoin users' satisfaction with the economy; a "misery index" maintained at a certain rate.

    It would be like a Fed but tweaked slowly.
    This could be VERY useful as the Fed Reserve Board has a difficult time raising interest rates when money velocity gets so high that pursuit of high returns results in excessive risk and reward for savings needs to be encouraged.

    A mathematical formula could ensure that the giddy high of an overheated economy will be cooled even if it makes the programmers the cause of much grumbling.

    I like it. If the Hacker group Anonymous got into this, they could probably make it happen. An interesting world would come of it. Imagine currency accepted worldwide and exquisitely controlled to avoid exploitation by plutocracy. (That's why I might trust Anonymous with the task. Google might pull it off if they tried.)

  • Richard Cownie on April 11, 2013 2:55 PM:

    "Inserting algorithms to maintain a range of money velocity and inflation couldn't be hard compared with the existing model."

    True if you mean "technically hard". Bitcoin has chosen to
    have a particular and inevitably deflationary schedule: the
    rate of creation of bitcoins falls exponentially over time.
    That's isn't necessary - but striking a balance between
    preserving the value of the currency (so that people will
    be willing to accept and hold it), and ensuring that it
    doesn't deflate rapidly (which would make people reluctant to spend it) is indeed hard. There is both the
    technical difficulty - similar to problems in control theory - of achieving a desired smooth output when the
    controllable inputs are relatively weak and have a delayed effect, and the uncontrollable external factors
    are relatively strong; and also the political problem that any
    action which changes the real value of the currency has winners and losers - inflation is good for lenders and bad for borrowers.