Why Bitcoin Will Never Be a Currency—in 2 Charts

By Matthew O'Brien
Reuters

Falling prices sound like a good thing, but they're not.

When prices fall, people put off buying things. And when people put off buying things, companies put off investing. And then the economy slumps—and keeps slumping. Even worse, people are stuck trying to pay back debts that don't fall with wages that do. So bankruptcies pile up, and so do bank losses. That makes people too scared to borrow, and banks too scared to lend, which only makes prices fall even more.

This self-perpetuating cycle of doom is what sunk the global economy in the 1930s, and what, to a lesser extent, has sunk Japan since the 1990s. And it's what has been sinking us since 2008, though this time central banks have at least kept prices from falling, just barely. 

Now, it doesn't make much sense, but there's actually a currency designed to create these kind of economic calamities. A currency designed for deflation. That's Bitcoin, the virtual currency you can theoretically use to buy things online. See, there's a predetermined number of bitcoins that will only grow at a low rate until 2040—and then stop. This artificial scarcity means that the dollar value of a bitcoin should go up considerably. And it has. In just the last year, it's gone up something like 64 times. That's enough that "Bitcoin millionaires" are now a thing.

Of course, a stronger Bitcoin is just another way of saying that things cost less in terms of Bitcoin. In other words, there's Bitcoin deflation. Just how much? Well, as you can see below, Peter Coy calculates that prices would have had to fall 98.5 percent the past year if they had been set in terms of Bitcoin. As point of comparison, prices fell about 10 percent a year during the worst of the Great Depression.

But prices aren't set in terms of Bitcoin. They're set in terms of dollars. So it doesn't hurt the real economy when the price of Bitcoin goes up. People just go on living their lives, mostly unaware of the virtual currency. But it does hurt the Bitcoin economy, such as it is, when the price of Bitcoin goes up. Why would anyone use their bitcoins to buy things when those bitcoins might double in value in a day—or hour—or two?

They wouldn't. Researchers found that 64 percent of bitcoins are in accounts that have never been used. And the ones that are being used aren't being used more. You can see that in the chart below from Jason Kuznicki, which looks at the dollar value of all bitcoin transactions each day divided by the dollar value of all bitcoins each day. It's hard to see any pattern here—and that's the point. If people were using bitcoins more, this ratio would be going up. It's not.

Bitcoin won't work as a currency as long as it's so deflationary. Why spend bitcoins today when they might be worth much more tomorrow? The only reason would be to buy or do things online that you can't buy or do with dollars (or euros or yuan)—something illegal. Now, black markets can be big markets, especially when it comes to evading capital controls, but not so big that Bitcoin would ever become more than a niche "currency."

What Bitcoin really needs is a central bank to stabilize its value. When the demand for Bitcoin goes up, they need to print more to keep it from skyrocketing. That is, they need to decide whether they want Bitcoin to be a Ponzi scheme for techno-libertarians or an actual medium of exchange. See, the technology of Bitcoin really is revolutionary, but the currency of Bitcoin is holding it back. In other words, Bitcoin really could have use as a payments system if it had a stable value. But it doesn't, so it's just a dotcom stock. And one that could be co-opted by banks that take its technology and use it with dollars instead.

So who's the perfect person to run Bitcoin? It'd have to be someone with central banking experience. Someone who understands why deflation is a problem. And someone who thinks virtual currencies hold promise. Someone like ... Ben Bernanke.

This article available online at:

http://www.theatlantic.com/business/archive/2013/12/why-bitcoin-will-never-be-a-currency-in-2-charts/282364/