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  • Apr 19, 2014
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Monitor
PUBLISHED : Wednesday, 17 July, 2013, 12:00am
UPDATED : Wednesday, 17 July, 2013, 6:06am

The fatal flaw with internet currency

Ever since the outbreak of the financial crisis in 2008, discontents have been searching for an alternative to the current international monetary system, with its reliance on the US dollar.

Some have fixed on the yuan as a substitute for the greenback. Yet, although China's leaders like the idea in principle, in practice they have been cautious about allowing greater international use of their currency.

In any case, to hard-core critics of the existing financial architecture, the yuan suffers from just the same disadvantages as the US dollar.

As they see it, the problem with conventional currencies, like the US dollar or the yuan, is that they are issued by governments. And with control of the printing presses, indebted governments, they argue, will never be able to resist the temptation to print as much money as it takes to pay off their debts, debasing their currencies and destroying the purchasing power of their citizens' savings.

This libertarian fringe longs for a currency independent of governments, whose supply cannot be debauched by central banks, and which trades outside the normal banking system.

Some believe gold is the answer. But gold can get stolen, which means it has to be stored in a secure vault. And that means governments in financial trouble can always seize their citizens' holdings, just as US president Franklin Roosevelt did in 1933. As a result, enthusiasts have identified another possible replacement for the US dollar: the Bitcoin.

Invented in 2009, Bitcoins are a digital currency designed to allow users to make internet payments at minimal cost.

The system is decentralised. Instead of transactions being cleared through a settlement system operated by a central bank which issues the currency, payments are validated by users running clever algorithms, and who are rewarded for their services with the creation of new Bitcoin units.

Bitcoins will never amount to anything more than a curiosity on the outer fringes of finance

But the best feature of Bitcoins, as far as financial libertarians are concerned, is that their supply is limited. The pace at which new units are created automatically declines over time, with the maximum possible number of Bitcoin units fixed at 21 million.

This limit means the currency cannot be debased. What's more, Bitcoin income is tax free, and Bitcoin savings are independent of banks, an advantage which prompted a surge of investor interest at the time of the Cypriot banking crisis earlier this year.

In mere weeks, the price of Bitcoins shot up more than tenfold to US$266, before dropping back to US$100 (see chart).

Despite the slump, believers remain convinced Bitcoins are the future of money.

Unfortunately, there is a fatal flaw with the whole concept. The very feature which most excites enthusiasts - the currency's limited supply - means Bitcoins will never amount to anything more than a minor curiosity on the outer fringes of finance.

With Bitcoins currently trading at US$100 each, their limited supply means that if they were to gain wider acceptance, their value would soar. And that would mean the value of goods and services priced in Bitcoins would have to fall - a lot.

As a monetary unit, the Bitcoin suffers from the same problem as gold. Its limited supply would make its widespread adoption massively deflationary. And deflation is one of the greatest economic evils there is. In a deflationary economy businesses have to sell ever greater quantities of goods and services to generate the same revenues and to service their existing debts.

But when prices are falling, consumers defer purchases, so making those sales becomes more and more difficult. In other words, deflation depresses demand and pushes up the real burden of debts. That removes the incentive to invest and crushes economic activity.

Alas, Bitcoins will never catch on. Nice try, must do better.

tom.holland@scmp.com

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will.bancroft.9
Wow this journo needs to read some monetary economics. The most uneducated piece I've read on money for a long time.
'Must do better' yourself.
It's the price that Bitcoin or gold are set at which leads to deflation, if wrongly done before letting the market decide where it should float to later. Saying its a problem with having limited supply of said money is wrong-headed and like putting the cart before the horse. Try reading Currency Wars by Jim Rickards as a 101 on this.
bluefirestorm
The irony is BitCoin is still valued based on the very currencies that BitCoin supporters want to do away with.
Plus, I don't foresee going to my local bakery to give him a string of 33 characters that he have to check for me to buy a loaf of bread.
How often do people (with the exception of bank note geeks and collectors) stop to look at the serial numbers of the bank notes that they give/receive when buying stuff and giving/receiving change? And these serial numbers are definitely shorter than 33 characters.
John Adams
Who controls the issuance of bitcoins to 21 Million?
impala
The algorithm does. It is supposed to be unalterable and unbreakable. Does it matter though?
jaychristopher
This is an unfortunate misconception. stateless said it right, this is solved in that bitcoin is infinitely divisible. It's already being discussed widely that people will start speaking in mBTC which is .001 bitcoin, making the current value about 10 cents a mBTC. There is values all along the way - currently down to .00000001 BTC but this is totally scalable in any direction.
****en.bitcoin.it/wiki/Units
impala
The real unfortunate misconception here is BitCoin itself. It is a pyramid scheme, a pure and simple one. The only 'value' BitCoins have is expressed in their USD (or other currency) equivalent. This value is only derived from what greater fools are willing to pay for it.

There are no hard (or any) assets backing BitCoins. There is no underlying future cash-flow. There is no power of taxation or veiled threat of force backing it up. No productive capability of any sort. Its 'value' is purely derived from more people pouring money into it. The only way its value will increase is to find more fools willing to pay more money for it, who are doing this probably because they think it will be worth even more in the future. To make this come true, you need more fools again. Sounds familiar? Yes, because that is the definition of a pyramid scheme.

Make no mistake, this is a zero-sum game in real (USD, GBP, take your pick) currency terms. Some may win, some will loose.

And no, it is not the same as gold, although there are some worrying (for gold) similarities. But at the end of the day, there is a real market for gold, with actual physical end-use demand, for jewellery, for storage, central-bank reserves, industrial use, commemorative coins, medals and so on, matched with actual physical supply.

So I wish you good luck toying around with BitCoin. Like any pyramid scheme, it may continue for quite some time, but make sure you aren't the last fool holding the straw.
HK_eh!
so is any fiat currency, USD, GBP, YEN, etc. pyramid scheme, the central bankers print as much as they like.
the only difference with Bitcoin is central bankers don't control the printing.
impala
No. The most obvious differences are that:

1. They are backed by sovereign states with taxation power, in turn backed up by a credible monopoly on the use of force if need be.

2. They indeed have Central Banks that have mandates and sufficient tools to ensure a stable internal value of the currency. And yes, I am happy to take an annual 2% inflation target as 'stable.' 'Printing money' is part of that toolbox, yes. I think that by now we can proclaim the inflationista argument (and with it a large chunk of Austrian voodoonomics) dead and buried, right? Despite years of money printing, inflation everywhere is nicely on target. If anything, it is below target, particularly in Japan, where they have been printing money for two decades.

3. The value of those currencies is ultimately based on the productive ability of the economies they are based on. (1) would not be worth anything without real economic growth, and management of the supply of money under (2) would be irrelevant if there would be no demand for money. The US, UK, and Japan, have advanced, highly productive economies with credible, stable institutional arrangements. And in those economies there are legions of individual men and women, and hundreds of thousands of firms who produce real added-value. That activity is what ultimately backs a currency, not some algorithm with a promise of limited supply.

My toenails are in limited supply too. If only I could convince enough fools... Hey, you wanna buy?
HK_eh!
do you really believe the govt inflation figures are not manipulated?
There is a lot of independent/shadow data that shows otherwise.
don't really care inflation/deflation terminology, when i pay more for the same item/size/quantity or pay same and get a smaller portion or inferior item than before, it's a loss of purchasing power.
impala
Yes, I do.

Bring on the data please. Looking forward.

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