The fatal flaw with internet currency

PUBLISHED : Wednesday, 17 July, 2013, 12:00am
UPDATED : Wednesday, 17 July, 2013, 6:06am

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.