Wednesday, March 20, 2013

Which is a Bubble: Bitcoins or Fiat Money?

The mainstream sees the exploding public interest on bitcoin as a threat and brands it a “bubble”.

Here is the Economist,
NOT MANY fund-managers have heard of Bitcoin, let alone put any of their clients’ money in it. But over the past few months, the world’s first “crypto-currency” has become one of the world’s hottest investments. Since September, when The Economist last wrote about it, the price of a unit of Bitcoin as recorded by Mt Gox, a popular Bitcoin exchange, has soared. Unlike other online currencies—such as the new Amazon Coins—the supply of Bitcoin is not determined by any central issuing authority. Instead, new coins are generated according to a predetermined formula by thousands of computers solving complex mathematical problems. As more coins are generated, these problems get ever more complex, increasing the cost of computing power necessary to generate them, and so setting a floor underneath the price. Mimicking gold, the currency is designed to be deflationary. However, there is every reason to think that the current Bitcoin boom will shortly bust. As the chart shows, online interest in the currency has spiked in recent months. Though an increasing number of legitimate businesses are adopting the currency—one Finnish software developer has offered to pay its employees in Bitcoin—it still has relatively few users. Its primary commercial use is probably to buy drugs from Silk Road, a sort of pirate eBay hidden in the “deep web”. This suggests that the new users are buying Bitcoin as an investment, not as a means of exchange. For any currency to thrive it needs users, not just speculators.
The idea that bitcoins “still has relatively few users” ergo a bubble simply begs the question. This doesn’t establish the bubble properties.

The transition towards “moneyness” is a market process and doesn’t come instantaneously. Since the article admits that bitcoin attempts to "mimic gold", then the process entails the expansion of the commodity’s marketability which may have partly been exhibited by the chart.

As the great dean of Austrian economics Murray N. Rothbard explained,
Once a commodity begins to be used as a medium of exchange, when the word gets out it generates even further use of the commodity as a medium. In short, when the word gets around that commodity X is being used as a medium in a certain village, more people living in or trading with that village will purchase that commodity, since they know that it is being used there as a medium of exchange. In this way, a commodity used as a medium feeds upon itself, and its use spirals upward, until before long the commodity is in general use throughout the society or country as a medium of exchange. But when a commodity is used as a medium for most or all exchanges, that commodity is defined as being a money.

In this way money enters the free market, as market participants begin to select suitable commodities for use as the medium of exchange, with that use rapidly escalating until a general medium of exchange, or money, becomes established in the market.
Paradoxically the article mentions a Finnish software company offering to pay employees based on bitcoins.
Another good example for this could be Iran. Hammered by trade and financial embargo, part of the embattled nation’s economic activities have shifted to using bitcoins

So expanding public interest on bitcoins does not necessarily entail a bubble.

The reality is that the ECB and other central banks see bitcoins as threat to their monopoly over Seigniorage privileges and thus engage in negative publicity or propaganda to besmirch a potential market based competitor.

The essence of bubbles is really a “something for nothing” or a "free lunch" dynamic.


If Bitcoins are generated with a huge cost, “As more coins are generated, these problems get ever more complex, increasing the cost of computing power necessary to generate them, and so setting a floor underneath the price”, then compare this with exploding balance sheets of global central banks, whom are simply digital entries as determined by political authorities to the banking system.

Guess which is unsustainable and has the character of a bubble?

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