Without a Central Bank, Cryptocurrencies Like Bitcoin Will Remain on the Economic Fringe

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

Ryan Cooper, a contributing editor of the Washington Monthly, is currently the Washington correspondent for The Week.