In the Virtual World of Bitcoin, Some Real-World Problems

Over the past few months a number of people have asked what I think of Bitcoin, an attempt to create a sort of private cybercurrency.

Alexander Kowalski at Bloomberg News directed me to Jim Surowiecki’s article on Bitcoin from the September/October edition of M.I.T. Technology Review. It is very interesting.

My first reaction to Bitcoin was to say, what’s new? We have lots of ways of making payments electronically; in fact, a lot of the conventional monetary system is already virtual, relying on digital accounting rather than green pieces of paper. But it turns out that there is a difference: Bitcoin, rather than fixing the value of the virtual currency in terms of those green pieces of paper, fixes the total quantity of cybercurrency instead, and lets its dollar value float. In effect, Bitcoin has created its own private gold standard world, in which the money supply is fixed rather than subject to increase via the printing press.

So how’s it going? The dollar value of that cybercurrency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good investment.
But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.

“People have come to see it primarily as a way to make money,” Mr. Surowiecki wrote in his article. “In other words, instead of being used as a currency, Bitcoins are today mostly seen as (and traded as) an investment.” He continues: “Successful currencies are used to transact day-to-day business and lubricate commerce. But if you buy Bitcoins hoping that their value will skyrocket … you’re not going to be interested in exchanging those Bitcoins for goods, since then you’ll lose out when the value of Bitcoins rises. Instead, you’re going to hold onto them and wait until you can cash out.”

Bear in mind that dollar prices have been relatively stable over the past few years — yes, we saw some deflation in 2008-2009, then some inflation as commodity prices rebounded, but overall consumer prices are only slightly higher than they were three years ago.

What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation.

And because of that, there has been an incentive to hoard the virtual currency rather than spending it.

The actual value of transactions in Bitcoins has fallen rather than rising. In effect, real gross Bitcoin product has fallen sharply.

So to the extent that the experiment tells us anything about monetary regimes, it reinforces the case against anything like a new gold standard — because it shows just how vulnerable such a standard would be to money-hoarding, deflation and depression.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007). Copyright 2011 The New York Times.