The popular bitcoin exchange Mt. Gox closed on Monday after a leaked “crisis strategy” document revealed that approximately 750,000 bitcoins had been stolen from online vaults. Customers were infuriated, but few were surprised. For weeks, Mt. Gox had been delaying withdrawals, and the company had moved out of its offices in Tokyo. Members of the Internet avant-garde, wearing Google Glass and holding MacBooks, were protesting outside of the closed offices as early as February 13.
Bitcoin claims to be “an innovative payment network and a new kind of money,” using cryptography to control the dispersement and transfer of funds. [Editor's Note: Capitalized "Bitcoin" refers to the currency network, while lowercase "bitcoin" refers to the currency itself.] Many Silicon Valley enthusiasts, including investor Marc Andreessen, have hailed Bitcoin as a “sweeping vista of opportunity.” Others, such as Nobel Prize-winning economist Paul Krugman, think that Bitcoin is “evil.”
Krugman may be hyperbolic, but his concern is well-founded. Last December, he said:I have had and am continuing to have a dialogue with smart technologists who are very high on Bitcoin—but when I try to get them to explain to me why Bitcoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem.
Krugman’s problem is that bitcoins do not meet the economic definition of a currency. To properly function, currencies need to do three things. First, currencies need to provide a unit of account. Bitcoin does that. Second, currencies need to function as a reliable medium of exchange. After the Mt. Gox theft, this function is, at best, tenuous. Finally, currencies need to store value. Bitcoins definitely do not do that.
Gold is a great store of value, because if all else fails, people can make pretty things with it and take advantage of its electrical conductivity. The U.S. dollar is (theoretically) a great store of value, because the Federal Reserve can buy dollars back to maintain a stable market price. Bitcoin has no secondary purpose, like gold, and it has no central bank, like the dollar. Consequently, the value of bitcoins fluctuates wildly, because the price is set by Internet speculators, like The Social Network‘s Winklevoss twins. The chart below shows the closing price of bitcoins, measured in U.S. dollars, over a one year period.
In just one month, between November 2013 and December 2013, the price of a bitcoin skyrocketed from approximately $200 to over $1,000. Post Mt. Gox, the price is hovering around $550. Now compare Bitcoin to Brazil’s Real, which economists and Brazilians consider to be very unstable.
Brazilians have mocked their currency as “surreal,” because its value has shifted by 20% over a one year period. Some Brazilians even printed fake currency featuring surrealist Salvador Dali to make the point. Maybe Krugman’s sinister description is not an exaggeration: a bitcoin’s value can fluctuate 1,000% in a single year, which is comically volatile compared to the Real.
Slate and others have suggested that the Mt. Gox theft and price fluctuations are just part of Bitcoin’s “growing pains,” as it becomes a legitimate currency. That approach is highly optimistic, especially given the market reaction to Mt. Gox.
Imagine that 6% of all U.S. dollars–the amount of bitcoins missing from Mt. Gox–were mysteriously stolen from banks and from under mattresses around the globe, and imagine that there was little hope that victims would get their money back. Do you think that people would want to convert more of their wealth into dollars?
The obvious answer is “no.” But after collapsing to $450 on Tuesday, the price of bitcoins has soared above $550 in 24 hours. Investors are still buying bitcoins… in droves. That’s not a market correction–that’s insanity. Bitcoin’s not a currency–it’s a speculative commodity.
When Andreessen describes Bitcoin’s potential, he’s right about many things. Although Bitcoin has been associated with the defunct black market website Silk Road, bitcoins are not primarily used to buy illegal products. (Actually, they’re not really used to buy anything, but that’s beside the point.) Bitcoins also offer an inexpensive and easy way to make transactions online, and the code itself solves the complex “Byzantine Generals’ Problem,” allowing new forms of authentication for digital signatures, contracts, and more.
But Andreessen’s arguments do nothing to alleviate Krugman’s concerns, and they should not convince anyone, except speculators, to invest in bitcoins. The technology may be exciting, and the promise may be genuine, but bitcoins are not currency; it’s unlikely that they ever will be. Instead, Bitcoin is a libertarian economic experiment that went viral. That doesn’t sound like a good investment.