Not since the introduction of the euro 15 years ago has there been so much debate about a new currency. Bitcoin has captured the imagination of the financial community.

With 12 million ‘coins’ in circulation, worth roughly $12bn in January 2014, the digital currency is still more of a curiosity than an economic force. Yet what is popularly being called the ‘geek dollar’ has a devoted following and enthusiasts believe it could one day rival conventional currencies. A growing number of businesses – including online gaming company Zynga and net retailer Overstock.com – are now willing to accept Bitcoin. Ben Bernanke, in his last months as Federal Reserve Chairman, declared that it “may have long-term promise” and the Department of Financial Services in New York has raised the prospect of regulating Bitcoin. Germany’s Ministry of Finance has formally recognised the Bitcoin as a valid “unit of account for transactions”.

“This has been a bold technological experiment,” says Mark Calabria, a former aide to the US Senate Committee on Banking, Housing and Urban Affairs and now a fellow at the Cato Institute in Washington. “Bitcoin is still in its infancy and could develop into something far more important.”

However, economists are asking whether the currency could ever really challenge the likes of the US dollar, and whether Bitcoin – which has risen in value 50-fold during the past year – is destined to collapse in value.

In the beginning…

An anonymous programmer or group going by the name of Satoshi Nakamoto created Bitcoin in 2008. That fact may be significant. “The currency came into being around the time that the Federal Reserve was engaged in quantitative easing – which many libertarians feared would lead to hyper-inflation and the debasing of the dollar,” says Justin Wolfers, a senior fellow at the Brookings Institution in Washington. “The currency’s core fan base has been [composed of] opponents of central banking.”

Part of the appeal of Bitcoin for such people is that there is a strictly limited supply. People ‘mine’ Bitcoins by solving cryptographic puzzles. When they’re successful, they are rewarded with a ‘block’ of new Bitcoins. The number of Bitcoins per block will decrease by 50% about every four years, capping the number of Bitcoins at 21 million.
A cap on the number of Bitcoins means the risk of chronic deflation This approach makes Bitcoin reminiscent of gold-based currencies, where supply was restricted by the ability of miners to extract gold from the ground, but Bitcoin is more rigid than that. This is another reason to doubt that it could ever be accepted as a fully fledged currency, Wolfers argues. “You run the risk of chronic deflation when you have such an absolute cap on how much currency can be generated,” he says. “If a demand for products and services expands, but the money supply does not, you can stifle economic growth.”

Economists’ concerns

The fact that inflation of traditional currencies has remained subdued – despite massive monetary stimulus in the United States and Britain – also casts doubt on the need for an alternative. Advocates of the status quo point out that there are certain democratic advantages to the currency system of monetary policy. The Federal Reserve and the Bank of England, though independent, are overseen by their representative governments. “I would rather have Janet Yellen [the new Chair of the Federal Reserve] in control than a group of anonymous computer geeks,” Wolfers observes.

So far, however, monetary policy controlled by computer whizzes seems like a distant prospect. To date, Bitcoin has failed to serve any of the main functions expected of a currency – including as a medium of exchange, a store of value or a unit of account.

First, the virtual currency is far from being accepted as legal tender, acceptable to all shops and individuals as payment. Only a handful of retailers are currently willing to accept it, although the list is growing.

Secondly, its value can fluctuate wildly, rising or falling by as much as 20% in a day. “This is a serious limitation as a medium of payment,” says François Velde, Senior Economist at the Chicago Federal Reserve Bank. “A successful currency is predictable and stable. Without that quality, sellers will be reluctant to accept it.” Similarly, these gyrations make the currency a poor unit of account.

Finally, exchanges of Bitcoin are far slower than conventional cash or bank transactions. “At a minimum, one must wait ten minutes and for large amounts it is customary to wait for an hour,” says Velde. “The reason for this delay is the security systems that are intended to ensure that a Bitcoin is not being spent twice. In this respect, Bitcoin is less efficient than existing currencies and payment infrastructures.”

In addition, there is concern that Bitcoins may at some point collapse in value. “It is not hard to see the risk of a bubble here,” says Calabria. The value of one Bitcoin started 2013 at $13, but began 2014 at $1,000. In contrast, central banks have a strong incentive to prevent the value of fiat currencies from collapsing, giving them at least some stability in most cases.

“There is no such authority standing behind Bitcoin and thus no limit on how far it could fall,” points out Julian Jessop, Chief Commodities Strategist at Capital Economics. “It also has no intrinsic value, unlike gold, which at least can be used in jewellery and has industrial functions too.”

One possible catalyst for such a fall would be hostile actions from governments. While some have been tolerant of the new virtual currency, they may be less forbearing if it becomes a more serious rival. The value of Bitcoin fell almost 40% in just one day in December after Chinese authorities cracked down on the currency.

So while economists see Bitcoin as a fascinating new development, few believe it will emerge as a serious threat to national currencies. “The system of money we have at the moment works extremely well,” says Wolfers. “Bitcoin is a brilliant solution in search of a problem.”

What are your views on Bitcoin – is it here to stay or a passing fad? Email richard.mitchell@cisi.org