Investors beware of Bitcoin

Bitcoin has a deflationary bias with all the adverse repercussions that the policy of QE is trying to avoid.

In response to the upheaval that followed the collapse of Lehman Brothers on 16 September 2008, the US Federal Reserve has electronically created over 3 trillion dollars. These dollars have been given to commercial banks in return for debt previously issued by the US Treasury. The Bank of England has followed suit. This “quantitative easing” was first tried on a large scale by the Bank of Japan (BoJ) 15 years ago when Japan’s property bubble burst, and BoJ has recently returned to the policy with renewed gusto. The European Central Bank has electronically created a similar amount of euros, though this has been lent to commercial banks, which is not the same as quantitative easing in the long run, but not substantially different in the short run. Many believe that this policy will bring inflation and the debasement of paper currency.

This view is reflected in the substantial appreciation in terms of dollars, sterling, euros and yen, until recently, of the price of gold and other commodities. The unprecedented degree of money creation, the revelation of widespread covert monitoring of citizens by the US spy agencies and tougher anti-money laundering rules everywhere have combined to create an environment in which novel, alternative, currencies have emerged, the most novel and famous being the Bitcoin.
Given these circumstances, the key characteristics of the bitcoin—developed in 2009 by a digital cryptographer with the pseudonym of Satoshi Nakamoto—are independence and limit in its supply and anonymity in its holding. The supply of bitcoins is capped at 21 million units and new supply up to that point is progressively reduced in two separate ways. A supply of bitcoin is granted to whoever cracks the code embedded in each transfer of bitcoins. The amount of bitcoins granted for cracking the code halves every year and with each transaction the code gets longer and harder to crack.
Like all fads, bitcoin is wrapped up in modern-sounding, grammar-less jargon that makes some prefer to enthuse rather than suffer the ignominy of admitting that they don’t understand it. Bitcoin, we are told, is a peer-to-peer payment system introduced as open source software. Cash is also a peer-to-peer payment system, but thankfully no one chooses to describe it as such.
Bitcoin is a cryptographer’s wet dream rather than a useful monetary system. While bitcoin supporters tap into an understandable reaction against bankers and claim it is a decentralized and democratic system of money, it so happens to give a built-in advantage to those with the biggest code-breaking capacity. It has a deflationary bias with all the adverse repercussions of that that the policy of quantitative easing is trying to avoid. And like everything else it is not “unhackable”. Bitcoins have been stolen and there are allegations of covert creation of bitcoins and cornering of supply by a few larger computer networks. But the reasons why bitcoins will be worthless within a couple years are different.
Bitcoins appeal to those who are suspicious, sometimes not unreasonably so, of national authority and laws, yet it is legitimate authority that makes a currency valuable.
The value of a currency relates not just to its supply but its demand. Governments create demand for their currency by making it legal tender, meaning that it cannot be refused as a form of payment and is the required form of payment for certain transactions such as taxes. Governments profit from being able to print the legal tender that people have to hold to make payments and so they are not going to bestow legal tender status on other currencies—especially in these times of fiscal rectitude. Moreover, national currency is a claim by the holder to the issuer and the issuer in turn is, mostly, the agent of the only power in the land that can honour this claim, by making other claims on income and assets of residents and citizens through the power of taxation.
Incidentally, governments may appear biased towards debasing their currency, but inflation is not costless. Inflation shifts wealth from creditors to debtors and from those without assets to those with assets. Too much inflation means the creditors leave and the asset-poor starve. Too little may force the debtors to default. The level of inflation in each country reflects individual accords between the winners and losers from inflation and it is better that these accords are set by democracies rather than universally pre-set by computer programmes.
Because of its anonymity, bitcoins are attractive in the laundering of illicit activities. Last year in the US, FBI shut down “Silk Road”, an online black market, and seized $28 million worth of bitcoins. This will be its undoing. After 9/11, the authorities have become far tougher in trying to crack down on the financing of illegal activities through anti-money laundering rules that require banks to know the source of funds being transacted. Bearer bonds or shares, for instance, where the owners are not registered anywhere but merely those who hold them, were once extremely popular, but today can no longer be used in the banking system as a method of payment or collateral or pledges. Bitcoin is just like a bearer bond. Sooner rather than later, holders will find that there are a diminishing number of greater fools left to buy bitcoins from them, and its price will collapse. Don’t be tempted.

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