Bitcoin: Money of the Future or Fool’s Gold?

In the weeks since Cyprus President Nicos Anastasiades threatened to plunder the bank deposits of private citizens in order to quell the nation’s banking crisis, both the stock and gold markets seem to have shrugged off the news. Interestingly, the unprecedented announcement appears to have provided the initial impetus behind the recent explosion in the price of bitcoins.

Two days after the Cyprus story broke, the price of a bitcoin jumped from $45 to $55. The digital currency continued to rise parabolically before reaching an all-time high of $266 on April 10. Like other euphoria-driven bubbles, this meteoric rise was followed by a violent correction that dragged the price down to $105 in a matter of hours. Subsequent price gyrations led to a suspension of trading on bitcoin’s largest exchange, Tokyo-based Mt. Gox. The nausea-inducing ride was the latest chapter in the digital currency’s brief yet fascinating history.

The Rise of Bitcoin

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The Bitcoin story began in 2008 when a pseudonymous character known as Satoshi Nakamoto announced the creation of the revolutionary virtual money on an obscure hacking forum. Though cryptographic by nature, the genesis of Bitcoin was explicitly motivated by contempt for the tyrannical and intrusive nature of the fiat money regime.

Today, the decentralized and nonpolitical bitcoin is the world’s most widely used alternative currency. Although it was first embraced by cypherpunks, anarchists, and libertarians, the virtual money has attracted a mainstream following as faith in fiat currencies weakens with each passing round of monetary stimulus.

The popularity of Bitcoin largely stems from its intelligent peer-to-peer framework that enables rapid and anonymous exchange across geographic boundaries and political lines. Unlike fiat money supplies which can be expanded with a quick keystroke, bitcoins are “mined” into existence when challenging proof-of-work problems are solved, usually by highly specialized and powerful computers. The difficulty of these puzzles is poised to increase over time, thereby ensuring that the supply of bitcoins grows at a diminishing rate until the final bitcoin is created in 2140.

In short, this digital money supply is based upon faith in mathematics, rather than trust of central banks and the government, which governs paper money.
Though it is not the first of its kind, Bitcoin is succeeding where prior digital currencies failed due to an ingenious feature of its network that registers a timestamp with each transaction, which prevents double spending since each transfer must be authenticated by more than half of the 20,000 independent users.
With its unique advantages and distrust for paper money on the rise, a marketplace for Bitcoin is beginning to take shape. Respected businesses such as WordPress, Reddit, and Namecheap now accept bitcoins, while the number of daily transactions has multiplied from 1,000 in early 2011 to roughly 50,000 today.

Avoid the “Greater Fool” Pitfall

In spite of an evolving marketplace, bitcoins remains a dangerous vehicle. After last week’s tumultuous ride, one must question whether Bitcoin is a legitimate alternative currency or simply a disruptive technological experiment.

Elementary economics tells us that for an object or record to constitute money, it must be:

  • a store of value
  • a unit of account, and
  • a medium of exchange
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Based on its small size and the inherent instability of its economy, Bitcoin fails to meet the first two criteria, since wild price flucutations make estimating day-to-day values a crapshoot. Even Bitcoin’s role as a medium of exchange is dubious, due to the fact that the majority of coins are still being hoarded for speculative purposes. Even if the maturation of its digital economy eventually brings about greater price stability, Bitcoin will forever remain a risky digital construct due to the fact that it is devoid of intrinsic value.

For investors looking to safeguard their wealth from the corrosive effects of inflation as well as the talons of marauding governments, an investment in Bitcoin is a daring gamble. Though the talking heads would like you to think that gold is a bubble in its own right, this rhetoric ignores the fact that the yellow metal has retained its perception of value since the dawn of human civilization. At the end of the day, investors must ask themselves if they would rather possess a tried and true source of wealth — in the form of gold, silver, or other precious metals — or roll the dice on the latest fad in monetary rebellion. This decision could have profound implications for one’s financial security.

Originally written for the website of the Hard Assets Alliance, an industry association of trusted economic and investment research firms that fosters a better understanding of prevailing economic trends and offers investing advice. Open a SmartMetals™ investing account from Hard Assets Alliance here.

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