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Why don’t economists like Bitcoin?

Why don’t economists like Bitcoin?


Paul Krugman and others can't get behind the virtual currency

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Nobel prize-winning economist and New York Times columnist Paul Krugman wrote a blog post this weekend with a tantalizing title, "Bitcoin Is Evil," that has provoked the expected backlash from proponents of the virtual currency.

The headline over-promises, unfortunately — while you could make an argument that Bitcoin nefariously wastes computer power, enables crime, and encourages anarchy, that’s not what Krugman’s saying. (Science fiction writer Charlie Stross’ "Why I want Bitcoin to die in a fire" is more satisfying.) Instead, Krugman attacks Bitcoin’s economic fundamentals for the zillionth time.

Almost any time you see someone from a university praising Bitcoin, that person is from the computer science department. And if you see someone from a university criticizing Bitcoin, that person is likely from the economics department. It’s understandable why technologists gravitate toward a math-based currency. But why don’t economists like Bitcoin?

It’s not that economists are Luddites, as Bitcoin fanatics might say, although no doubt there is an element of bedeutungslosigkeitschmach. Rather, it’s because the odds are objectively against Bitcoin’s long-term success. It’s very difficult to start anything that depends on a lot of people using it, and the challenges proliferate when that thing is a whole entire new type of money. There are countless possible deaths of Bitcoin. The technology fails. Overspeculation causes an irrecoverable crash. The price never settles down. Deflationary pressure annihilates liquidity. A government shuts it down. A new currency makes it obsolete. Users abandon it for some other reason. And so on.

Objectively, the odds are against Bitcoin’s long-term success

It’s difficult to predict what will happen to Bitcoin because it is unlike any currency ever created. You can draw parallels to monetary anomalies like e-Gold, the stone coin statues of Yap, or the Iraqi dinar, but there’s never been anything quite like it. Instead of a central authority, it is governed by a computer protocol. Instead of serving one country or group of countries, it serves the whole world. And because its source code is public, anyone can launch their own version of Bitcoin at any time.

"It’s something economists had never had to think about until this was developed, and we're just beginning to think through all the implications of it," says Steve Horwitz, an economist at St. Lawrence University who studies private monetary systems. "There’s not a unanimous opinion for sure."

University of Berkeley economist Brad DeLong believes that Bitcoin will fail because the cost of producing a Bitcoin clone is zero. George Mason economist Tyler Cowen agrees, and adds a warning about deflation. Krugman’s main concern of late is the predictability of Bitcoin’s value in the future.

Bitcoin’s success has the potential to disrupt a lot of ideas about money. "To be successful, money must be both a medium of exchange and a reasonably stable store of value," Krugman writes. He isn’t convinced that Bitcoin is a good medium of exchange, but it’s the store of value question where Bitcoiners think very differently from economists. In Krugman’s mind, a currency that is a reliable store of value is traditionally either backed by a central authority willing to buy back the currency, the way the dollar is backed by the Treasury, or it has some intrinsic value, the way gold can be made into jewelry. If a currency has no central authority and no intrinsic value, people can’t trust that it will retain value over time.

"It’s something economists had never had to think about until this was developed."

There is some evidence that human psychology may assume a store of value where an economist would say there is none, however. In 1993, Saddam Hussein started printing his own currency, the Saddam dinar, which citizens were told to exchange for their old 25-dinar notes. Citizens had little confidence in the dictator, who was printing Saddam dinars like crazy. They kept using their old dinars as a medium of exchange and believed it was a relatively stable store of value. Of course, they were wrong. The old dinar gained in value until one was worth 300 Saddam dinars. But in 2003, the US occupation government announced a new Iraqi dinar at an exchange rate that cut the old dinar’s value in half.

If Bitcoin is successful, it could prove that money doesn’t need to function as a stable store of value — the price of Bitcoin could jump around constantly, and in the age of the internet it’s trivial to program prices of goods and services to fluctuate with it.

Its success could also prove that use as a medium of exchange can be the basis for believing a currency is a store of value. If people believe that they will be able to buy things with Bitcoin and exchange it for other currencies indefinitely, that could convince them to use it as a store of value. Many early adopters have already put their savings into Bitcoin. And if the technology is sound and the user base is (eventually) global, that doesn’t seem that insane. That’s why technologists keep talking about Bitcoin as a means of exchange when Krugman asks them why it’s a stable store of value: if Bitcoin takes off as a global means of exchange, that could be enough to make it succeed. The Economist put it best: "All currencies involve some measure of consensual hallucination, but Bitcoin... involves more than most."

Correction: An earlier version of this story said Steve Horwitz is a faculty member at George Mason University; that is incorrect. He got his Ph.D from GMU but teaches at St. Lawrence University.