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Bitcoin is too cheap for its own good

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A dramatic increase in price would put an end to its cycle of boom and bust


Last week, when Bitcoin’s price hit a new high of $1,240, Bloomberg News compared it to a massive bubble. Then over the weekend, on the news that China’s central banks would be banning Bitcoin, the price fell nearly 50 percent down to $680 apiece. It was the latest in a roller-coaster ride of Bitcoin booms and busts. But the truth is that the wild swings in price Bitcoin has been experiencing are a natural reaction to the massive global interest in a pool of money that is relatively tiny compared to its government-backed peers. And it’s preventing Bitcoin from achieving its real purpose as an innovative new form of currency.

For the first two years of its existence, when its value was still relatively low, the digital currency known as Bitcoin was mainly of interest to cryptographers, hackers, and mathematicians. It is algorithmically generated, impossible to counterfeit, largely anonymous, and capable of moving peer-to-peer without additional fees from middlemen such as banks — technological virtues which give Bitcoin properties uniquely suited to our modern economy. "It really has the potential to become the native unit of exchange on the internet," says Chris Dixon, a serial entrepreneur and venture capitalist with Andreessen Horowitz. "But that won’t be possible while it’s being inflated by traders who see its value mainly as speculative investment."

Bitcoin is behaving naturally given the global demand and limited supplyWhile an increasing number of businesses from Wordpress to Lamborghini dealers to Virgin Galactic have declared that they are accepting the currency, consumers will be wary of spending a Bitcoin that might be worth double tomorrow, and the majority of merchants aren’t likely to accept a payment that could lose half its value overnight. As Tim Lee pointed out, there is a fundamental irony to Bitcoin. Its creator — or creators — capped the supply of the currency at 21 million units in total, a structural constraint intended to limit the volatility of inflation. But as demand for Bitcoin has skyrocketed, the constrained supply has led to a wild fluctuation in price.

How can Bitcoin escape the trap of its current identity as a volatile, speculative investment? Advocates argue that a drastically larger monetary base could help to stabilize prices by ensuring that every trade represents a smaller percentage of the overall number of bitcoins available on the market. "In my opinion ... for Bitcoin to fulfill its promise as a global currency, global transaction network, and global remittance network, the monetary base will need to be a lot higher than [about] $10 billion," says Barry Silbert, founder of SecondMarket, which recently announced the launch of its own Bitcoin fund. For a major retailer to start accepting Bitcoin they would need to be able to quickly and easily convert it to their local currency or have the stomach to stand Bitcoin’s dips and dives in price. "The thing that will most positively impact consumer and merchant adoption longer term is a higher price," says Silbert.

It’s not just small independents who see real potential in Bitcoin as a currency. The Federal Reserve noted in a recent primer that it has potential to store value, and a group of economists from Bank of America issued a study concluding that "Bitcoin could become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money-transfer providers. As a medium of exchange, Bitcoin has clear potential for growth, in our view."

Its value as an investment is undermining its utility as a currency and technology

According to the bank’s economists, while Bitcoin may be a little overvalued now, it is hardly the Ponzi scheme many are making it out to be. But they too felt its intrinsic purpose was compromised, at least for the moment, by the overheated interest in its potential gains. "Bitcoin’s role as a store of value can compromise its viability as a medium of exchange. Its high volatility, a result of speculative activities, is hindering its general acceptance as a means of payments for online commerce."

The more Bitcoin can prove its value over traditional currency, say proponents, the more prices will stabilize. "I think the key driver for long-term stability will be getting more utility use cases," says Dixon. "This is of course a chicken-and-egg problem, but there are enough use cases where the incentives are high — for example low-margin cross-border selling and machine-to-machine payments — that I think this will happen." In order for Bitcoin to truly work, in other words, the majority of users would need to stop treating it like a potential payday, and start putting it to work in the everyday economy.