Bitcoins: As Good as Money in the Bank?

Print your own U.S. dollars and the Secret Service will come after you. The laws of physics will stop you from turning lead into gold. But you can safely mint your own “bitcoins,” a cyber-gold currency that lies beyond government control.

In 2009 the pseudonymous Satoshi Nakamoto released protocols for this online currency. The bitcoin system uses so-called public key encryption to assign currency to different owners. You have a secret code that you can use to prove you own a bitcoin or to transfer ownership of a bitcoin without ever having to reveal your code.

A decentralized network keeps track of all this. With the right software you can safely, securely and anonymously send and receive bitcoins across the Internet as a form of payment. A few million U.S. dollars’ worth of trade takes place every day using bitcoins.

You get bitcoins by buying them with traditional currency, trading them for goods or creating new bitcoins yourself. If you set your computer to solve certain mathematical puzzles, the bitcoin network will occasionally assign you new coins. The supply of bitcoins, therefore, keeps increasing and people then have an incentive to join the bitcoin system.

Bitcoins are often used for illegal transactions on digital black market websites such as Silk Road where people don't want to leave a credit card trail. (Beware: The FBI probably has other methods of keeping track of what you do on sites that trade in illegal goods.)

Bitcoins could become important if people lose trust in traditional currencies. Governments sometimes use inflation to reduce the real burden of their sovereign debt. By holding U.S. dollars, you assume the risk that the Federal Reserve will decimate the dollar's value by printing a huge number to finance deficit spending.

Bitcoins are protected from massive inflation, however, because of inherent mathematical limits on how many new coins can be created. Bitcoins have the best growth potential in corrupt dictatorships where the government is a risk not only for destroying the local currency, but also for confiscating dollars in electronic bank accounts.

Residents in such countries could keep bitcoin wealth on cell phones and pay for goods without having to carry cash. Also, if a citizen protects his cell phone with a password and keeps a copy of his bitcoin master code at home, he wouldn't lose his bitcoins even if his cell phone were stolen. Some people speculate on bitcoins by purchasing a large number in the hope that their price will soon rise.

The daily fluctuations in the price of bitcoins are so huge and unmoored to any fundamental that this should be considered a form of gambling, not better investing. Bitcoin prices could even fall to zero.

Like any fiat currency, people want bitcoins just because other people want them as they, unlike food, have no inherent consumption value. This means, however, that if many bitcoin holders suspect that bitcoins will become worthless, these holders will dump their bitcoins on the market, lowering their price. Fear that this might happen could cause panic selling that quickly eviscerates the bitcoins’ value. Bitcoins, then, are like a magic deity that retains its power only if the people keep believing in it.

This article was originally published in the August 2013 issue of BetterInvesting Magazine. While the article was written specific to bitcoin, most of the article also pertains to other cryptocurrencies which have emerged since. James D. Miller is a Professor of Economics at Smith College. He has a J.D. from Stanford and a Ph.D. in Economics from The University of Chicago.

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