Inside the Bitcoin economy | The economist

On the volatility of the Bitcoin dollar rates

April 11, 2013

BITCOIN, a “cryptocurrency” that the entire financial world is talking about, has had a crazy few days. Bitcoins have always been volatile, but over the past week the currency collapsed and rose to nearly $ 300 before falling and losing about 60% of its value in a matter of hours. Felix Salmon contemplates the carnage and writes:

Bitcoin is clearly not an effective store of wealth – just look at how quickly that wealth can be evaporated. It’s also not a useful payment mechanism considering how quickly its value can fluctuate. Currently, it can take an hour for a Bitcoin transaction to be deleted. This means that when the transaction is deleted, the value of the transaction can be radically different from its value at the beginning. Bitcoin only works for payments if you can be fairly certain that its value will remain reasonably constant for at least the next hour or so.

I will play the pedant and find that this is not entirely true. The dollar is one of the most successful currencies in history, I think it’s fair to say, and yet like virtually any floating currency, it’s prone to wild volatility. In the late 1990s, the trade-weighted dollar rose nearly 50%. It then turned on a dime and fell 30%. Then, in a few weeks in late 2008, it jumped nearly 20%. Again, this is the trade-weighted dollar, not a single currency pair (which can be much crazier more volatile).

Now, over long periods of time, these fluctuations can have significant macroeconomic effects. But on a scale of weeks or months, or even a year or two, the average American has almost no idea that such movements are taking place, and neither does he care. And that’s because America is a massive economy where trade is a relatively small percentage of GDP, where everyone is paid in dollars, and where everything is valued in dollars. Foreign exchange volatility matters only insofar as the exchanges you are interested in have a foreign component.

In Bitcoinia (as we might call the Bitcoin economy), this means that volatility is very important right now. Almost every good that can be bought with bitcoins is actually valued in dollars and sold at a bitcoin price that reflects the prevailing exchange rate. So there is almost no Bitcoin frame of reference that is independent of the Bitcoin-Dollar exchange rate. Bitcoinia usually lacks internal supply chains in which contracts for intermediate products are made out and processed in Bitcoins. People don’t take home bitcoin paychecks. Put simply: every good in Bitcoinia is an import and every job has to be outsourced. In this type of economy, exchange rate volatility is very important indeed.

But just because Bitcoinia works this way now doesn’t mean it will work that way over and over again. The more purchasing power Bitcoinia has, the greater the incentive to meet the demand for Bitcoinia. The more transactions there are in Bitcoinia, the more entrepreneurs want to hedge their risk of currency volatility by paying suppliers or employees in the same currency they accept as payment. And bitcoin wage payments are increasing the demand for goods and services that can be bought with bitcoins. The greater the ability to buy and sell what is needed exclusively within Bitcoinia, the lower the volatility of the forex.

Whether Bitcoinia actually reaches this critical mass is a very open question and I certainly have my doubts. In the early days, volatility is a big deal, and large swings against other currencies can kill the Bitcoin economy in its cradle. A bit of macroeconomic management could be recommended to create enough stability for critical mass to build, but Bitcoin is not about centralized management. As skeptical as bitcoinistas may be about the value of central banking, it turned out that way for a very, very good reason. And if the bitcoin economy manages to find a completely decentralized way to stabilize without this top-down maintenance, that would be something very interesting indeed. More likely: Either Bitcoinia will remain a small fringe economy due to its inherent instability, or a stabilizing financial structure will somehow grow within it. And then one day we could see a Bitcoinian JP Morgan gathering Bitcoinia’s financial eminences in a virtual office to work together to prevent the impending financial panic …

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