Could Bitcoin ever be a “real” currency?

By Filipe R. Costa

Demand for the digital currency Bitcoin spreading like the Spanish Influenza outbreak of 1917. Originally conceived as a theoretical experiment among computer geeks a few short years ago, it has quickly morphed into a globally accepted method of exchange. Bitcoin’s early forays into becoming a means of physical trade began with pizza payments, but today a variety of goods and services can be bought with this currency, including as diverse items as college education and financing electoral campaigns.

Trading from a few cents at its debut, the price of Bitcoin quickly rose to the hundreds of dollars and, in the last few days, broke through the $1,000 level.

Call it a bubble, a fad, a buying frenzy or just pure madness, the truth is Bitcoin is here to stay, especially as the Chinese appear to be driving demand. Mt. Gox was the largest Bitcoing exchange, where millions of dollars are traded every day, until BTC China took over the number 1 spot. In January, BTC’s average daily volume was 1,100 Bitcoins, but this has now risen to 90,000, making a daily market worth $90m.

It is quite normal for such a fledgling market to experience large volatility. On November 18^th on Mt. Gox Bitcoing hit $900, fell to $600 and recovered to $800 in the course of a single trading session. Yesterday was an even bumpier ride as the price dropped dramatically below $500 and recovered to just over $600 (shown below). The lack of liquidity and legal framework makes Bitcoin extremely sensitive to political and economic events:

Fiat currencies, such as the pound or the dollar, are accepted because everyone accepts them. This might sound like a truism, but it makes a lot of sense. It is true that these currencies also have systemic backing, but they are essentially products of rules and regulations. They are not backed by anything physical. The system is based on trust.

Were inflation to spiral out of control, that trust could very quickly be lost (as has happened many times in the past) and people will resort to whatever other means of exchange they can, where value is retained. This presents a possible long term path for Bitcoin or whatever follows in its steps. So could Bitcoin ever perform such a role?

In reality it seems unlikely.

Bitcoin’s supply is tightly regulated by its algorithm. At the same time the electronic currency has been exposed to a substantial increase in demand. This basically meant the price could only go up. The fact that supply does not adjust to demand suggests that Bitcoin is ill suited to becoming a genuine “currency” as we might ordinarily recognise it. I am not talking about the centrally managed version of supply adjustment, which the Federal Reserve is inflicting upon us all, but rather the natural adjustment that occurs through economic activity.

It has been said that the amazing rise of Bitcoin reflects concerns about the world’s easy money policies. If this is true, I personally wouldn’t want to use Bitcoin as a hedge against inflation. I’d use gold. Draw your own conclusions about this, but to my mind it suggests the current gold market does not reflect the underlying reality.