There is much happening in the world of currencies to grab attention these days—from the trajectory of the US dollar after the end of the second round of quantitative easing to the future of the euro in case Greece implodes.
The spectacular collapse in the value of an online currency that is issued privately has little immediate relevance in these testing times, but what has happened in the market for Bitcoins in the past few days matters, since there is a growing group out there that distrusts currencies issued by national governments, as they have an incentive to inflate away their debts by debasing these same currencies. The Bitcoin blow-up gives us some sense about the risks of private currencies.
Bitcoins are digital currency introduced in 2009 by Satoshi Nakamoto, a secretive computer programmer. The currency is bought and sold electronically through a peer-to-peer network that is beyond the control of any central authority. Supply is created with the help of an algorithm. Bitcoins can be bought on several online exchanges, and are useful to buy some goods and assets in the real world.
Demand for Bitcoins had soared in recent months. One dollar could buy you one Bitcoin in the beginning of the year. By the end of May, one Bitcoin was worth $30. But its value collapsed last week, to 1 cent per Bitcoin. That is depreciation of Zimbabwean proportions. It appears that a security breach at Mt Gox Bitcoin Exchange, the biggest in the game, compromised user accounts and helped a rogue trader dump Bitcoins and then buy them back at rock-bottom rates.
The Bitcoin collapse should serve as a cautionary tale. The race to depreciate currencies and inflate away public debt may lead to a loss of confidence in national currencies in the future. That is one reason why gold has been on an extended bull run. Following F.A. Hayek, there are many who believe that competing private currencies would correct the inflationary bias that is embedded in money issued by sovereign governments. But it seems privately issued currencies also carry significant risks, and managing these risks can impose huge costs on both economic agents and society at large.
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