A nice piece by Prof Noah Smith.
He says bitcoin is too volatile at the moment. It can only become a currency if it becomes less exciting and more boring:
Is bitcoin ever going to become money? That’s certainly on the mind of bitcoin enthusiasts and backers of the blockchain record-keeping technology that potentially makes it possible. It’s also on the minds of the economists at central banks, who wonder how the new currency will affect their ability to manage inflation and economic growth. The answer to the question depends on the answer to a much deeper question: What is money, anyway?
To me, the answer has always seemed simple: Money is what you exchange for goods and services. But plenty of people don’t seem to be on the same page. You see many declare stubbornly that “gold is money,” even though they can’t go into McDonald’s and use their gold collectible coins to buy a Big Mac. What these gold bugs mean is that — in their view — gold will hold its value during the long term. In other words, they predict that in 100 years, they will be able to trade their gold collectible coins for whatever the dominant currency is then, and use that currency to buy about as many Big Macs as they could today if they sold their collectible coins for dollars.
But being a good long-term store of value isn’t really a desirable characteristic in a currency. The reason this is true comes from a very deep fact in finance — the tradeoff between risk and expected return. In general, if you want something whose value is stable in the short term, you will need to accept that it won’t go up much — or may even go down — in the long term. If you want to build your wealth, you will have to accept some short-term fluctuations.
Short-term fluctuations are bad, bad, bad for money. You don’t want your cash to suddenly drop in value by 30 percent between the time it goes into your bank account and the time you go to the store to buy things. That’s why we don’t use shares of stock to buy laundry detergent; they’re just too volatile. But stocks are great for building your wealth during the long term.
In contrast, money tends to lose value slowly. This is because we have central banks that target small positive rates of inflation, usually about 2 percent a year. Fiat money is very stable in value during the short term, making it useful for buying things, but not useful for building wealth. If you keep the bulk of your wealth in cash under the bed, it will slowly erode. That’s why you should keep most of your wealth in investments such as stocks and bonds, instead.
So the fact that gold tends to hold its value during long periods of time is exactly why gold isn’t money. The gold bugs are simply wrong. Gold is a high-volatility asset with (probably) a positive expected return, which makes it something other than money.
Prof Smith is not really right here. Gold may not become money in terms of daily transactions. But it surely does a good job of store of value. You use money to buy stocks, bonds or gold to preserve value of your money. Infact, even if money loses its value slowly you are always warned not to keep your savings as idle cash. This is also one of the core ideas of finance. No other form of money has caught human imagination as gold has.
So what about bitcoin?
Bitcoin has, since its creation, been enormously volatile against the U.S. dollar. Because of that volatility, not many people use bitcoin to buy things, since that requires keeping bitcoin in an account for days or weeks. Right now, that’s a dangerous prospect.
Bitcoin service providers have tried to get around this by offering just-in-time bitcoin services. These are services that convert your dollars to bitcoin, make a purchase in bitcoin, and then convert the bitcoin back into dollars again in the seller’s account. This all happens lightning-fast, so there is no time for bitcoin to fluctuate in value during the transaction.
But as economics blogger JP Koning has pointed out, this is all a little pointless. Why not just make the purchase in dollars, and cut out the bitcoin middleman? If the customer and the merchant both hold dollars in their accounts before and after the transaction, we’re still talking about a U.S. dollar-based economy.
So to become money, bitcoin volatility needs to fall to the point where it’s safe to keep your cash in bitcoin for days or weeks without losing significant value. That’s going to be a tall order in rich countries, where powerful central banks keep inflation volatility very, very low. Poor countries with weak central banks, such as Zimbabwe, might be better candidates for bitcoin, just as poor anarchic medieval Europe once used gold as money. But in the rich countries, it’s going to be a much more uphill battle.
The hope of bitcoin boosters — and bitcoin technology backers — is that there will be a virtuous cycle. They are counting on lower volatility to persuade a few more merchants and customers to adopt bitcoin as their payment system, which will in turn drive volatility still lower and so on, until bitcoin becomes everyone’s favorite form of money. And volatility has been falling, as bitcoin enthusiast and Mercatus Center researcher Eli Dourado has pointed out as the following chart shows:
So the potential is there. Now, this is a simplified view. There are other issues affecting bitcoin, such as the timing of payments and whether you can get a refund. Dourado and Koning tackle some of these issues. But right now, volatility almost certainly overwhelms these other concerns. If you want to turn bitcoin into real money, figure out how to damp down the fluctuations in the number of bitcoins it takes to buy a gallon of milk, a dozen eggs and a bottle of laundry detergent.
As for gold … well, unless civilization collapses, it’s never going to be money again. Sorry, gold bugs.
Actually, there is one other factor which is going to keep bitcoin away. It is central banks themselves. With bitcoin, central banks lose their monopoly power and like many other firms will become part of a museum due to technology. So there are some interesting battles here.
Having said that how far are we from bitcoin kind of a world. Some cash will remain but with transactions increasingly moving to the digital world, we are moving to a bitcoin world. Central banks lost power to manage money in 1980s due to financial innovation like credit cards, ATMs so on. Now with internet and mobile payments, control is being lost further, Though the key is that it is basically central bank and domestic bank money which is being routed via these channels. The challenge for bitcoin is to either complement or provide an alternative to the central bank money.
Imagine you have some money in your bank account with a % in central bank money and rest in bitcoin money and you can use either. That is the kind of vision one needs to think about and making it happen. And guess what? None of this is really new. Before central banks got monopoly to issue currency notes, banks issued multiple currencies and one could have many types in bank account. This is also something Austrian school argues strongly for as well.
On gold? You never know? I mean we could have it before civilization collapses..who knows?