Don’t get bitten by Bitcoins

Editor’s Note: James J. Angel is associate professor of finance at the McDonough School of Business, Georgetown University. For 2013, he is a visiting associate professor at the Wharton School, University of Pennsylvania.

In recent days, Bitcoins have enjoyed a media buzz as the value of one Bitcoin jumped on several Bitcoin exchanges to more than $200 per Bitcoin. But by Wednesday, it fell to $105.

Bitcoins are an attempt at creating an electronic currency that is beyond the control of any government. They are created through a digital mining system, in which digital “miners” are granted Bitcoins by using their computers to do computations that verify Bitcoin transactions. Pretty clever.

With allegedly strict rules on the creation of Bitcoins, the money supply is limited. Theoretically, no government can water down the Bitcoin with any type of quantitative easing. As a result, Bitcoins seem to present the best of all possible worlds – the convenience of modern digital payment technology and the stability of a fixed money supply.

James J. Angel

Fearmongers point out that banks are no longer safe as government authorities in the European Union have signaled their willingness to confiscate funds from even insured depositors. Those fearing the collapse of their local currency or their local banking system won’t have to lug around hunks of metal as a way to store their wealth. Why not turn to Bitcoins?

The near anonymity built into the Bitcoin system keeps funds away from the prying eyes of tax collectors, who are getting ever better at shutting down tax havens. This potential for anonymity makes the currency ideal for drug smugglers, terrorists and money launderers, as well as the merely paranoid.

So are Bitcoins the currency of the future? I think not.

No one really knows who is really behind Bitcoins, as the creator is just a pseudonym Satoshi Nakamoto. That in itself should be a huge red flag. I would certainly not trust my life savings to some mysterious computer algorithm created by shadowy anonymous characters in a system that attracts underworld types.

One of the self-proclaimed largest Bitcoin exchanges is Mt. Gox. The name originally stood for Magic: The Gathering Exchange, an online site designed to trade cards used in playing the card game popular with the younger set. An exchange based on trading kiddy cards does not seem like a sound foundation for a monetary system.

There is no government regulating participants in the system to prevent fraud and abuse. I would not be surprised if the Bitcoin mining software becomes a magnet for computer viruses. After all, the tax evaders, drug dealers and terrorists attracted to Bitcoin would not be likely to cooperate with authorities when they have been hacked and robbed.

It would be close to the perfect crime to create a pseudomonetary system that rips off other evildoers. Just be careful when the bad guys find out where you live.

Even if the system is not one big scam designed to enrich its shadowy creators, it can be hacked and can break like any technology. The authorities won’t be too eager to help out Bitcoin-based financial enterprises when they get in trouble, just as they were all too eager to punish the depositors of the Cyprus banks storing questionable funds from Russian oligarchs.

Rather than being a safe place to keep money, the exchange rate of Bitcoins relative to other global currencies has fluctuated wildly. The recent jumps on price give all of the impression of being a bubble that could soon pop. If Bitcoin ever could establish itself as a legitimate payment scheme, which I doubt, it’s hard to tell what the appropriate exchange rates should be with respect to other currencies.

Bitcoins are not the first attempt to create digital money. Other ventures, such as Cybercash, have come and gone, as well as various attempts to create local currencies. Governments don’t like the competition. Managing a currency is a very profitable activity for governments, and they depend on seignorage – the profit stemming from printing money – in various degrees to cover budget deficits.

Indeed, one can always pay the troops by printing more almost worthless money, as the U.S. did in the American Revolution and Robert Mugabe did in Zimbabwe. One can expect governments to throw up legal roadblocks to prevent such competition from cutting into the lucrative business of printing money.

Moreover, it would not be good for the global economic system to have a totally fixed money supply. A growing economy needs a money supply that grows at the same rate to keep prices stable. Much as we love to criticize the governmental entities that control the monetary system, it does help to have some human judgment (armed with a checkbook) involved to deal with crises.

Our banking system is as safe as it is because there are lenders of last resort who can create more money in a crisis to protect the entire system from collapsing in a liquidity crisis. Iceland and Cyprus have discovered how painful it is to have a banking system without such a deep pocket lender of last resort.

A financial system based on Bitcoins would have no possibility of there being such a backstop. In short, Bitcoins look like quite a bit of trouble.

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The opinions expressed in this commentary are solely those of John J. Donohue.