The sudden drop in the value of Bitcoins, the hot new Internet currency, has added urgency to the question of whether Bitcoin is the way of the future, or just another bubble. Not to keep readers in suspense, the answer is a bubble, but a particularly interesting example of one. In particular, Bitcoin represents what ought to be the final refutation of the efficient-markets hypothesis, which still guides most regulation of financial markets.
Before going any further, what is Bitcoin? As with any question nowadays, Wikipedia provides a good initial explanation and plenty of references. For our purposes, however, the most important fact is that bitcoins are initially produced by running difficult (but useless) algorithmic calculations. By analogy with gold, the producers are called miners.
The number of bitcoins that can be produced has been set to a predetermined schedule (from 2009 to 2140) by the organizer of the scheme, who uses the pseudonym Satoshi Nakamoto. Since the number of new bitcoins allowed halves every four years, and computers are getting steadily faster, the complexity of the computation required to produce each coin is increasing rapidly.
Once bitcoins have been produced and authenticated, the miners are free to exchange them for U.S. dollars, at the market-determined exchange rate. Alternatively, they may use them to buy goods and services from anyone willing to take bitcoins in return.
It might seem that Bitcoin is just like a fiat currency issued by governments. Writing in the Wall Street Journal, Jack Hough says precisely that it's a purely online currency with no intrinsic value; its worth is based solely on the willingness of holders and merchants to accept it in trade. In that respect, it's not so different from fiat currencies like the dollar or Euro, but whereas governments back such money, Bitcoins lack central control.
But this is a misunderstanding of what money does and where it came from. The “fiat” (meaning “let there be”) in “fiat money” reflects the power of governments to command and tax. Because of their power to tax, governments can make money by fiat, simply by declaring their willingness to accept that money in repayment of tax debts.
Historically, money arose from, and in conjunction with, this power. (This point has been made repeatedly over the years, most recently in David Graeber’s controversial Debt: The First 5000 Years, a surprise publishing hit for an anthropologist. )
By contrast, Bitcoin looks more like the “just so” story, commonly told in economics textbooks, in which money arises to simplify what would otherwise be complex and cumbersome barter transactions.
That would be fine if Bitcoin were simply a unit of account, used to keep track of transactions. But all the interest in Bitcoin is in the idea that it is a store of value, one that may be expected to show steady appreciation rather than depreciation. So Bitcoin needs to be evaluated as a financial asset.
Viewed in this way, Bitcoin is perhaps the finest example of a pure bubble. It beats the classic historical example, produced during the 18th century South Sea Bubble of "a company for carrying out an undertaking of great advantage, but nobody to know what it is." After all, the promoter of this enterprise might, in principle, have had a genuine secret plan. Bitcoin also outmatches Ponzi schemes, which rely on the claim that the issuer is undertaking some kind of financial arbitrage (the original Ponzi scheme was supposed to involve postal orders). The closest parallel is the fictitious dotcom company imagined in Garry Trudeau’s Doonesbury, whose only product was its own stock.