Two big things have happened in the cryptocurrency world recently. The first is that there are now two competing versions of bitcoin: bitcoin core and bitcoin classic. There is quite a lot of argument about which will become more popular. The second development is that the price of bitcoin – now known as bitcoin core – rose a lot in late 2015.
This has raised the expectations of many cryptocurrency buffs that bitcoin will replace the fiat money printed by central banks.
But when I read these debates, I see a lot of misunderstanding. Whether people are talking about which version of bitcoin will prevail, or whether cryptocurrency in general will replace fiat currency, they keep making the same error.
That error is the assumption that long-term value is what makes a currency good. The truth is it’s almost the opposite.
Ben Bernanke and Harold James noted in a 1990 paper, the countries that abandoned the gold standard soon began to recover.
Skeptics will note that although liquidity is the primary source of money’s value, it isn’t the only source. You also need money to hold its value over short periods of time. There’s a lag between when you get money and when you spend it. You’d like the value of what you exchanged for the money to be very close to the value of the things you spend the money on a little while later.
So if you want money to be a good short-term store of value, you need it to have low volatility. That’s the main reason high inflation is bad, actually. It also tends to be very volatile, making money’s value more uncertain in the short term, which gets in the way of money doing its job.
That’s why central banks try very hard to maintain their inflation-fighting credibility. If people believe that the central bank might decide to devalue the currency at any time, then they will have an incentive to abandon the currency for alternative forms of payment, like bitcoin, gold or a foreign currency. Fears of central bank irresponsibility could thus become self-fulfilling prophecies.
The currencies of rich countries such as the U.S. and Japan are remarkably stable in value. Both inflation and the volatility of inflation have rarely changed dramatically month to month, especially after the mid-1990s. People expect this state of affairs to continue – they think the dollar isn’t risky in the short term. And that is why the U.S. dollar remains a good form of money. Compare this to bitcoin’s price, which gyrates all over the place!
Now, in the financial world, we expect low risk to come at a price: poor long-term returns. And in fact, the value of the U.S. dollar decreases over time, at a very slow consistent rate. That’s exactly what finance would predict – in exchange for being a good short-term store of value, good money is a terrible long-term investment.
So for people who want to make bitcoin replace fiat currency, I have some advice: focus on low volatility. Instead of getting people excited about investing in bitcoin, focus on finding a way to stabilize the amount of real consumption goods that people can buy with each bitcoin. My suggestion? Peg the currency to the price of a Big Mac.
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Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications. For more columns from Bloomberg View, visit http://www.bloomberg.com/view