Today I corresponded with a journalist from the German weekly magazine Der Spiegel about the Bitcoin phenomenon. For those who haven't heard about bitcoins, this is one of a number of new "digitial currencies" that are created and stored electronically. They are also called cryptocurrencies because they make use of novel forms of cryptographic algorithms. There are some very useful write-ups on the Bitcoin phenomenon in The Economist magazine on June 13, 2011 (Virtual currency: bits and bob) and on October 21, 2011 (Virtual currencies: The bursting of the Bitcoin bubble).

Bitcoins is, on balance, a terrible idea. In short, as a currency it will never have the same liquidity as a fiat currency backed by a government. Because of limited supply and demand, volatility in the Bitcoin price will render this currency useless as a "safe haven" from currency turmoil elsewhere. Bitcoins may also run the risk of bubbles and speculative attacks. From a monetary economics perspective, Bitcoins suffer all the same problems as any other commodity-based currency such as a gold or silver standard. In fact, the gold standard contributed its fair share to the Great Depression by handcuffing monetary policy when monetary stimulus was the only way to stop deflation. For a modern economy, a commodity-based currency provides too little flexibility. In the presence of economic growth and a fixed supply of currency, deflation is programmed into the economy!

The rise of Bitcoins makes a good point about the transaction costs dealing with conventional currencies and making payments over the internet. We are thoroughly lacking a cheap form of cross-border payment. For example, credit card payments incur a steep "discount" (usually 2-4%, sometimes more), collected from the merchants but ultimately paid by the consumers. Bank charges are often not reflective of their true cost. We are also lacking a good system for micropayments (say, anything less than a dollar) except where you buy from the same merchant (e.g., Apple iTunes). The novel cryptographic algorithms in the Bitcoin system are quite nifty, and the Bitcoins transaction mechanism has many appealing features that computer specialists will appreciate and applaud. A practical problem is the trade-off with respect to anonymity. Anonymity in cross-border transactions has obvious risks and challenges, and quite troublingly, Bitcoins have been implicated in money-laundering by US senator Charles Schumer.

There is also the risk that someone may hack the bitcoin algorithm and steal someone's bitcoin stash. Even a good algorithm may have vulnerabilities. Where there is money, there will be thieves, bitcoins or not.

I can't see Bitcoins taking off as a replacement for fiat currency, and neither should it. Because of the current problems with the Euro, a lot of people are looking for "safe havens". Some flee into gold (bad idea as the price of gold is utterly through the roof) and others into obscure schemes such as Bitcoins. Money is just a form of trust—the trust that someone will accept the currency in exchange for goods and services. Currently, few merchants accept Bitcoins—and those that do are mostly doing this for the publicity it entails. But the Canadian Dollars and US Dollars that I carry in my wallet are accepted widely. I for one trust the Bank of Canada, which is comfortably independent and has an excellent track-record.

At the end of the day, Bitcoins appeal to those who distrust central banks. Arguably, over the course of history one can point to plenty of central banks that have let down the citizens of their respective countrues. It took a long time to understand how to make central banks work well, and independent from political interference. Today, we have a large number of central banks that have this independence and an excellent track record—and yes, we also have still a fair number of central banks that lack independence and/or competence. And for those that worry about inflation, the long-term safe haven for that is real assets (company stocks, real estate).