Bitcoin is in hyperdeflation
Bubble or not, the underpinnings of Bitcoin pose problems to its use as a popular currency.
Business Insider's Joe Weisenthal covers the still-soaring price of Bitcoin – which has now broken $100 – and puts an interesting spin on the situation: the Bitcoin economy is now suffering hyperdeflation. He writes:
So a few weeks ago, a pizza might have cost you one Bitcoin. Today it might only cost you a fifth of a Bitcoin, which sounds great, but then if you're looking at the above chart, why would you spend anything?
Why would you buy a pizza (or pot or anything else) when tomorrow your Bitcoin will be worth more? With this kind of chart, you'd be insane to do anything but hoard your coins.
So yes, all the hype is great for some folks in the ecosystem, but ultimately there's a reason that over time, government prefer to see their currency slowly depreciate. A surging currency leads to hoarding which kills real transactions.
I've written repeatedly that I think the current price of Bitcoin is the result of a volatile bubble – though I'm no more certain than anyone else as to when that bubble will burst – and that explanation is part of the reason why. The faster the Bitcoin price rises, the fewer actual transactions you'll see being made with it. Insofar as there is a "real" price of the currency, as opposed to the inflated price it's showing now, that must be based on people actually using Bitcoin, rather than hoarding it. While the currency is in hyperdeflation, that won't happen (outside of a few crazy people doing things like selling their houses in it).
But while the bubble-like price of Bitcoin at the moment must be separated from its long-term prospects, those are also harmed by the promise of deflation.
The way the currency works, an ever-decreasing amount of new coins are introduced to the money supply, until 2140, when every coin in existence will have been created. Since Bitcoins can be destroyed – losing the private key for your account is basically the same as shredding your wallet – the economy will actually enter deflation some time before then, even counted in Bitcoin terms. With deflation comes hoarding, as things become cheaper to buy in the future rather than now; and that slump in demand would have the same effect as a permanent recession.
A normal currency could implement some unconventional policy to fight that. A tax on cash holdings, for instance, would serve to drop the real interest rate low enough to prompt some spending again. But that can't happen with Bitcoin, where holdings are anonymous by default, and – let's be honest, here – a large proportion of the actual use of the currency is criminal in nature.
Bubble or not, the underpinnings of Bitcoin pose problems to its use as a popular currency. Hyperdeflation may not spark the same populist fear as hyperinflation, but it's just as bad.