On March 20, 2014, a $500,000 home in Bali became the largest transaction made using bitcoin, the decentralized virtual currency. Five days later, the Internal Revenue Service issued a ruling declaring that bitcoin will be treated as property for tax purposes and subject to the same regulations as stocks. To put that in perspective, if the anonymous purchaser of the $500,000 villa paid using bitcoins acquired on February 17—when the conversion rate of dollars per bitcoin was extremely low—on March 20, that purchaser would be required to declare and pay tax on a capital gain of $283,333.
There are different first responses to the news. The decision is seen as the first move in keeping an eye on the enigmatic, occasionally criminal activities that are connected to bitcoin by people worried about security in the Internet Age. In addition to seizing over 26,000 BTC, which was worth around $3.6 million at the time, the FBI also shut down Silk Road, the “ebay for narcotics,” in October. The decision indicates that bitcoin is getting closer to the mainstream, as legal property now and hopefully as a recognized, nationless currency in the future. This is exciting news for those who are captivated by bitcoin as an experiment in monetary independence. In any case, new financial technology is progressively compelling governments around the world to act.
The IRS ruling’s clearest and most significant message is that bitcoin is still not accepted as legal tender in the US. It was a wise choice. Because of the similarities between bitcoin and the gold standard and the damage that a deflationary monetary system does, it can be beneficial to visualize what would occur if bitcoin became a significant international currency in order to understand why.
Beyond the metaphor of “mine,” which depicts how new bitcoins are discovered using processing power, there are other parallels between bitcoin and the gold standard. In particular, both have a deflationary bias, which means that eventually prices will tend to decline regardless of how they operate. Since bitcoin is so unstable, some economists, like Brad DeLong of Berkeley, doubt that it can even serve as a store of value. Figure 1 How, then, can there be a clear trend?
A arbitrary cap of 21 million BTC is placed on the entire supply of bitcoin. Simply said, inflation is impossible without increasing the money supply. This was Milton Friedman’s compelling justification for price fluctuations (though Friedman was more concerned with too much expansion of the money supply leading to too much inflation). The generation of bitcoin slows down every four years, according to the bitcoin protocol, which means that the money supply eventually comes to a grinding halt.
The inability of central banks to stop deflation is another political factor that makes both the gold standard and bitcoin susceptible to it. Few central banks in the interwar period had the authority to engage in open market operations, and discount policy was weak as a result of little borrowing by private banks. That powerlessness, however, is intentional; according to the bitcoin website, “Bitcoin is open-source; its design is public; nobody owns or controls Bitcoin and everyone may participate.” Bitcoin lacks a central bank. It is money that is unhindered by the government.
Then again, what’s wrong with deflation? Why did Ben Bernanke and Shinz Abe battle it like their financial foe? I will wait to buy a good if the price drops from what it is now to a lower level in the future. The economy slows down if everyone has this mindset. Deflation also indicates decreased demand for labor, which leads to unemployment since falling prices do not necessarily translate into falling wages. Increased effective interest rates, lower investment, and decreased demand are further effects of deflation. The final channel should ring true because deflation puts stress on bank equity, which was a major factor in the financial panics during the Great Depression.
In a recent essay, Paul Krugman stated that it is “always crucial and always difficult to separate positive economics—how things are—from normative economics—how they ought to be.” It should be understood, however, that in the case of bitcoin, how things are does in fact suggest how they ought to be. The danger of a deflationary monetary system is an important lesson from 1925 to 1936 for 2009 and beyond, a lesson that the officials responsible for the IRS’s recent decision rightly understood.
