The price of Bitcoin, the electronic currency, is soaring again after regulators seemed relatively supportive of the virtual currency during a Senate hearing this week.
The tone from the hearing appears to have encouraged those who trade in the digital currency that the legal risks of holding it — that the government would find a way to quash Bitcoin entirely or regulate it into oblivion — have been overstated, and that the currency could eventually become more and more useful for transactions around the world.
That was enough for Bitcoin's price to jump, from $600 before the hearing to as high as $900. Holders of Bitcoin are, by extension, a good bit richer today than they were yesterday or last week (we're looking at you, Winklevii).
Yet this run-up is also an example of one of the most profound challenges that Bitcoin faces in becoming widely used in mainstream commerce.
For a currency, wild swings in value are a bug, not a feature, even (perhaps especially) when that swing drives the value upward.
Think of it this way. Say your local coffee shop accepted Bitcoin as payment. In the last 24 hours, the shop's price for a grande latte would have risen 50 percent and then fallen something like 15 percent. The coffee shop might have chosen to let its real price fluctuate by leaving the price of a latte at some fixed level (say 0.05 Bitcoin). Or it could have kept the real price unchanged by switching up the nominal price every hour, or even in real time. As in, a latte that cost 0.05 Bitcoin in the morning might have cost 0.03 Bitcoin in the afternoon.
That's called a menu cost — the hassle factor of constantly changing prices. It is usually discussed in the context of high inflation.
In Weimar Germany, for example, the price restaurants charged for a meal was higher by the time you were finished eating it than when you sat down to order. The menu cost also applies just as much to deflation, or falling prices, as it does rising prices.
In other words, as long as Bitcoin is volatile, it won't be a particularly good currency for use in routine commerce.
But why is it so volatile? Unfortunately for Bitcoin enthusiasts, that volatility is deeply entwined with the currency's raison d'Ãªtre.
Bitcoin is “mined” by technologists solving difficult problems. That means its supply is set to increase at a constant rate, not a rate tied to demand for the currency at any given moment.
So when the enthusiasm for Bitcoin bursts (such as from a friendly Senate hearing), no one has the ability to immediately produce more supply to satiate it.
Conversely, if some legal action crushes demand, and sellers flood the market, no entity is in position to drain that extra supply and keep things stable.
The fact that demand for money fluctuates isn't unique to Bitcoin. It happens with dollars, too.
In the fall of 2008, for example, demand for dollars grew so much that severe deflation surely would have set in had an official entity not been around with the power and will to create trillions of new dollars to satiate that demand and keep prices relatively stable.
Fortunately, there is a possible solution for Bitcoin's volatility problem: some kind of central institution. A bank of sorts. One with the bottomless ability to either pump extra Bitcoin into the market or suck it out, depending on what's needed to maintain stable prices.
With all that power, measures need to be taken to ensure that this Bitcoin overseer is independent and credible.
Of course, you'll need somebody to run it.
And if outgoing Federal Reserve Chairman Ben Bernanke doesn't get a job running a central bank for frequent flier miles, as endorsed in this space a few weeks ago, maybe Bitcoiners can give him a call.