Commenting on Thomas Lowenthal’s original article at ArsTechnica on Bitcoin and the dangers involved in introducing a new currency.
The closest parallel to a pure digital currency play is the travails of paper money. Coinage is at least based on the value of the coin making up the face value. Paper money has no such associations which is why the gold bugs still want to return to the standard.
Money is only valuable when backed by a government that can use sufficient force to ensure that it will be used for all trade, debts and promissory notes. When a person asks, “You and what army?” a government can easily respond.
The reason paper money failed so often (going back to the first paper money issued in China … oooh, 1,300 or so years ago?) was that either the scrip was private (issued by banks / money lenders) or governments were insufficiently unified. When people suffered doubts then merchants would just refuse to accept the scrip, inflation would go supernova and the currency would fail.
The alternative is Dutch Disease, where the scrip is seen as more valuable than it really is and you get a bubble (dotcom stocks – or buying LinkedIn stocks today).
The problem with Bitcoin is a bit esoteric. Another of ArsTechnica’s writers (Tim Lee) has waded in on the potential for scrip issuers to collude and debase the currency. Ignore all the tech jargon and Bitcoin works very similarly to the US currency system. Money supply is set, but individual banks are permitted to “create” new money based on their internal reserves. The liberty which banks have to create scrip is managed by the Federal Reserve who decide whether more money needs to be created (to support growth) or less (to reduce inflation). If the Fed does a good job, all is well. If they do a terrible job you get runaway inflation or, worse, asset-price bubbles.
Bitcoin doesn’t have a version of the Federal Reserve. Because of the distributed model, and lack of oversight or punitive punch (i.e. there is no army), Bitcoin vendors can collude to create more cash in circulation than the original algorithms would permit. Bubble, boom, crash.