A major correction in Bitcoin prices occurred this week, with the price plummeting from a high of $266 to a low of $105, last time I looked, it was back above $170 and climbing. In this article, I would like to discuss why this occurred and what it means for the currency system.
First off, I want to reiterate that the currency itself has not been compromised or damaged in anyway. The Bitcoin network continues to hum along just fine. The reason being given for the sharp drop in price is a massive influx of new subscribers to the largest Bitcoin exchange. Mt. Gox states, "Indeed the rather astonishing amount of new accounts opened in the last few days, added to the existing ones, plus the number of trades made a huge impact on the overall system that started to lag. As expected in such a situation, people started to panic, started to sell Bitcoin in mass (Panic Sale), resulting in an increase of trade that ultimately froze the trade engine!"
Some critics would say that these wild swings in price make Bitcoin a poor currency choice. I want to offer a rather simple counter argument to this. Prior to the 1933, the dollar represented a set weight of gold. When America operated under a gold standard, inflation over time was virtually zero. In terms of gold, purchasing power increased dramatically all the way up until the creation of the Federal Reserve. During that same time period, the value of gold fluctuated wildly in much the same way Bitcoin is doing today, yet the economy kept on chugging along just fine. Consider that under a gold standard, the price of gold is fixed. It cannot fluctuate against the dollar, because the dollar represents a weight, not a price. However, if we represent the price of gold in 1998 dollars, you'll be able to see the historical trends quite clearly. Gold is extremely stable in value over the long term, even if it might swing wildly in value during the short term. The market has proven itself to be quite capable of dealing with these large swings in a currency's value.
There were some banking panics that took place prior to 1933 (much like the Bitcoin exchange panics we see today), but the only times America experienced a major depression under the gold standard were the periods when the central bank monkeyed with the money supply (something that wouldn't be possible under a 100% reserve privately run gold standard). This is a key argument against centrally planned fiat money systems. Austrian economists directly relate inflation of the money supply to the business cycle. Ultimately, inflation is a form of theft, as it is directly responsible for stealing earned wealth from existing savings and transferring that wealth to those who get the new money first. The redistribution of wealth that results from counterfeiting (inflation) causes huge changes in the structure of production, along with a tremendous waste of real physical resources.
Bitcoin essentially operates exactly like a gold standard, only without the gold. Under a gold standard, gold basically sits in bank vaults unused. It is merely used as an accounting unit by banks to ensure that they aren't magically creating money out of thin air. With Bitcoin, the cryptography ensures that the accounting ledger entries are not tampered with, making an audit of a bank's gold holdings unnecessary. If you understand the economics of how a gold standard works, you will understand the economics of how a Bitcoin monetary system works. For those of you who are interested, I recommend reading Rothbard's, America's Great Depression along with, The Case Against the Fed in order to get a better picture of just how destructive our centrally planned banking system has been to the American economy.
Other common objections to Bitcoins are that they are deflationary, which leads to so-called "hoarding" that prevents full employment, worsens the position of debtors and creates downward pressure on wages. You can find answers to all of those objections in this article. I've also seen objections to Bitcoin by gold standard advocates who claim that digital account balances are inherently worthless. Obviously they aren't, otherwise our modern banking system wouldn't be functional today. I address the gold standard advocates in this article.
In conclusion, Bitcoin investors who are in it for the long haul have nothing to fear from these wild price fluctuations. Over time, the exchanges will become more robust and distributed, Bitcoin point of sale systems will become more widespread, prices will stabilize, and merchant acceptance will continue to expand at its present geometric rates. The Bitcoin monetary system offers us international digital currency transactions that are outside the control of sociopathic bankers and politicians. As such, it's not going away anytime soon.