View source for Bitcoin is ludicrous, but it tells us something important about the nature of money

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There was a great piece in the satirical news source The Onion a few years ago in which it “reported” that Fed chairman Ben Bernanke experienced a moment of existential panic during a congressional hearing as he paused, shook his head, and said, “It’s just an illusion . . . Just look at it: meaningless pieces of paper with numbers printed on them. Worthless.”
Sayeth the Onion headline: “U.S. Economy Grinds to Halt As Nation Realizes Money Just A Symbolic, Mutually Shared Illusion.”

It’s all just an illusion, man.

Which brings us to bitcoin. It is a digital currency, which a certain variety of techno-utopian futurist crowd views as a form of money unencumbered by the shackles of privacy-reducing international anti-money laundering laws and inflation-tolerant central banks. Its value has been extraordinarily volatile over the last several weeks, rising from $20 a couple of months back, to over $250, to around $60 on Friday, with a couple of trading halts in between.
Bitcoin really is a tiny market in the scheme of things, and its recent gyrations mean that the dollar, euro and yen have nothing to fear from the competition. If a currency can lose 75 percent of its buying power in two days, it may not be the best store of value. But it also an important window into the strange and uncomfortable mystery of “What is money,” which is a harder question to answer than one might think.
We can all agree that the dollar bills in my wallet are money, as are the quarters and dimes in the jar on my dresser. So are the funds deposited in my checking account. The investment I have in a money market mutual fund probably counts, too; after all, I can write a check from that account and use it to buy things. Gold isn’t money, but can be readily traded for money, so it can be a reasonable substitute if you’re into that sort of thing. My refrigerator is definitely not money; even though it has value, it would be a lot harder than gold to convert it into money if I fell on hard times.
The common thread here is that money has almost nothing to do with physical form. It also doesn’t have much to do with who creates it: The dollar bills were issued by the Federal Reserve, the checking account created by my neighborhood bank, the money market fund was created by a mutual fund manager, the gold was mined out of the ground, and the refrigerator was made by General Electric.
Rather, what makes money money is what you can do with it. If you can purchase the goods and services that you want and need with it, it is money; if you can’t, it isn’t.  Money is memory, said Narayana Kocherlakota in an important 1996 paper (he is now president of the Minneapolis Fed). It is the way we as a society record how much capacity to buy stuff each of us possess. In other words, The Onion was right. Money really is just a symbolic, mutually shared illusion.
That reality has important implications for all the monetary debates that captivate people today, from David Stockman’s assailing 80 years of economic policy to fretting over whether the Bank of Japan will unleash some dangerous inflation genie with its new bout of activism to the question of whether the euro zone can hold together.
Once you accept that money truly is an idea rather than a thing, it becomes clearer that there is no single “right” way to run a monetary system. It is merely trying to figure out, through trial and error (and mankind has had plenty of error over our history), what system works best.
Some societies, including this one until 1933, have strictly tied the value of their money to gold or other precious metals. That has some advantages, most notably that a government can’t create more of it from thin air and thus allow inflation to take hold. But it has some significant downsides as well. For one, the government may not be able to create new gold from thin air, but miners can definitely get it out of the ground. And it is a strange state of affairs when the price level of an entire society is allowed to fluctuate based on advances in mining technology or the discovery or non-discovery of new reserves.
All of the advanced nations in modern times instead have a central bank to be in charge of issuing money. The logic is that rather than tie the value of money to some material, instead put some politically independent, sober-minded economists in charge and assign them some goal. In practice, many countries have made that goal “manage the money supply so that prices rise about 2 percent each year, no more, no less). Because these institutions are imbued with the power of the state, the money they issue has the credibility of the entire government behind it.
As Joe Weisenthal wrote Thursday, “the U.S. dollar isn’t just important because other people think it is. The U.S. dollar is important, because the world’s strongest entity, with the full force of the U.S. army, the FBI, the CIA, the NSA, and various local authorities with guns demands that you pay them in U.S. dollars. That’s not faith. That’s the law.”
So why would somebody want to go and invent bitcoins? There is a certain theoretical elegance to the idea of a borderless currency, with its supply limited by the difficulty of working out very tough mathematical problems. But going back to where we started, money is useful inasmuch as it can be used to buy things. And two massive things stand in the way of bitcoin ever being anything more than a monetary curio. Ironically, both are byproducts of the things that bitcoin enthusiasts most like about it.
First, because it has the endorsement of no government, it will never be usable for official transactions. If you are an American, you will eventually have to pay your taxes, which means getting hold of some dollars, and as long as everyone needs to use dollars, that will be the way the currency in which an overwhelming majority of U.S. transactions occur.
Second, the cap on the supply of bitcoins may reassure people that there will be no inflation, but in fact it ensures that it can never go into widespread use. A currency needs to be elastic — that is, its supply has to rise and fall in order to keep prices stable even as people’s demand for money varies. Part of the reason the Federal Reserve was created a century ago is that the dollar was at that time an inelastic currency, its supply was basically fixed based on how much gold banks had in their vaults. That meant that when harvest season came around in what was then a heavily agricultural nation, there was always a shortage of cash and a spike in interest rates, and in some years a banking panic.
Bitcoin exacerbates that problem. Its supply is capped in the long run. That means that if it ever came under widespread use, demand for bitcoins would rise faster than supply (which is what happened between February and earlier this week), and the price rise rapidly. That may sound good — your money is more valuable! — but in fact it means that prices of goods and services are plummeting. That’s deflation, which as the Great Depression showed us, is not much fun. It is a situation in which everyone has every incentive to hoard money rather than spend it, leading the gears of commerce to grind to a halt.
In effect, bitcoin is a reminder of this fundamental truth: To function in a modern economy, you’re always putting your faith in something, whether you like it or not. And you may not like putting that faith in a powerful, independent central bank imbued with power from the state, but the alternatives may just be a lot worse.
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