The popular view today is based on the linear Quantity Theory of Money. It seems to be common sense. If more units of a currency are issued, then the value of each unit should fall. Many people may not think of it in explicit terms, but the idea is that the value of one unit of a currency is 1/N, where N is the total money supply. If you double the money supply, then you halve the value of each currency unit.
Inflation, according to this view, is either the cause—the increase in the money supply itself. Or it’s the effect—rising prices. The Keynesians hold that inflation is good, and the Monetarists basically agree, though they quibble that the rate should be limited. The Austrians universally think inflation is bad.
The Quantity Theory is not based in reality. One should think of this theory like the Lamarckian theory of evolution. Lamarck asserted that changes to an animal’s body—e.g. its tail is cut off—can be passed on to its offspring. At the time, this theory may have seemed only common sense, and it was very convenient, if not tempting. The same is true with the Quantity Theory of Money. It is convenient, seems like common sense, tempting—and wrong.
The Fed has been inflicting Quantitative Easing on us for five years. There are many negative effects, but rising prices, today, is at best debatable. Certainly, even where prices have risen, the increase is not nearly proportional to the increase in the money supply. Advocates of the theory explain this by saying that the money hasn’t entered the economy, it’s sitting on bank balance sheets. However, money is always on bank balance sheets in a debt-based system, so this answer is not satisfying.
Enter, bitcoin, a cryptography-based currency and technology developed by someone with the pseudonym Satoshi Nakamoto. It has been designed to have a limited rate of growth in the total quantity of currency, up to a predefined cap. There can never be more than 21M bitcoins. The Quantity Theory says that this will make prices of goods measured in bitcoins stable.
One problem with this theory is that the real costs in terms of land, capital, and labor to produce things is steadily falling. Every productive enterprise is constantly seeking to drive cost out of production. If a currency had a constant value, then prices in terms of this currency would be falling.
As we shall see below, the value of bitcoin will be anything but constant. Without a mechanism for responding to increased market demand by creating more currency, there is a fatal flaw.
In the real world, when prices appear to be stable it is not because anything is static or unmoving. It is because there is constant arbitrage. Arbitrage is the act of straddling a spread. If one thing becomes more valuable relative to something else, then someone will take the arbitrage. For example, if the price of eggs in a city downtown rises relative to the price of eggs in a farm town 50 miles away, then someone will buy eggs in the farm town and sell them in the city. This will lift the price in the farm town and depress the price in the city center, until there is not much of a gap any more.
To continue with the analogy on to another point, what happens if the price of eggs in the farm town is higher than the price in the city? This arbitrage is one-way. Distributors can only buy in the farm town and sell in the city; they do not distribute in the other direction.
There must be another arbitrage or arbitrages, if the farm-city egg spread is to remains stable. Indeed, there is. If the price of eggs gets cheap in the city, then consumers will prefer eggs to other foods.
In the body of a vertebrate, every joint is stabilized by a pair of muscles. Consider the upper arm. The biceps flexes it, and the triceps extends it. Muscles can only pull, but not push. There must be a second, opposing, muscle to move the joint in the opposite direction. This is analogous to arbitrage, as each arbitrage can only pull a spread tighter in one direction, but not push in the other.
No market is more important than the markets for money and credit.
So what happens when the price of money itself rises? In thinking about this question and the answer, you should not look at the dollar. The dollar is defective by design and does not work the way proper money ought to. The dollar is the product of fiat, not of a market. Everything about it is driven by force wielded by the government.
It is more instructive to consider gold. Gold is produced by gold miners. They buy labor, oil, truck tires, machine parts, and they sell gold. As we saw above, they bid up these inputs and offer gold metal onto the market. The gap between the value of gold and the value of this broad swath across the major factors in the real economy is thus closed by the arbitrage of gold mining companies. This keeps the value of gold from becoming too high, or in other words allows gold to be produced in response to market demand.
What happens if market demand for gold drops? One reaction is that the jeweler and the artisan increase their activities. They tend to bid up gold metal, and sell jewelry and objets d’art onto the market. There is another kind of arbitrage, which is outside the scope of this article but it’s worth mentioning. If the demand for gold metal drops, then the owners of gold, otherwise known as savers, can lend gold for interest. This tends to press down the bid on the rate of interest.
Now consider bitcoin. Bitcoin is not a fiat currency. No government forces anyone in any way to use it. However, bitcoin is irredeemable. That is, there is no agreement by anyone to redeem bitcoin in exchange for a defined quantity of gold, silver, or any real good. With its fixed quantity, there are no arbitrages regarding the value of bitcoin. So what does this mean? What will happen?
The value of bitcoin will be set entirely by speculators. In gold, there are numerous forces in reality—i.e. numerous arbitrages—that will keep the value of gold tied to the values of every other thing in the economic universe. The value of gold in a free market is the exact opposite of untethered and arbitrary. The value of gold cannot crash and it cannot shoot the moon.
Satoshi Nakamoto ignored these forces, and his design does not provide for them. The value of bitcoin is not tethered by the value of labor and capital. It was assumed to be sufficient that its quantity is fixed. It is the exact opposite of sufficient—a fatal flaw based on the Quantity Theory of Money, which is flawed to its core.
The speculators will use bitcoin as a toy to generate profits (as they already do). When the value of bitcoin is rising, it will be obvious. Everyone has a chart, and they can pile on. The value can rise much farther than anyone would expect. Eventually, the chart will show a topping pattern. Momentum will dry up. The speculators can see this too, and thus will begin a collapsing wave of bitcoin.
If a giant speculative spike occurred in food, the consequence is that poor people starve. When the price crashes, the consequence is that food producers will go bankrupt. As bad as this is, the consequences when the value of money spikes and crashes are incalculably worse. This is because every business, including food growers, depends on a stable currency.
To understand this, let’s ask the following question. If you take two bushels of corn and feed it to raise one chicken from egg to market, did you create or destroy wealth? Which has greater value, two bushels or one chicken? To answer, we use the common denominator of money. If Two bushels cost ½ ounce of silver and a chicken is 2 ounces of silver, then feeding the corn to the chick creates value.
Simple cases like this can be (and were, in the ancient world) resolved without money. Complex cases cannot be. If you borrow money to buy land, erect a building, buy machines and inventory, then hire people to manufacture computer chips, did you create or destroy wealth? This question cannot be answered without a stable unit of measure. It would not have been possible to answer it in the ancient world.
Businesses keep books to measure profit and loss. The very principle of bookkeeping depends on a constant value of the unit of account, the numeraire. When the value of the numeraire spikes and crashes, then business which produce wealth can go bankrupt. At the same time others, which destroy wealth, can grow larger, employing more people and more capital to scale up their wealth-destroying activities. This is occurring today on a massive scale.
Bitcoin may make a great speculation today, because its unique combination of technologies enables many transactions that would otherwise be impossible (due to government fiat). If you live in a country that does not recognize your right to freedom of speech, you can trade your local currency for bitcoin, pay WordPress, and have your blog hosted safely outside your regime. There are many other kinds of legitimate transactions that are made possible by bitcoin.
Bitcoin would not work as the exclusive currency. Its unstable value is not suited to being used as the numeraire. For the same reason, it is not suitable for hoarding by wage earners. As I explain in In a Gold Standard, How are Interest Rates Set? it is the arbitrage between hoarding and saving (i.e. lending) that sets the floor under the rate of interest. If bitcoin is unsuitable for hoarding, then either it will not develop a lending market, or the lending market will not have a stable interest rate. A destabilized interest rate is the root cause of the ongoing global financial crisis.
Bitcoin works well as a foil to fiat currencies. It makes it possible for people to conduct business that would otherwise be impossible. If enough people participate, then it becomes more difficult and more unpopular for governments to act to squelch those activities. It’s a pointed object lesson, showing people what is possible in a less-unfree market. Hopefully it will motivate them to clamor for more freedom.
Only gold serves as the objective measure of value necessary to act as the numeraire. It is no coincidence that the quantity of monetary gold is not fixed, but has elegant mechanisms to expand and contract in response to changing market demand.
 See the Wikipedia entry on Lamarckis
 See my paper In a Gold Standard, How are Interest Rates Set?
 See my papers: The Theory of Interest and Prices in Paper Currency