By Matt Cropp
Since Mt. Gox was compromised, cratered, and shut down, much of the discussion in the bitcoin community has centered around the direct losses potentially suffered by traders. However, less talked about, but of equal (or greater) importance, is the effect of this crisis on the underlying bitcoin economy. While the losses to traders are the easiest aspect of the current situation to observe, much of the support for the value of bitcoin is derived from the size of the underlying goods and services economy, which was severely disrupted by the Mt. Gox crash in a number of ways.
First of all, as the dominant exchange market, a great number of businesses tied their prices to current price on Mt. Gox. When the exchange collapsed, such businesses were left with no sense of how much a bitcoin was actually worth and thus how much to sell their goods for. Some, such as SquareWear and CfVenture, arbitrarily pegged their prices to the rate of $15/bitcoin, which allowed them to keep doing business, but exposed them to greater levels of risk for a similar profit margin. For some enterprises, this sort of uncertainty was too much. After the crisis hit, Metaco.in (the newly launched social buying site) “decided to hold off on offering another deal for 48 hours. We thought it might be a waste to offer a deal right now. Lots of people don’t have access to their coins and the bitcoin world’s focus is not on e-commerce.” It is hard to know exactly how many other firms similarly decided to suspended (or even cease) operations, but it is clear that the inability to predictably price caused significant harm to the bitcoin economy.
Another blow has come from the fact that, as options have yet to be widely adopted by merchants, the primary mechanism for managing currency risk has been to cash out a portion of a business’ earnings into another currency such as Dollars or Euros (for a more in-depth discussion of this practice, see “Hedging Your Bets” in the June 6, 2011 issue of the Bitcoin Sun). According to an informal poll recently done on the Bitcoin.org forum, more than half of bitcoin business people were engaging in this strategy to some extent. With the collapse of Mt. Gox, those entrepreneurs found themselves unable to optimally manage their level of risk, which likely drove many to meet their needs in less efficient ways, adding drag to the growth of the bitcoin economy.
A final dynamic of the crisis that has hurt bitcoin businesses is the uncertainty experienced by Mt. Gox users. In general, anyone with money has two mental categories for their holdings: savings money and consumption money. Savings money can be viewed as a sort of base-line of wealth – an individual’s sense of financial self is rooted in this quantity, and they experience anxiety when the number drops below a certain amount. Consumption money, by contrast, is the variable amount that one has in excess of one’s savings base-line which can be spent without provoking anxiety that one is becoming less wealthy; this latter source funds most purchases in the bitcoin economy.
For a large number of bitcoin users, the Mt. Gox crisis radically altered their internal calculus. Since it was unclear when and how much of their money they would ultimately be able to extract from Mt. Gox, the size of their holdings on the site was mentally subtracted from their self-perceived wealth. In such a situation, the first “pool” that gets depleted in order to stave off the anxiety of seeing one’s self as becoming poorer is “consumption money,” and, as a result, many people either pulled back or completely ceased spending, to the detriment of bitcoin’s goods and services economy.
In economics, the Quantity Theory of Money demonstrates that the value of money is dependent upon the money supply and the velocity with which money moves through the economy. Since bitcoin keeps the supply of money predictable, the sustainable value of the cryptocurrency is ultimately rooted in the health of the bitcoin economy. As this crisis has reduced the velocity with which bitcoins move through the economy thanks to the aforementioned dynamics, we can expect that the price of bitcoin will stabilize substantially below pre-crisis levels, and its long-term recovery will be dependent upon the healthy growth of the underlying goods and services economy. Hopefully, this crisis has been a wake-up call that will spark diversification and strengthening of the currency markets, as the success of the whole project ultimately rides on the success of merchants’ use of bitcoins. If, on the other hand, such crises continue unabated, merchants will ultimately be forced to move to other mechanisms of exchange, and the bitcoin experiment will be at an end.