Bitcoin broke $1,000 last week after Fed chief Ben Bernanke told Congress that virtual currencies “may have long-term promise.” Bitcoin is, of course, the most famous virtual currency. People can use bitcoins—which are just strings of numbers—to buy goods and services by transferring them electronically across the Internet. Enthusiasm about bitcoin has soared with its price, but the theories as to why are as speculative as the currency itself. Many critics see a bubble based on thegreater fool theory that if I pay something for a worthless asset I can make profits by reselling it at a higher price to someone more foolish than I am. Other former skeptics, like Business Insider's Joe Weisenthal, are coming around. To cut through the confusion, one needs to see that there are two different theories as to how bitcoins work—a wrong theory which is driving the excitement, and a banal theory which may leave a marginal place for bitcoin in the financial system.

The exciting, wrong theory is that bitcoin will become a self-sustaining currency that replaces fiat currencies like the dollar, yen, and euro. People will prefer bitcoins to regular currencies because those currencies are controlled by central banks, and hence ultimately governments, which from time to time find it irresistible to use inflation to finance wars, bridges-to-nowhere, and other foolish projects. Because the supply of bitcoins is limited, there is no inflation risk. The price of bitcoins has taken flight because investors believe that people will eventually see the advantages of virtual currencies and scramble to acquire them for their virtual piggy banks.

The problem with the argument is that the money supply needs to be flexible so that the government can address economic ups and downs. Bitcoin’s supply is fixed by algorithms that require increasingly immense computer power to mine new coins. The various experiments with currencies that are fixed to something out of the control of a government (gold and foreign currencies) have always ended in tears, usually when an economy enters recession and the government finds itself unable to devalue the currency in order to stimulate exports or domestic investment. In the unlikely event that bitcoin ever threatens the dollar, the U.S. government would shut it down. And if somehow bitcoin nonetheless thwarted efforts by the government to control it, it would surely be a victim of its own success, as other virtual currencies would flood the market, resulting in a volatile situation in which exchange rate risk—a problem faced by exporters and importers—would exist at home as well. Indeed, at least 30 virtual currencies have already entered the market. 

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