It's pretty simple. It has to do with the fact that, from the beginning, bitcoin's mysterious inventor decided that there would only ever be 21 million coins. That limited supply means that any increase in demand can send prices soaring into the stratosphere, especially when people see everyone around them making a lifetime's worth of money in a couple of months. After all, the only thing worse than being the greater fool who buys into a bubble is being the greatest one who stays out and doesn't make any money off it.
What does it mean, though, if a “currency” goes up in value, like bitcoin has, from $775 last year to more than $17,000 today? Just that a single coin can now buy 22 times more stuff than it could before. Which, when you think about it, is the same as saying that the prices of everything else have gone down massively in terms of bitcoin.
About 95.4 percent, to be exact. That, to update a chart Bloomberg's Peter Coy put together a few years ago, is what the bitcoin inflation — or, in this case, deflation — rate would have been the last 12 months. That's pretty normal for it, too. As you can see below, bitcoin's extreme volatility means that prices tend to either rise 200 or 300 percent, or, more often, fall 80 to 90 percent against it. (To give you an idea of how extreme that is, the last time the United States experienced sustained deflation was during the Great Depression, when prices fell 10 percent per year).
Now, that last part might sound like a good thing — who doesn't like being able to buy more for less? — but it's death for a currency. Think about it like this. Would you ever take out a mortgage in bitcoin when you knew that what was originally, say, $200,000 worth of debt might turn into $3.4 million worth a year later? Or use it to pay for a big night out when those same bitcoin would be worth $169,000 not too far down the road? Of course not. Nobody wants to borrow or spend money they think is only going to go up in value — at which point you have to wonder whether it's really money at all.
And the answer is no. Just because you call something a currency doesn't mean it is one. It has to be a stable store of value that people actually use to buy things with. Bitcoin fails on both accounts. Indeed, in the past year, the number of bitcoin transactions is up only about 33 percent from what was (and is still) a very low level. That's nowhere near the type of hockey stick growth you'd expect from a technology that really was taking over the world.
What is bitcoin then? Well, the important thing to understand is that it's not just a failed currency. It's also a failed payment system. See, every time a new bitcoin is “mined” — they're released on a set schedule for anyone to win by running a computationally complex computer program — it updates a public record of every single bitcoin transaction. In theory, that could let you transfer things online without having to pay a trusted third party, such as a bank, to do so, since everyone already knows how many bitcoin everyone else has to send. In practice, though, all it's done is make you pay a new third party (the bitcoin network) even more than you were before. That's because bitcoin's limited bandwidth means that it can't even handle its limited number of transactions. There's a line, and you have to pay if you want to get near the front — an average of over $20 now.
So a bitcoin is just a share of this system. It's like stock in a newer-and-not-improved PayPal. Although that might be selling it a bit short. It's more like a time machine that exclusively takes you back to 1999, the peak of the dot-com mania. That was the last time people managed to convince themselves that something that shouldn't have been worth anything — like any company that lost money selling things online, or had a computer term in its name, or even a car dealer that claimed to have come up with a cure for AIDS — could be worth, yes, anything, because they were the future and anyone who said otherwise was just a Luddite.
But I'm sure this time will be different.