Currencies are, ultimately, about stability. There are any number of wild variations and permutations on equities, bonds, and commodities for one looking to invest, trade, or just plain speculate. When one turns assets into currency, the idea is that you’re NOT speculating anymore. Unless you’re a FOREX trader, but those people are crazy. For the rest of us, the whole point of a currency is that its value is largely static.
You don’t want to go to the ATM, pull out $100, then find out the next day it’s worth half that. No, you can rely on that dollar being largely worth the same thing it was last week or month. The entire economy hinges on this concept. Otherwise we’re all taking live chickens to Krogers so we can barter for groceries. It’s no good. But, crazy as this sounds, it’s happened. Currencies crash, become worthless, and some have even ceased to exist. And the results can be devastating.
Do You Know the Value of a Bitcoin? Does Anyone?
Ultimately, a currency is not unlike a middle reliever in baseball: if people are talking about it, it’s probably a bad thing. You never see headlines like “Dollar Chugging Along Just Fine” or “Inflation Still at Modest and Sustainable Levels.” No, when a currency is front-page news, it’s more along the lines of “Hyperinflation Means Everything You’ve Ever Earned is Now Worthless” or “Why God? Why?”
So why are we even talking about this? Why have the arcane ins and outs of what money is been thrust into the public consciousness from the dark corners where they typically reside, picked over by obscure analysts and quants? In a word: Bitcoin. That’s the currency that has managed to dominate headlines recently. And, as one would expect, it’s not because it’s functioning as a stable, reliable means for engaging in trade.
The wildly-volatile online crypto-currency has rocketed to massive highs with equally sharp fall-offs. While some would have you believe that it’s the future of world finance, anything with such major fluctuations in value doesn’t have any value as a currency. There could be a time, down the road, where that’s the case, but for the time being it’s used almost exclusively by currency speculators.
But if Bitcoin does completely crash out, what happens? Fortunately, we have some historical precedent to help us understand how these systems rise, fall, and keep going after the worst has happened.
Currencies Backed by Nations
Without digging too deeply into the history of the gold standard (we’ll save that for another time), it’s important to note that currencies are backed by governments. The size and strength of a sovereign nation gives a currency a backer that will make people respect its value. So it’s typically a lack of stability for a country’s government that can lead to a lack of confidence and declining value. A military invasion or ongoing civil war can make a government look weak and ultimately erode the value of its currency. Also, the nonexistence of said government can put a real hamper on a currency.
For instance, the Confederate States of America printed their own currency starting in 1861. “Greybacks,” as they were known, were the accepted currency throughout the South. The bills were issued with a note stating that they would be worth a certain value “two years after the ratification of a treaty of peace between the Confederate States of America and the United States of America.”
Of course, said peace treaty never came. What’s more, as the years wore on and it became more and more clear to even the casual observer that things weren’t going to end well for the Confederate States of America, the Confederate dollar started to hemorrhage. It rapidly dropped in value until it was virtually worthless by the end of 1864.
Of course, this meant that anyone who had their money in CSA dollars ended up with some worthless scraps of paper. And this illustrates the fact that nobody likes to think about: ANY currency is effectively a bet on that currency’s government. Of course, the great irony is that, while thousands of Southerners were effectively wiped out when the Confederate dollar lost all its value, they’re currently collectibles. A Confederate $1,000 bill is worth upwards of $75,000 at this point. That’s gotta sting.
The psychology of hyperinflation is not entirely unlike that of a bank run. Banks don’t actually have enough cash on hand to cover all of their accounts at any given point in time. As long as everyone trusts the bank, it’s not an issue, but as soon as confidence slips, it can create a snowballing sense of fear that leads to everyone trying to pull out their money before the bank runs out.
Likewise, currency only has the value that we all agree on it having. Without that, it’s just slips of paper. So once anyone starts to get worried, they may start asking for more money to cover a perceived slip in value. Multiply this across an entire economy and things can start to get out of control. Like it did, famously, in Germany in the early 1920s.
Post-World War I Germany Goes Nuts
The erosion of a currency doesn’t necessarily require a major physical threat to a country’s government, though. Sometimes just good old-fashioned incompetence in a nation’s monetary policy can get you there, too. Take for instance Germany’s Weimar Republic.
Admittedly, Germany found themselves in a tight spot after World War I, forced to pay reparations to the allied nations who were, understandably, a little peeved that Germany had managed to fight the majority of the war on the territory of other countries. However, Germany had borrowed heavily to fight the war, leading the Mark to devalue significantly, dropping about half its buying power against the US dollar in just four years.
Once the massive tab came due on the money owed, Germany started scrambling to find a way to pay. Without gold reserves or foreign currency, they decided to print money. Which was a great solution to the problem of paying reparations. I mean, it wrecked the economy completely and led to a state of hyperinflation where the paper mark was ultimately 1 trillion times less valuable in 1923 as it was in 1914 (not an exaggeration: literally trillion with a capital T).
The resulting economic disaster has since become legend, and an oft-repeated cautionary tale for those who favor a more conservative approach to monetary policy. Old ladies took wheelbarrows of cash to stores to buy a single loaf of bread, people used paper marks as wallpaper because it was far cheaper, and thieves would steal laundry baskets full of money. Just the baskets, though. They would leave the cash behind.
What’s Different with Bitcoin?
Ultimately, Bitcoin is not the accepted currency of a single nation, or any wide group of people, really. And, as such, no one is relying on it for their livelihood. Not even the Winklevoss twins. And as such, maybe we can all take a step back and enjoy the ride to some degree of another. However, it’s worth noting that if the full faith and credit of an entire nation is no guarantee against a rapid devaluation, maybe Bitcoin has more trouble on the horizon than some are willing to admit.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer