BitCoin is Fatally Flawed

February 21, 2011

BitCoin is a peer-to-peer virtual currency based on strong cryptography that is starting to gain some traction for use in transactions for real-world goods and services. It recalls plot devices from Neal Stephenson’s Cryptonomicon or Daniel Suarez’s Freedom™ where major characters are involved in a nascent new economy based on some form of cryptographic cyberbucks. To a certain extent virtual currencies are not new. Edward Castronova has shown that virtual currencies in massively muliplayer online games (MMO) have virtual currencies that exchange into hard currencies and therefore the MMO worlds have GDPs that rival large nations. People will exchange hard currency for virtual goods. Consider that Zynga (Farmville, Mafia Wars) earned half a billion US Dollars selling virtual goods in 2010.

The thing that is different about BitCoin is that it is a peer-to-peer system and as such there is no central bank to control the money supply and no middle-man to mediate transactions. Transactions are anonymous, and secured through a public key cryptogrpahy system.The record of every transaction is stored on every BitCoin node. Ownership of BitCoins is established by possessing the private key used in transactions to acquire coinage.

Instead of a central bank, BitCoin uses a complex, brute-force mathematical function to generate currency. As nodes come online, the peers scale the difficulty of solving the problem such that over time the rate of currency creation will decline as it approaches a maximum of 21 million BitCoins in circulation.

My critique of BitCoin doesn’t depend on the cryptography. I’m willing to stipulate that the system is adequately secure for the purposes of this discussion.

The problem lies in the cap of 21 million BitCoins being created as well as inevitable loss of private keys which will cause coinage to permanently fall out of circulation. This is a deflationary system.

BitCoin is a Deflationary Currency System and That’s Bad

Let’s do a thought experiment. Suppose that the world lost confidence in US Dollars, UK Pounds and Euros and instead BitCoin became the standard transactional currency. Currently, a BitCoin trades can be exchanged for roughly one US Dollar, but if it were used widely by billions of people the exchange rate would have to change such that a single BitCoin is worth millions of Dollars. This is because the supply of BitCoins is capped at 21 million. Anyone who acquired BitCoins now at one-to-one exchange rate and held on to them would be a huge winner.

BitCoins can be traded in fractions up to 8 decimal places. If BitCoin were to ever to become a general currency used by billions, this precision would not be enough for minimum transactions to be small enough to buy consumable goods.

But wait, there’s more.

Suppose you are an appliance dealer. You buy appliances in BitCoin and sell them at a later time in BitCoin. But because the value of BitCoin is always increasing, you may well be forced to sell your appliances for fewer BitCoins than you paid for them. Loans have to be paid back with money that is more valuable than the money that was loaned. Even a 0% loan is unattractive if it must be paid back with currency that is worth 10% or 20% more than what was loaded. It becomes unprofitable to be in business. It becomes too risky to take a loan to start a new business. Money becomes more valuable but it goes out of circulation because everyone is terrified to spend it.

This scenario is call a deflationary spiral. BitCoin is designed to work like the Gold Standard in that it is a fixed pool of currency. But the fact is that having a fixed pool of currency is incredibly dangerous. The Gold Standard caused the Great Depression in the 20th Century and the Panic of 1837 in the 19th century. If you’re not convinced, I recommend listening to “Gold Standard, R.I.P” from NPR’s Planet Money podcast.

I don’t think BitCoin will ever come to this. Long before there is a Great BitCoin Depression, the world will have realized that it is a flawed monetary system. I think we’re much more likely to end up with in a future that conducts business in Facebook Credits than BitCoin.

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