Bitcoin, the digital cryptocurrency designed to enable anonymous peer-to-peer financial exchanges without the involvement of third parties, is having serious teething problems. However, most such problems are associated with bitcoin storage or conversion, and should settle down as the currency is more widely accepted. Assuming this happens, let's look at the strengths and weaknesses of a mature Bitcoin currency in a modern economy.

What is Bitcoin?

Going right to the source, the following is a quote from Bitcoin’s main page:

“Bitcoin uses public-key cryptography, peer-to-peer networking, and proof-of-work to process and verify payments. Bitcoins are sent (or signed over) from one address to another with each user potentially having many, many addresses. Each payment transaction is broadcast to the network and included in the blockchain so that the included bitcoins cannot be spent twice. (The blockchain is the distributed record of all transactions involving bitcoins.) After an hour or two, each transaction is locked in time by the massive amount of processing power that continues to extend the blockchain. Using these techniques, Bitcoin provides a fast and extremely reliable payment network that anyone can use.”

Each transfer from A to B is accompanied by a digital signature generated using the private key of A. While everyone can verify the signature using A’s public key, only A can generate a valid digital signature with which to transfer ownership of bitcoins. Ultimately, the ownership of bitcoins is defined by the series of transactions in which they have been involved. This distributed knowledge is the heart of the Bitcoin system.

For the purposes of this article, I’m going to presume that the Bitcoin system has essentially the attributes listed above, even though it may be vulnerable to some level of attacks and misuse. Just as bank robberies and fraud don’t destabilize a conventional monetary system, attacks on Bitcoin are arguably sufficiently difficult that they will be unable to destabilize Bitcoin.

What is money, anyway?

Money is a consensual system developed to avoid the cumbersome trappings of a barter-based society. It is usually considered to have six core attributes: to provide a medium of exchange, a store of value, a measure of value, and must be portable, fungible, and frangible. (Portable means it can be used anywhere, fungible means that the currency can be exchanged for itself without risking loss of value, and frangible means capable of being broken into fragments, for example to make change.)

To this list I add the attributes of natural scarcity and commercial uselessness. If money is backed by something common or easily made, establishing scarcity (controlling the money supply) will be challenging. On the other hand, if money is backed by a scarce material that becomes useful commercially, controlling the money supply again becomes difficult. This sort of linkage drives economic mechanisms that tend to produce very short and erratic economic cycles.

From barter to money

Barter exchange of chickens for a newspaper subscription (Photo: US Library of Congress)

In a pure barter economy, to make a transaction requires what 19th century English economist and logician William Stanley Jevons (who was incidentally the inventor of the Logic Piano, an early mechanical computer capable of performing logical inference) called a coincidence of wants; both parties to a transaction must want exactly what the other has to trade. If I have a batch of rabbit pelts and offer to trade some to a farmer for cornmeal, the farmer must want a batch of rabbit pelts more than he wants the cornmeal.

One of money’s purposes is to provide a more convenient medium of exchange, allowing goods and services to be transferred via an intermediary currency. In this case, my rabbit pelts are bought from me by a furrier for ten units of money. This arguably maximizes the value of my pelts, as the furrier has a personal and immediate use for them. I then use four of these units to buy cornmeal from a storekeeper, and, no longer needing to find a restaurant needing rabbit pelts to get a good meal, I also use three units to pay for a steak and bottle of wine to celebrate my commercial success. (Actually, I'm not sure I would want a meal in a restaurant that needs rabbit pelts...)

Money must also allow people to compare the value of dissimilar goods and services, and then hold that value into the future. In principle, how much money corresponds to various goods and services reflects a broad consensus developed through the workings of a free market. The ability of a currency to hold value is important. If my ten units of money might only purchase only five units worth next year, it would be inefficient to save money for future needs. Such problems make the economic future of individuals, companies, and countries a bit of a crap shoot.

A large rai stone on the island of Yap (Photo: Bartak Cieslak)

Finally, money must be practical for all intended uses. If you are the proud possessor of a four metric ton (4.4 ton) rai stone (a huge stone disk traditionally used as currency on Yap Island), taking it down to the trading post to buy a can of Spam (still considered a delicacy across much of the South Pacific) is not a very practical notion. Rai stones are not fungible, frangible, or portable. Some currencies work better for day to day economic transactions than others.

Poor choices for a currency

On one extreme, government-issued fiat currencies are associated with a long history of economic disasters. Fiat currencies (those declared legal tender by a government) are not intrinsically evil. Indeed, they can possess most of the features of a good, solid currency. However, a fiat currency is not naturally scarce, so scarcity has to be established by decree and willpower. The problem is that such currencies offer a beguiling target for manipulation of the money supply, usually for short-term political benefit.

A 100 quintillion pengo note issued in Hungary in 1946 was the largest denomination banknote ever issued (Photo: Timur Lenk)

As a result, fiat currency is naturally unstable against hyperinflation. The most extreme example on record was the post-WWII Hungarian bout of hyperinflation. The figure above shows a 100 quintillion pengo note issued in July of 1946, when the yearly inflation rate in Hungary was 1.3 × 10^16 percent per month. Not a good model to follow.

On the other extreme is the use of gold coinage as an absolutely fixed currency. No notes, no certificates, no checks, no leveraged loans; in short, a money supply equal to the amount of gold coins in circulation. This example requires a bit more detail to see its limitations as currency.

Does a pure gold coinage system serve as a reliable measure or store of value? That depends on your definitions. Given a fixed amount of gold, is there necessarily a fixed amount of monetary gold? Clearly not, as gold is useful.

About 70 percent of all gold is at least temporarily trapped in gold reserves, jewelry, artwork, or industrial uses. The dynamics and price levels of an economy depend on the gold that is actually circulating (known as M0), not on the total amount of gold possessed. Only about 30 percent of all gold would be available in the form of circulating coins (easily spent money).

However, illiquid gold can and does move slowly in and out of the real-time economy, thereby changing the effective money supply available to pay for goods and services. In a financial downturn, the same amount of circulating gold is chasing fewer goods, so gold loses some of its monetary value.

People who can no longer buy enough "stuff" on their income will convert some of their hoards or jewelry into gold coins so they can buy what they need. However, injecting additional gold into circulation drives further inflation, forming an inflationary cycle. Similar dynamics drive deflation during economic good times.

Increasing the amount of gold held within an economy (via mining or conquest) also has an inflationary effect. Perhaps the clearest example of gold supply-based inflation was the Spanish inflation of the 1600s, in which the massive infusion of gold and silver from the New World produced a most unusual inflation lasting for a period of nearly 100 years. The Conquistadors thought they were bringing home wealth, but in fact were only bringing money. This inflation affected the whole of Western Europe, and damaged the Spanish economy beyond repair, leading eventually to the end of the Spanish Empire and the rise of the British Empire.

There are numerous reasons, some described above, which suggest the value of goods and services as measured solely in gold coinage can be rather unstable, not making a very good foundation for a stable economy (although better than some).

Bitcoin as a currency: Pros and cons

For this section, Bitcoin is being discussed with the characteristics expected if it were a mature world currency. Just as in dealing with fiat currencies, the fact of bank robberies, fraud, swindles, and scams will not be considered as important unless Bitcoin has a particular vulnerability. In particular, we will be looking toward a point in time where Bitcoin no longer has major speculative traffic distorting its use as a currency. We will, however, assume an extreme case in which there is no fractional-reserve banking in the economy, so that loans don’t increase the money supply.At first glance, Bitcoin appears to be a rather pure fiat currency, save for not having been declared legal tender. There is, however, a huge difference. Bitcoins may have absolutely no intrinsic value (argued earlier to be a good property for a currency), but they do have a strictly defined intrinsic scarcity. The number of bitcoins issued for circulation will inflate from today’s 12.5 million to a peak of 21 million, which for all practical purposes will be reached in about 2025 (at that point the number will be less than three percent short of the peak.)

As with most currencies, the number of bitcoins actually in circulation will differ somewhat from 21 million. The M0 for bitcoins is reduced by saving, lost wallets (bitcoins that can no longer be accessed), government seizures of bitcoins without their private key (bitcoins cannot be reintroduced into commerce without the private key of the owner), and other potential modes of inactivation.

Deflation of prices in a Bitcoin economy is often put forward as a major reason not to depend on such a currency. However, a major goal of civilization is to reduce the effective price of goods and services as time goes on, so that each person becomes more prosperous. This argues for a natural role for deflation; indeed, neither inflation nor deflation pose major difficulties to an economy if they are reasonably predictable.

There are two main reasons for deflation to occur in an economy. Deflation is usually defined as a general drop in prices of goods and services. However, monetarists use deflation to describe a decline in the money supply. These are very different events with different consequences.

Deflation is often pointed out as a driving force for saving currency. After all, it will be worth more next year, so why spend it this year? When the money supply is decreased artificially, prices will fall, but a large set of future expectations, such as loan repayments, will be set on their heads. More loans will be unpaid, further reducing the money supply, and the increase in value of money decreases its velocity in the economy. The result is an artificial decrease of price levels, a feedback loop that can lead to a deflationary spiral.

In the case of a roughly fixed money supply, however, neither saving nor deflation exert an unfavorable influence on the economy. Saving actually becomes a new form of investment: investment in the growth of the overall economy. Next year a saver will own the same percentage of a larger economy. However, if an individual wants to seek more growth, they can loan their money out to receive, say, 1.03 times the amount of bitcoins lent when the loan comes due next year. People who will accept additional risk can start businesses, or invest in an existing business. The expectation is that most people will choose a degree of risk that will keep most of the bitcoins in circulation. None of this, of course, changes the money supply in the absence of fractional-reserve banking. Indeed, none of these investments requires a banking system at all.

Another issue often raised about deflation is deferment of purchases. Detractors claim there is a driving force to put purchases off to the future, as they will effectively be cheaper at that time. The counter-argument is that we continue to buy computers every couple of years, even though twice the computing power for the same price will be available two years from now. Why do we do this? We need extra computing power now. The actual direction of this deflationary driving force is toward an economy more tightly focused on what consumers need and prize highly, rather than on simply maximizing purchases. As always, the market makes such adjustments with a minimum of fuss, if left alone to do its work.

Although not restricted to a Bitcoin economy, a requirement for reasonable predictability of a market economy is that the market be as efficient as possible. In addition to freedom of information, this requires an absence of non-market influences. One such influence is questionable survival; free markets work best in a prosperous society.

Another is the effect of economically active entities that are “too large” in some sense. These can include government, monopolies, oligopolies, cartels, unions, and the like. A free market requires competition, which such entities are designed to restrict. Arguably the proper economic role for government is to enforce contracts and limits, but that is a story for another time.

If the psychological barriers to the term “deflation” are ignored, there appears to be no reason why a Bitcoin economy cannot run a healthy course, at least as far as the dynamics of money in the economy are concerned. Will a transition to some form of intrinsically stable cryptocurrency be made in the future? It seems a natural path, given our drive toward a culture of information.

Will Bitcoin itself be that currency? Personally, I doubt it. While Bitcoin is an important experiment, I suspect we will have a number of lessons to learn about cryptographic currencies before actually adopting one. However, I’ve been wrong many times, and momentum may overcome careful introspection once again. Time will tell.

Source: Bitcoin