Chuck Moulton is the chair of the Libertarian Party of Virginia. The following was published July 16, 2013 on Cato Unbound.

Governments have historically done a terrible job administering monetary systems. Through a gradual inflation, the U.S. dollar has lost 96% of its purchasing power in the last 100 years. Even worse, the dollar’s inflation has been anything but stable, with booms and busts including episodes of deflation and double digit inflation. Yet compared with most other government monies the dollar is a paragon of stability. Currency crises around the world are frequent in the financial news – including the occasional hyperinflation.

It should be no surprise to any student of economics that when government has a monopoly on money, it will be mismanaged. A better approach would be a free market in money: currency competition among entrepreneurs. Bitcoin is one of the opening salvos in this battle with new developments happening in the crypto-world every day. There is software like Gunbot that automates a persons cryptocurrency trading so they can make the most profit. This is just one of the developments that Bitcoin has brought forward. In some respects it is very promising as an alternative currency and as a possible wholesale replacement for a national currency. In other respects it falls short.

Bitcoin is a fiat currency that has achieved popularity and value without the mandate of a government legal tender law. On the contrary, the government strongly discourages bitcoin use and has used regulations to frustrate its adoption. I’m unaware of any previous widespread adoption of a fiat currency through voluntary spontaneous order; they invariably have been imposed by coercive central planning.

Many cultures adopted gold as their commodity money due its high degree of marketability, which can be traced back to the following important characteristics: gold is uniform, durable, divisible, portable, and stable in value. This is why so many people still want to buy gold bullion sydney from places like Jaggards. Bitcoins compare with gold quite favorably by those metrics. Bitcoins are durable as just bytes on a hard drive; divisible and fusible because they are divisible to 8 decimal places; portable in that you can hold all bitcoins ever issued on a thumb drive; stable value is a bit questionable, but their growth rate is fixed by a technology rule, so seasons play no part in the supply side of their value; and uniform due to the block chain verification of bitcoin ownership.

The bitcoin protocol distributes seigniorage income among users who run decentralized mining software with spare processor cycles. A new block is created every 10 minutes that solves a cryptographic puzzle to verify the most recent transactions. Each block contains new bitcoins plus transaction fees in the form of tips. Specialized mining machines running arrays of graphics cards (GPU) now collect much of the seigniorage; some bitcoin clones such as litecoin seek to reverse that trend, making the computation more memory intensive to favor CPUs over GPUs. Bitcoin’s Cantillon effect – the redistribution of wealth to those who receive new money earlier when the money supply expands – benefits hordes of miners rather than a select group of primary dealers.

The price level of bitcoins is determined by the intersection of money supply and money demand from people wanting to buy bitcoin on a minute-basis.

Money supply of bitcoins is predictable due to a monetary rule: it will increase at a decelerating rate with some bitcoins created with each new block roughly every 10 minutes – that number halving every four years. This is a geometric series that converges over time to 21 million bitcoins. Because the rule is embedded in the program code, it is harder to modify than a rule imposed by central bankers, by statute, or even by the Constitution.

Money demand of bitcoins is more chaotic. Over time bitcoin has become more attractive due to money’s network effect: its value for any individual increases as more people use it. Positive shocks to money demand include prominent positive media mentions of bitcoin and popular websites beginning to accept bitcoin. Negative shocks to money demand include exchange shutdowns due to security vulnerabilities and government action.

Because the money supply is so stable, bitcoin’s price level variability is almost entirely attributable to money demand fluctuations. Normally currencies dampen or eliminate the effect of seasonal or event driven money demand shocks on the price level with an elastic money supply.

Commodity money has long-term money supply elasticity due to mining. If the price level of gold rises due to a rightward shift in money demand, this incentivizes more intensive mining of gold, which will push the gold supply curve right and thus return the price level to its previous long term equilibrium. Even though bitcoin analogizes its money creation to mining, it lacks this negative feedback mechanism. If the price level of bitcoin rises due to a rightward shift in money demand, this incentivizes more people to mine for bitcoins. But here the analogy falls apart. When more people mine bitcoin they will be able to solve the cryptographic puzzle quicker. The network automatically adjusts the difficulty of the puzzle to make it again solve in an average time of 10 minutes, taking into account the additional miners / CPU cycles doing work. So instead of adjusting the money supply curve, positive shocks to money demand just make the cryptography stronger.

Several economists have suggested changing the bitcoin protocol or creating a new cryptographic currency with a money supply that is elastic to money demand. A better and simpler policy would be to freeze the monetary base and let the money multiplier handle money supply elasticity. Fractional reserve banking introduces elasticity into the money supply through a money multiplier on the monetary base as deposits are lent out. Unfortunately there are not yet any real bitcoin banks that loan out deposits (Flexcoin is a money warehouse with 100% reserves). The money multiplier can either be controlled by a central bank manipulating interest rates or allowed to develop organically with free banking, which entails free-market interest rates and competitive bank-issued notes redeemable on demand for base money. Free banking does a much better job than central banks smoothing out seasonal variations in the price level due to Christmas shopping, farm harvests, etc.

George Selgin’s productivity norm research into deflation distinguishes between velocity and real output driven changes. In his model under a free banking system changes in money demand due to velocity fluctuations are matched by corresponding changes in the money supply to hold the price level fixed, but changes in money demand due to rises or drops in real output are allowed to fully affect the price level. Even if bitcoins were paired with free banking to stabilize velocity effects, we would still expect the price level to fall as real output rises.

One common problem with deflationary economies is making small change. Bitcoins anticipate this problem, as they are divisible down to 8 decimal places: buyers and sellers can trade 0.00000001 bitcoins. This also leaves open the possibility of micropayments for goods and services like viewing a webpage.

It would be entirely reasonable for a developing country to dollarize to bitcoins, embracing sound money as a replacement for a faltering, untrusted national currency. Coupling bitcoins with free banking both introduces elasticity into the money supply to smooth out the price level and also creates a physical manifestation of bitcoins that people can trade for goods and services without needing Internet connectivity. As a second best alternative to dollarization, a country could implement a currency board fixed 1:1 to bitcoins.

The biggest challenge to bitcoin and other alternative currencies is government intervention in the form of legal tender, counterfeiting, and anti–money laundering laws.

Legal tender laws encourage the use of a particular currency through three main mechanisms: public receivability for taxes, court enforcement for repayment of debt, and laws requiring use for spot transactions. So far they have not been an impediment to bitcoin’s gradual adoption as an alternative currency in parallel with the dollar, though no doubt that would change if domestic businesses began refusing dollar transactions en masse.

Counterfeiting laws have been used against other alternative currencies such as the Liberty Dollar, which was shut down on the grounds that its notes and coins resembled the dollar. Bitcoin is unlikely to suffer from this line of attack because it uses a completely different unit of account and has a unique sign (?).

Anti–money laundering laws have been bitcoin’s albatross since its inception. The relevant provisions (codified in the Bank Secrecy Act, the Money Laundering Control Act, and title III of the USA PATRIOT Act) boil down to registering, recordkeeping, and reporting requirements. By criminalizing innocuous behavior, these laws have made it easier to identify and prosecute drug traffickers and terrorists at the expense of a huge regulatory burden on financial institutions. Bitcoin is anonymous by design. There is a record of every bitcoin transaction; however, addresses are not easily tied to individuals, and people can create as many addresses as they want. On the Tor network, coin mixing services like Bitcoin Fog further obfuscate the source of funds and online black markets like Silk Road facilitate the anonymous sale of drugs. FinCEN wants to regulate bitcoin not because it’s an alternative currency, but rather because it’s a payment processor (anonymous transactions frustrate the goals of anti–money laundering laws); therefore, bitcoin exchanges have been targeted as unlicensed money transmitting businesses. It’s lose/lose: either the exchanges shut down, or they cripple one of the best bitcoin features (anonymity) by spying on their customers for the government. In this era of government monitoring of phone calls, email, instant messages, Facebook, Skype chats, postal mail, and income, we all should be very skeptical of anti–money laundering laws, which let the surveillance state monitor financial transactions.

The uncertain legal landscape and cost of complying with regulations discourage bitcoin adoption by risk averse companies. Also hurt are the unbanked poor, who can’t afford transaction fees charged by conventional banks, and immigrants, who want to cheaply send remittances to their families abroad; bitcoin could address both issues if regulation didn’t price solutions out of the market.

Bitcoin has great promise as an alternative currency or a replacement national currency; however, it has several technological issues that suggest a second or third generation cryptocurrency may be the one to finally take hold. The block chain size has been growing exponentially because it records all transactions ever, which means within a few years it won’t be storable on most hard drives. BitTorrent could store parts of the block chain in a distributed decentralized fashion though. Transactions are only processed every 10 minutes, requiring the customer to wait until the payment can be verified. This makes bitcoin a bit unworkable as payment for a book or a coffee at a normal store. In theory an intermediary such as a bitcoin bank debit card or redeemable paper bitcoin bank notes could process transactions faster internally and clear to bitcoins later. Or an alternative implementation could process transactions faster – for example, litecoin creates a new block every 2.5 minutes. The wildly variable bitcoin price level inhibits its adoption; however, this can be mitigated with fractional reserve bitcoin banks and free banking, using the money multiplier to make bitcoin elastic to demand. These issues are worrisome, yet surmountable.

Money is one half of practically all transactions. It’s too important to leave to government, which mismanages everything. Economists ought to look closely at bitcoin as a sound-money alternative to the dollar.