The Pink Cow is the first restaurant in Tokyo that lets you pay with Bitcoin, the world's most popular digital currency. In some ways, this California-Mexican cafe – a hangout run by an American expatriate who believes in new ideas – sits at the center of the Bitcoin universe. The digital currency was created by an anonymous computer programmer who many assume is Japanese, and the first big Bitcoin exchange – the web service where so many people bought their first bitcoins – is operated out of a Tokyo office not far from this wonderfully quirky bar and restaurant in the city's Roppongi district.

But when the Tokyo Bitcoin Meetup Group holds one of its weekly gatherings at the Pink Cow – bringing together Bitcoin enthusiasts from across the city and beyond – only about a third of them actually pay for dinner and drinks with bitcoins. People like Marco Crispini, an expatriate from Britain, and Aya Walraven, who moved to Tokyo from Canada, very much believe in the digital currency. And they own bitcoins. But they prefer not to spend them because their value just keeps going up.

>In other words: What they would have spent on a $20 Cal-Mex meal is now worth about $90

You can see their point. In the month since Crispini and Walraven declined to spend their bitcoins on burritos at a mid-October meetup, the value of the currency rose from about $160 on the Tokyo-based Mt. Gox exchange to well above $700. In other words: What they would have spent on a $20 Cal-Mex meal is now worth at least $90.

The trouble is that this sort of bitcoin hoarding leaves many questioning the future of the currency. If economic incentives encourage people to hoard their bitcoins rather than spend them, the thinking goes, the currency will never fulfill the extravagant promises laid down by the biggest believers, who say it will streamline monetary transactions, free the world from the financial manipulation of big government and big banks, breakdown the financial walls between nations, and, well, remake the worldwide economy.

The concerns are justified. Even some of Bitcoin's most ardent supporters – like Fred Friis, one of the Tokyo Bitcoiners who regularly spends his digital currency at the Pink Cow – say that the consistent increase in the currency's value is a "legitimate issue."

But Friis also says – and rightly so – that the issue shouldn't be exaggerated. According to many economists who have closely followed the progress of the digital money, Bitcoin's recent ups – and downs – are to be expected from a currency so young, a currency that is just now attracting major attention from the mainstream population. The bottom could fall out of the market, but the currency could just as easily stabilize and reach a point where its value is consistent enough that people no longer hoard the stuff.

Yes, Bitcoin is what some call a deflationary currency. Because the system was designed to allow the creation of only a finite number of bitcoins (see our "Bitcoin Survival Guide"), there will come a point where, as demand rises, the value of the currency will only go up (making the price of goods and services fall, hence the term deflation). And that could lead to hoarding on an even larger scale.

But that moment is a long way off, and it won't necessarily prevent the currency from flourishing, says Peter Rodriguez, a professor of economics and senior associate dean at the University of Virginia's Darden School of Business. After all, many deflationary currencies have flourished in the past.

"The analogy is gold," says Simon Johnson, a professor of entrepreneurship at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. "Gold is a finite resource, and until the big South African discoveries in the 1890s, there wasn't that much gold. But people were happy to make payments with it. The whole idea that people won't make payments with something that's finite and held as a store of value is not correct."

Bitcoin Deflated —————-

Matthew Yglesias, an economics journalist and pundit who currently writes for the online magazine Slate, has long questioned whether Bitcoin can survive in the long term. "If you have persistent deflation, then simply holding the cash becomes a way of earning a return," he tells WIRED. "If that's the case, your economy will be starved of funds for investment and won't be able to grow."

>'I wish Bitcoin had more inflation built in, to encourage people to spend money and create a healthy economy' Adam Sah

The main issue here is that the worldwide network of computers that controls the digital currency only creates a limited number of bitcoins every so often and will one day stop making bitcoins entirely. This will happen in about the year 2140, and as some people manage to lose their bitcoins – misplacing the digital keys that control them – the supply of the currency will actually drop.

In theory, this means that, if demand for the currency continues to grow, the value of bitcoins will necessarily continue to rise. The result, according to Yglesias and many others, is that people will have little incentive to spend their money – and the bitcoin economy will come crashing down.

This limited-supply issue is the most common argument against the viability of the new currency. You read it so often on the web. It comes up time and again at Bitcoin meetups like those at the Pink Cow. And it's a very real concern for merchants who accept payments in the digital currency. "I dislike the pure deflation model," says Adam Sah, the founder and CEO of Buyer's Best Friend, which accepts the currency. "I wish bitcoin had more inflation built in, to encourage people to spend money and create a healthy economy."

But this issue shouldn't be confused with what is currently happening in the Bitcoin world. Yes, we've seen a steady climb in the value of the currency, and yes, this has slowed spending at some merchants. Michal Handerhan – the CEO and co-founder of BitcoinShop.US – says that his sales have dropped 20 percent in recent weeks. "People are holding their bitcoins," he says, "and won't let go." But that has little to do with the limited-supply issue. It's just that the currency is experiencing some very normal growing pains as more and more people jump on board.

The limited-supply issue won't really come into play for many, many years, and even if it does cause problems, there are good reasons to believe that these problems can be alleviated – reasons that go to the heart of the Bitcoin architecture.

At the Pink Cow, a patron pays for his meal in bitcoins. Photo: Ariel Zambelich/WIRED

Portrait of a Bitcoin as a Young Currency —————————————–

Bitcoin is still so very young. It arrived little more than four years ago, when a programmer or group of programmers under the name Satoshi Nakamoto released an open source software platform onto the internet and others jumped on board, helping to develop the system and expand it to an ever-growing number of online machines. Driven by this distributed piece of software, the currency is just now beginning to reach the mainstream. The recent spike in value is only natural. It just means a large number of people are suddenly embracing the currency.

>'Theory would predict that, as the currency grows in value, people would tend to hold it rather than spend. But all the empirical evidence we have shows precisely the opposite' Jeffrey Tucker

"In a strange way, this is a necessary moment to establish the validity of Bitcoin," Rodriguez says.

Yes, the current price volatility could become a problem. "On the one hand, these huge price increases may lead people to buy bitcoins for speculative purposes and hang on to them to make capital gains," says François Velde, a senior economist in the research department at the Federal Reserve Bank of Chicago who recently penned a widely-read public primer on bitcoin. "And then other people might see the volatility and think: 'Whoa. If this is going up like that, it could come down just as quickly. I'm not gonna use this as a currency. The value is just too unstable.'"

But this won't necessarily keep the currency from succeeding, and at the moment, it doesn't seem to be a huge issue. Even though the value of a bitcoin is on such a steep climb, the number of worldwide bitcoin transactions continues to increase as well. People are not only willing to invest in bitcoins. They're willing to trade them and, in some cases, spend them too. For Jeffrey Tucker, an economist who writes about the intersection of economics and technology, this is proof that hoarding is not the problem many say it is.

"Theory would predict that, as the currency grows in value, people would tend to hold it rather than spend," he says. "But all the empirical evidence we have shows precisely the opposite."

Separately, the system may run into a problem when it stops producing new bitcoins – way off in the year 2140. But this is only really a problem if Bitcoin begins to replace federal monies – if it becomes what's called "the unit of account" in countries like Japan and the U.S. This means that goods and services would actually be priced in bitcoins.

As it stands, our goods and services are still priced in currencies like yen and dollars. At merchants that accept bitcoins, like the Subway sandwich shop in Allentown, Pennsylvania, prices are merely converted from federal currencies into the digital money. But if bitcoin becomes the unit of account and then a depression hits, it could be difficult to turn the economy around.

"In a depressed economy, when there's not growth in price levels, deflationary expectations do encourage a collective retreat of spending behavior, and in order to push out of that, you have to reverse those expectations," Rodriguez says. "If you had no discretion to expand the currency, you couldn't necessarily reverse those expectations."

But it's wrong to think that deflation will necessarily be a problem. Federal Reserve Bank of Chicago economist Volde cites what is called The Friedman Rule. Proposed by economist Milton Friedman, the rule essentially says that a certain amount of deflation is actually preferred. "This idea has been around for decades," Volde says. "Deflation doesn't mean that a currency won't be used."

Bitcoin Is More Than Bitcoin —————————-

But let's say Bitcoin does take over the world. Let's say that in some distant future it does become the unit of account in Japan and the U.S. and elsewhere. Let's say deflation does become a problem. There are still ways around it.

The bitcoin system runs on open source software, and that means it can be changed. It's just that the change must be approved by a majority of those participating the system.

>'Bitcoin is a software program. People can upgrade it' Joshua Kroll

"Bitcoin is a software program," says Joshua Kroll, a computer science researcher at Princeton University who has closely studied bitcoin alongside various Princeton academics who deal not only in technology but public policy. "People can upgrade it."

Some have argued (in the pages of WIRED in fact) that bitcoin should be updated to include some form of central control, a means of manipulating the value of the currency. But this runs counter to one of the main ideas behind Bitcoin. For many, bitcoin is a way to remove money from the grips of big governments and big banks. "It is always the government paper fiat money that gets corrupted throughout history," says Ken Shishido, who helps oversee the Tokyo Bitcoin Meetup Group. "Bitcoin is not just a new digital currency. It is actually about liberty."

The historic problem that monies have, says MIT Sloan economist Johnson, is that governments promise not to mint more of them, but then they do. The inevitable result: inflation. "The basic problem with money is not limited supply," Johnson says. "The basic problem is that once you create it, it's valuable, and if you're the person who created it, you have an incentive to create more." Bitcoin was designed as a way around this problem.

It's more likely that the massive community that runs Bitcoin would upgrade the system so that it consistently expands the supply of bitcoins into the very distant future. That would alleviate the deflation problem without giving anyone central control.

Joshua Kroll believes that the system will have to be modified in some way. It's not just that it needs a way of fighting deflation, he says. It needs a way of encouraging people to operate the machines that make up the worldwide bitcoin network.

Today, when the system creates new bitcoins, it automatically doles them out to people who run the hardware that drives the system. If you take this away, Kroll says, there will be no incentive for people to keep contributing processing power to the system through what are called bitcoin miners. "If the miner reward goes to zero, people will stop investing in miners," he says. "And this is a problem."

The system does allow bitcoin holders to include transaction fees when they send and receive money, and the idea is that these fees – which go to the miners – will provide the needed incentive. But Kroll says that isn't enough. You have to enforce some sort of standard payment to the miners, he says. It follows, then, that if you change the system so that it keeps creating bitcoins, you solve not only the hardware problem but the deflation problem.

What Bitcoin Really Is ———————-

That may or may not happen. But the larger point is that the system will be what the people want it to be.

Bitcoin is a currency, like the dollar or the yen. And it's a means of processing payments over internet, like PayPal. But it's also a piece of technology controlled by the masses, like Linux, the increasingly popular open source computer operating system, or the internet itself. What history has shown is that, once they get going, things like Linux and the internet take on lives of their own.

It's not just that people across the world use the internet. They also help run it – not because there's an immediate monetary payoff but because the internet can help fuel so many other endeavors, many of which can generate money on their own. You could certainly argue that people will continue to run bitcoin miners even if they don't get paid for doing so. They may run them just to keep the Bitcoin system going, knowing that the system will reward them in other ways.

But if the system needs change – if it can't survive unless it continues to make new bitcoins – people will change it. Like the internet, Bitcoin has its limitations, but it's something that anyone can modify. What that means is that any problem with the currency can be solved, including the limited-supply problem. We could even see a "fork" of the Bitcoin system, where someone takes the open source code and creates a new system that then exceeds the popularity of Bitcoin.

This phenomenon has value in its own right. As Peter Rodriguez points out, Bitcoin can generate consumer confidence simply because it isn't controlled by a single, central authority. People trust things that they have control over.

The point is not that Bitcoin is a deflationary currency. The point is that it can be anything.

Additional reporting by Robert McMillan