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Pros and cons of a mature Bitcoin economy

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March 13, 2014

Bitcoin replaces trust with cryptography to provide a monetary system without surprises

Bitcoin replaces trust with cryptography to provide a monetary system without surprises

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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 bankno...

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

About the Author
Brian Dodson From an early age Brian wanted to become a scientist. He did, earning a Ph.D. in physics and embarking on an R&D career which has recently broken the 40th anniversary. What he didn't expect was that along the way he would become a patent agent, a rocket scientist, a gourmet cook, a biotech entrepreneur, an opera tenor and a science writer.   All articles by Brian Dodson
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16 Comments

Very good article!

asdf
13th March, 2014 @ 09:57 pm PDT

While many economists like to say that gold was an "unstable" currency, actual history shows otherwise. Situations like the one in Spain were exceedingly rare, and today's knowledge of economics is more than enough to deal with it. The concept of currency inflation was not exactly common knowledge 400 years ago. It is today, precisely because we do have fiat money which is habitually inflated.

And contrary to what you write here, Bitcoin does have an "intrinsic value", but I mean that in the old economic sense of "intrinsic value"... which is an unfortunate name for the property because technically it is literally "intrinsic" nor does it have much to do with any subjective "value". Nevertheless, it does have "intrinsic value" in the old sense of that phrase, because it has a cost of production and distribution. But again I want to emphasize this intrinsic value has NOTHING to do with what people normally think of as "value".

Commodity prices (and unlike fiat dollars, Bitcoin is very much a commodity) tend to gravitate toward this "intrinsic value", which is equal to the cost of production and distribution, for a very simple reason: supply and demand. If the price is much higher, more people will produce, which increases the supply, in turn bringing the price back down. If the price is too low, people will stop producing (obviously: there is no profit in it) lowering the supply which again raises prices. (It should be self-evident that nobody in a free market will produce at a loss for very long.)

So by that older meaning of "intrinsic value", Bitcoin very definitely has one. It is by no mean fixed, however, because the cost of Bitcoin mining does go up with time, and eventually will no longer be possible.

And again, just to drive the point home: that property which old economists labeled "intrinsic value" is not "intrinsic" to the good, in the current economic sense (rather it is due to a collection of outside factors), nor is it a "value" in the sense most people mean. Technically speaking, it is a cost. The term "value" was used because it is a point around which prices in a free market tend to gravitate. Just as Bitcoin will, when the market becomes sane again.

Anne Ominous
14th March, 2014 @ 12:14 am PDT

What's the difference between 'illegal' gold and the 'legal' gold? Gold is gold in this material plane, pure metal with a history going back thousands of years. Gold is an element that cannot be divided.

OK, so some will attempt to divide it along moral grounds. Gold was and is a corruption in the grand scheme.. Manna, scruples, currency...

Bitcoin is at least a worthy challenge to the old corrupted gold.

Threesixty
14th March, 2014 @ 01:34 am PDT

As a matter of interest, I suggest the term "Inflation" is wrong, because if I need more units of the fiat currency to purchase a specific item, the value of that currency has "deflated"

In most cases it is the value of the fiat currency that "deflates". over time.

In the shorter term the value of commodities can inflate due to higher demand and short supply and then deflate again as supply meets demand.

Jan Davel
14th March, 2014 @ 02:13 am PDT

There's $7billion dollars worth of these sitting in 1 million bitcoin wallets.

That represent a huge number of people, with a lot of wealth, and as we all know - everyone is greedy.

I think any other crypto-currency has less chance of success at toppling bitcoin, than does any new search engine at toppling google.

Since bitcoin, more than a thousand other new crypto currencies have sprung up. I have never seen even one of those in media yet.

Everyone who wants to get into crypto currency already has - in bitcoin. You've got less of a chance of convincing them to move to something else, than you have of convincing a mac bigot to switch to windows.

Bitcoin isn't going away.

christopher
14th March, 2014 @ 03:55 am PDT

Whenever there's a con, there are pros working it.

MBadgero
14th March, 2014 @ 05:00 am PDT

Again, an excellent article with a few surprises. I'm an anthropologist and precious few people know about the rai stone, and even fewer are aware of the popularity of Spam throughout Oceania.

HighPockets
14th March, 2014 @ 11:33 am PDT

Here's about all you need to know about it; it's really BitCONJOB. There's virtually NO human labor behind the creation of these fictitious electronic bookkeeping entries, and so they will NEVER attain let alone maintain any significant stability as to perceived purchasing power.

Case in point; say today that you want to sell your goods or services at some rate of BitCONJOB (or LiteCONJOBs, or MaxCONJOBS or any of the other 40+ "digital currencies" out there) coins because you feel that it's a good, fair exchange. OK, so now you got your X amount of Satoshies or whatever you may want to call them in trade for something. But then tomorrow, you discover that almost everyone else like you is providing the exact same service or goods for TWICE as much as you just got for yours! Whatcha gonna do when you got screwed?? WHERE is the yardstick (or scale or measuring cup, etc) by which you are measuring the perceived purchasing power of your TOTALLY fiat electronic currency against?? There isn't one, Bub! What do you do when the "exchange" goes bankrupt like Mt. Gox or someone steals the contents of your cyber wallet? If Silk Road could be shut down and it's "assets" purloined by the feds, who's to say that it can't happen to you too?

With these "digital" currencies, you will NEVER even have two electrons to rub together, no matter how many electronic bookkeeping entries may be showing in your account!! Oh yeah, that sure is a real confidence builder right there, isn't it? Money is an idea backed by confidence, and the less the amount of confidence there is in a medium of exchange, the less it is a money.

Randy

Expanded Viewpoint
14th March, 2014 @ 01:08 pm PDT

There is no way that major world governments are going to let BitCoin displace their currencies.

Governments need control of their currency so they can print more, issue debt to borrow money, and play politics with voters and other nations.

Right now BitCoin is such a small threat that only a few countries have either banned it or made it very difficult to use - Russia, China, Taiwan, Iceland, India, Indonesia, Vietnam, and a few others.

Canada's gov't recently issued a statement saying BitCoin will be regulated under the existing 'Terrorist Financing Act' which means it will be nearly impossible to use BitCoin in Canada.

If BitCoin grows any more, all governments will simply pass laws banning the use of BitCoin or will not allow BitCoin to be converted into any currency.

robo
14th March, 2014 @ 01:53 pm PDT

"Fiat currencies are not intrinsically evil." Really? It is not evil to force a product or service on people at the point of a gun? You must be confusing common practices of govt. as proof of good. Govt. does not define what is good or evil. Although, from personal experience (at 71), I tend to assume if the govt. does it, it must be immoral. At least, the means of govt. are immoral, being brute force, not reason or logic. It begs the question: If a thing is necessary, why can't it be sold on its merits, rather than forced on us at gun point, e.g., legal tender law? No one had to force gold or silver money on society. It was used for centuries because it worked. It was replaced by fiat paper because no choice was given, e.g., gold was outlawed and the "promise to pay" gold/silver was broken. People had accepted the paper currency as a receipt for money, not as money. Out of convenience, the paper became money, but its tie to precious metal (promise to remit) was still a limiting factor on the new paper money creation, i.e., printing. This kept paper money honest (scarce) by allowing for redemption. Mining is a lot more work than printing. When govt. broke its promise to remit metal the new paper money had to be protected from competition by giving it a monopoly. The bankers in bed with govt. knew the market would not accept paper money otherwise. Why? Paper money is not scarce. It violates a prime requirement of money. In doing so, it allows the international banking cartel to steal wealth by legal counterfeiting.

This is not just evil, it is evil on a global scale.

Don Duncan
14th March, 2014 @ 02:31 pm PDT

There was and never is a requirment for money to be scarce, only that it should be created and DESTROYED in line with demand.

Backing money with Gold rather than a basket of goods caused tight money - another evil - causing bankruptcies simpy by restricting trade in society.

But inflation was and still is caused by the banking sector issuing FIAT loans via fractional reserve lending, leveraging its own debt money into the economy where a return on interest owed requires the borrower to raise prices and speculate. The M1(real coin) money to pay debt money does not exist in the economy hence price bubbles and bankruptcies as borrowers cease payment.

Currency speculation by banks is 'always' and I do mean that the sole cause of Hyperinflation caused by raiding a countries foreign reserves by shorting their currency by hedge funds and investment arms including that of Mexico, Hungary and the EU (EMU) after allowing a currency to float on an exchange rather than have a fixed exchange rate. However hyperinflation is such that if a country has foreign debt which it has to repay in that nations currency, it must pay at the speculative exchange rate with the subsequent need for devaluation and inflation which is a feedback of devaluation. The US has had an inflation rate of 1000 % since 1913, the date the Federal Reserve was allowed control of the US money supply which became debt backed. The UK has had an inflation rate of 1000 % since 1975, all due to debt backed money owed to foreign governments.

This all gets even more interesting if you back your currency in a precious metal which gets raided by countries demanding you pay the value on your notes in Gold and it turns out the national bank of choice has none in the vault.

L1ma
15th March, 2014 @ 10:33 am PDT

Gold is real substance. You do a job you want to get paid in a currency that is back by that, so I suggest the U.S. return to it. It doesn't make logical sense to be paid in an algorithm. Seems to be like the Biblical opening for something sinister under the guise of trying to be helpful.

I don't trust it.

Gargamoth
16th March, 2014 @ 11:06 am PDT

Our system is held together by everyone pretending that the imaginary value of our currency is real. Then we inflate our way out of debt and into more wealth. What could go wrong?

Bob
17th March, 2014 @ 09:29 am PDT

Lack of transparency means that ever more spectacular prosecutions will eventually erode bitcoin's value to it's real worth. nothing.

Anonymous payments only appeal to criminals.

nutcase
17th March, 2014 @ 09:22 pm PDT

As a cryptologyst for more than 15 years, public key infrastructure used in bitcoins definitely not a good approach as United States of America had imposed stricted key issuance and the weaknesses of algorithm that can be cracked by some supercomputer. PKI is good for the use of digital online authentication, message digest for verification and some low level security,not for very high level security. The company shall use a high level grade of military security to ensure high confidennce level of customer, very tight security to protect from hackers and many loop holes introduced by PKI. Hope the company take this into first consideration before introducing such a weak product.

Haizad Said
26th March, 2014 @ 08:13 pm PDT

nutcase: Cash is anonymous. Cash is all that existed once. Does that mean society and its monetary system was a criminals paradise? No. The Mafia was created by Prohibition. Prohibition was created by a govt. that violated the right to happiness.

Govt. loves any system that allows it to keep track of every transaction. A non-private digital currency would allow total monetary control. In short order we would all be slaves.

Crypto-currency frees us from criminal govt. theft. That is its primary value.

Don Duncan
14th June, 2014 @ 12:12 am PDT
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