What The Fuckonomics – Bitcoin Edition

I’ve frequently criticized bitcoin in light of its growing popularity and the increasing attention it has received from economics writers and thinkers on the internet. However, my issues with bitcoin are both too numerous and too complex to be spelled out in 140 character bites. As a result, I’ve spent the last several days drafting this lengthy analysis of how traditional currencies work, what bitcoin is, and how bitcoin performs – or fails to perform – the same functions as ordinary currencies. 

What is bitcoin?

Let’s start at the very beginning here by asking the rudimentary question: what is bitcoin? Bitcoin is the predominate player in the new market of “cryptocurrencies” that has grown rapidly over the last couple of years. To put it very simply, bitcoin is a digital currency which is not attached to any government entity. This means that bitcoin does not have the official backing of a government or central bank as most sovereign national currencies do. The lack of attachment to a national government or a central bank is often a selling point for bitcoin as many of its adherents and investors tend to subscribe to various strands of libertarian ideology.

Rather than being “printed” like existing fiat currencies (The concept of printing currency is anachronistic in the digital age and is in some senses counterproductive, sparking as it does mental comparisons to inter-war German citizens using wheelbarrows full of freshly printed marks to purchase groceries. However, it is conceptually accurate enough to serve here.), bitcoins are mined. Bitcoin mining is performed by computers solving increasingly complicated equations. The rate of increase of the complexity of the equations is set in such a way as to control the growth rate of the total money supply in the bitcoin economy for a certain period of time, after which point all bitcoins will have been mined and the number of bitcoins in circulation will remain fixed.

Bitcoin transactions are completed via an encrypted process that transfers funds from the account of one user to another. All transactions must be verified by all other bitcoin users in order to ensure that no double counting occurs. However in practice, this function is largely monitored and maintained by a small subset of bitcoin users with the technical capacity to do so. Due to the encrypted nature of the transactions, bitcoins enable anonymous transaction. This is another major selling point of bitcoin to many users.

Having sketched out the broad details of what bitcoin is and how it works (poorly and imprecisely, given my rudimentary understanding of the technical details), it’s time to move on to the next logical question. To wit – what is a currency and to what extent, and how successfully, does bitcoin mimic the attributes of a traditional currency?

What is currency?

Generally speaking, currencies are deemed to share three defining functions and three defining characteristics. 

The characteristics are:

• Rarity
• Indestructability
• Divisibility

The functions are:

• Medium of Exchange
• Unit of Account
• Store of Value

I’ll take these one at a time to describe how traditional currencies execute these functions and how bitcoin compares. Bitcoin largely possesses the characteristics that currency must possess, however its functionality leaves much to be desired in my opinion, making it unlikely to ever be widely adopted as a substitute for traditional currencies.

Rarity

While currencies are not required to be extremely rare (gold and silver are actually surprisingly abundant elements), they must be sufficiently rare to ensure that the supply is not subject to drastic swings. This is mostly to ensure that individuals cannot create meaningfully large stocks of previously uncirculated currency to enrich themselves and/or debase the currency. In modern economies, this requirement for rarity has been replaced by a slightly different characteristic that achieves the same end, namely the status of a central bank as the monopoly issuer of currency. While US dollars themselves are not comprised of rare or difficult to attain materials, the social and legal norms that we have created successfully achieve the same end as rarity did in more simplistic economies that used precious metal coins, etc. for currency.

As advertised, bitcoins are certainly rare enough to act as a currency. The supply of them is fairly limited, there is an upper limit on the total supply, and the rate of growth of supply is predetermined. While I am personally skeptical that the bitcoin system is technically robust enough to ensure that no “counterfeiting” occurs, this is merely an impression of mine formed with an obvious lack of technical knowledge for me to verify my concern. That being the case, I’d give bitcoin a passing grade on this score.

Indestructability

This is not to say that currency must be literally indestructible, but it must be relatively permanent and not subject to too much damage. The reasoning here is fairly obvious. Nobody would ever consider using something that degrades quickly as a currency as they would in short order see their wealth literally disintegrating in front of them. Precious metal coinage again demonstrates why it represented much of the history of currency, as it clearly passes this test. In modern fiat monetary systems, this problem has been tackled in a couple ways. Firstly, currency is constantly pulled out of circulation and replaced to ensure that it remains usable. Secondly, much of the “currency” used in modern economies is digital at this point, and therefore not subject to physical degradation.

Again, bitcoin has the characteristic of indestructability in the same way that digital US dollars that exist merely as computer entries in your bank account are, virtually, indestructible. With respect to both bitcoin and electronic dollars, I find that there is some question as to whether they really meet this criterion. While your digital wealth may not be able to be destroyed, and lack of internet access or other technological problems can potentially make your wealth either temporarily or permanently inaccessible. This is a broader concern of our increasingly digitized economy.

Divisibility

This characteristic is very easy to understand from a pragmatic perspective. All economic transactions are not going to occur in neat increments. As a result, your currency must be divisible into smaller units to facilitate all transactions. Historically this was often done by physically clipping metal coins into smaller pieces to execute smaller transactions. In our modern economy, this is done by offering a wide range of larger or smaller increments (including the too small and totally unnecessary penny – but that’s a gripe for a different day).

In this area, cryptocurrencies are actually far superior to traditional currencies. There’s nothing to prevent bitcoins from being transacted in virtually any increment. Particularly as the value of existing bitcoins grows, it will probably become very common for goods or services to cost .0001 bitcoins. The very digital nature of the currency makes this characteristic a moot point.

Medium of Exchange

According to most economic historians, the creation of the first currencies was an organic process intended to solve a basic problem in early human societies. Economies have always entailed the exchange of goods and services among individuals. Initially these exchanges were fairly simplistic and were generally executed via barter. A farmer in need of new equipment may agree to trade a certain quantity of wheat for new farm implements produced by a blacksmith, for example. However, increasingly complex societies soon found themselves with a problem. Barter transactions can only occur in situations in which two or more parties find themselves with a mutual incidence of wants or needs. That is to say, it is necessary that each party to a transaction have something desired by the other party in sufficient quantity to facilitate a trade. Even if very basic economies, such mutual incidence of wants are frequently absent. So a blacksmith may be more than happy to trade a portion of his output to the farmer, but may have no current need of wheat.

In these instances, the benefit of currency as a medium of exchange becomes immediately obvious. Currencies serve as a means of bridging the gap in the wants and needs of various economic actors. With a currency, the previously referenced blacksmith can sell tools to a farmer in return for an agreed upon amount of the local currency. The blacksmith can then use the income gained in this way to purchase whatever goods she may desire without concern for arranging a barter transaction.

Bitcoin fulfills this role quite nicely, and even has some advantages over traditional currencies in this respect. Firstly, bitcoin allows for transactions in illegal goods that would otherwise have to take place using physical cash. While the “benefit” here may seem dubious to some, from a purely economic perspective, it is facilitating a subset of commercial transactions that were previously much more difficult. Secondly, the payment architecture of bitcoin relies much less on intermediaries than traditional alternatives. Most transactions have to flow through a bank, and ultimately a central bank, to be cleared. While there is in some sense an intermediary in the bitcoin economy since all transactions must be registered with other users, there is no central clearing authority (While this can be viewed as a strength of bitcoin, it does carry the risk that there is no central authority to resolve disputes over payments). Thirdly, bitcoin makes international transactions, which can take a great deal of time and be fairly complicated, much easier.

In the role of a media of exchange, cryptocurrencies could be very successful and may even spark more innovation by more traditional financial intermediaries. The anonymity and speed of bitcoin transactions, along with the agnosticism with respect to national borders, could make its transaction architecture a model for future development, whether the bitcoin currency itself ultimately thrives or dies off.

Unit of Account

The unit of account function of a currency is fairly simple to understand. Once human societies moved beyond a subsistence level, it became increasingly important to have a standardized way to track wealth and value and to price the goods and services that one may be offering or seeking in the economy. For example, individuals who opted to save a portion of current output for future consumption needed a means of valuing and tracking this wealth. Merchants, farmers, businesses, and governments similarly required a means to track the value of stored wealth over time. Additionally, currencies allowed for meaningful price comparisons by creating a standardized measure of value.

Bitcoin has trouble fulfilling this function currently, although it is not impossible that it grow into this role over time. At the moment, very few goods are services are priced in bitcoins. It is much more common, even among merchants that transact in bitcoins, to price their goods and services in a traditional currency (usually either the local currency or a major international reserve currency such as the dollar or the euro). Transactions are then completed based on the spot exchange rate between the currency in which the good is priced and bitcoins. Over its brief history, the exchange value of bitcoins in terms of other major currencies has been extremely volatile. This is less than ideal for a currency, and makes it extremely risky for a person to price a good in bitcoins and accept the exchange rate risk that that entails. One could quickly find that the value of her good or service priced in bitcoins has changed drastically in terms of whatever local currency she will be converting her bitcoins to after a transaction.

Store of Value

Given their nature as relatively rare and relatively permanent, currencies have historically been used largely as a way to accumulate and store wealth. In the case of precious metals and the like, this is done very simply by maintaining physical hoards of currency. The modern corollary is to save funds in a bank account denominated in the local currency (Which will, of course, lose some value over time due to inflation. This gets into a much larger discussion of central banking and how monetary policy impacts the larger economy. While it may seem evasive not to address this issue – particularly since so many bitcoin advocates point to “theft” via inflation as one of the reasons to purchase bitcoins – it is an ancillary point in an analysis of bitcoin itself as a currency, rather than in its role as a competitor to fiat currencies.).

Here again, bitcoin’s extremely volatile exchange rate does it a serious disservice. While the price trend of bitcoin has clearly been up, this general upward movement has been interrupted by sharp downward corrections. When individuals choose to store their wealth in a currency, they are generally hoping to avoid volatility. Certainly, having one’s savings in a currency that is drastically increasing in value is beneficial, but being unable to have a fairly stable value for your accumulated wealth, and lacking the ability to pull it out at a stable price for one’s needs, is detrimental. As such, when viewed merely on its merits as a store of wealth – and not as a speculative investment – bitcoin seems to fall short.

Bitcoin as Speculative Investment

Much of bitcoin’s recent cache has developed from the stratospheric increase in its value over the last one to two years. This raises a few interesting questions for bitcoin’s future as a legitimate currency. First, there is nothing wrong, theoretically, with bitcoin as an investment vehicle. It does differ from the majority of speculative investments in that it has no intrinsic value. Shares of stock, for example, represent a legal entitlement to the future revenue streams of the issuing company. Exchange Traded Funds (ETFs) generally have some underlying tangible asset, such as bonds, shares of stock, physical capital, etc. upon which their value is based. Traditional sovereign currencies enjoy a monopoly on financial transactions with the government of the country in question, which provides them with at least a minimal “real” value beyond their transactional value for other private goods and services. However, bitcoin is hardly alone in having no intrinsic value placing a floor under its price.

Having said that, the current speculative fever surrounding bitcoin actually does significant damage to its ability to function as a currency. Given the common view that bitcoins will only go up in value, there is a reasonable desire on the part of many market participants to hoard them. This makes fewer of them available for commercial exchange, which adds volatility to the market price of bitcoins and increases the difficulty of transactions. While to date this issue has not become too serious, largely because new bitcoins are still being mined and because the real transactional demands on the system have been low thus far, it could be a major problem in the future.

So, is bitcoin really a currency?

Bitcoin is, in some respects, like a traditional currency. It is most similar to a currency, and most likely to have a lasting impact on the global financial system, as a medium of exchange. While there are still some problems to be resolved, bitcoin has already demonstrated its usefulness in facilitating transactions. Furthermore, it has done so in a way that has filled two important gaps left by existing, traditional currencies. First, bitcoin has made international transactions much simpler in many respects. Particularly given the hesitancy of many US financial institutions to update their payment architecture for a globalized and digitized world, bitcoin could play an important role in developing means to execute international transactions and transfers without relying on banks or the few competitors to banks that have arisen in this space, such as PayPal.

Second, bitcoin has been a trailblazer in the field of facilitating illegal or unsavory transactions, mostly for illegal drugs, but also for weapons or other illegal services. Eschewing any question of morality, this aspect of bitcoin does entail a certain risk to its legitimate functions. If bitcoin becomes associated largely with its role in black markets and criminal activity (or its related role in money laundering and avoiding capital controls in closed financial systems), it is almost certain to earn the scrutiny and ire of government officials around the globe. This could carry serious risks for those holding bitcoins for legitimate commercial or investment purposes.

However, beyond its role as an effective medium of exchange, I believe that bitcoin currently fails to achieve the other two traditional functions of currency listed above. The fact that the market for bitcoins is currently extremely shallow – there are few participants and even fewer with sufficient stores of bitcoins and the requisite desire to transact in them – means that it is likely to remain volatile for some time. Especially as the total number of bitcoins in circulation approaches its predetermined maximum, this tendency could be exacerbated even further, leading to major bouts of deflation in the bitcoin economy.

Conclusion

While bitcoin “works” as a currency in some sense right now, it cannot continue to do so in its present form. The stability required of currencies will only develop to the extent that bitcoins become widely accepted. Additionally, the number of commercial entities transacting in bitcoins must grow so that consumers feel they can use bitcoins for many, or most, of their commercial purposes. Given the technical complexity, the (possibly unfair) association with illegal activity, and the novelty of the concept, I find it unlikely that the requisite widespread adoption will occur. Additionally, I think the opacity and concentration of bitcoin holdings will continue to place deflationary pressure on the system, further reducing its usefulness as a currency. These issues may not be insoluble, but I believe they are sufficient hurtles to ensure that bitcoin remains, at best, a niche product for speculative investors, ideological libertarians who appreciate its separation from the traditional financial system, and those wishing to utilize it for illegal activities.

Also, too, bitcoins are fucking stupid.