This is part 2 of a two part series on Bitcoin. Part 1 here.
Just before the MtGox Bitcoin exchange went bankrupt I posted that “Bitcoin is a far better payment system than currency. And that’s just fine.” A lot has happened since. Not just the MtGox collapse, but also the contested Newsweek story claiming Dorian Nakamoto is the founder of Bitcoin. The reaction to these events has become a Bitcoin Rorschach test. Those who view Bitcoin as a flawed replacement for traditional currency doubled down on their hate. Those who view Bitcoin as a payments system, powered by a solution to the Byzantine Generals problem, doubled down on their love. While I’m in the Payments/Byzantine Generals camp, the currency camp has good points. So consider this part two of a series on Bitcoin. As such I’ll jump right in. If you need more background jump to links at bottom.
Let’s start with the ever colorful Nouriel Roubini laying out the “not a currency” position on twitter. I’ll consolidate his tweets for readability:
Apart from a base 4 criminal activities, Bitcoin is not a currency as it is not a unit of account or a means of payments or store of value. Bitcoin is not a unit of account as no price of goods and services is set in Bitcoin unit nor it ever will. So it isn’t a currency. Bitcoin isn’t means of payment as few transactions in Bitcoin. And given its volatility all who accept it convert it right back into $/€/¥. Bitcoin isn’t a store of value as little wealth is in Bitcoin and no assets in it. Also given price volatility it is a lousy store of value. So Bitcoin isn’t a currency. It is btw a Ponzi game and a conduit for criminal/illegal activities. And it isn’t safe given hacking of it.
The “Ponzi” accusation in particular got Bitcoin advocates fired up. In less strident tones, here’s Paul Krugman back in December making a similar argument:
So far almost all of the Bitcoin discussion has been positive economics — can this actually work? And I have to say that I’m still deeply unconvinced. To be successful, money must be both a medium of exchange and a reasonably stable store of value. And it remains completely unclear why BitCoin should be a stable store of value.
I have had and am continuing to have a dialogue with smart technologists who are very high on BitCoin — but when I try to get them to explain to me why BitCoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem.
The pushback is directed against hard core Bitcoin proponents who argue Bitcoin is a complete currency in the traditional sense. These people are wrong. And adding fuel to the fire, many of these advocates have libertarian politics, giving progressives an extra reason to hate them. Hence the harsh critiques from Roubini and Krugman. In any case, a better way to think about Bitcoin is as a different beast entirely. It has some overlap with traditional currencies. But also abilities a traditional currency doesn’t have. Let’s see: we have a new technology that’s worse than the existing standard, but cheaper and better in ways traditionally less important. Almost a textbook definition of technology disruption. Geek nirvana. Compare the two in table format.
As mentioned in part 1, in some ways Bitcoin is closer to software powered gold than a modern fiat currency. Which is why the Japanese government decided to regulate Bitcoin “not as a currency but as a commodity akin to gold.” On the other hand, arguing for Bitcoin’s greatest strength is Bitcoin’s chief scientist Gavin Andresen: “The whole reason geeks get excited about Bitcoin is that it is the most efficient way to do financial transactions.” Hence Silicon Valley companies like Coinbase and BitPay are using Bitcoin as a payment system, allowing people to swap in and out of Bitcoin to transfer money quickly and cheaply. These new companies have a whole different level of funding and security than old school Bitcoin companies like MtGox, which after all stood for “Magic the Gathering: Online Exchange“. You can’t make this stuff up. Magic is fine and all, but I doubt anyone’s shocked to find Magic card players don’t make excellent bankers. Except for these guys.
So what’s the future hold? Journalist Felix Salmon asked Marc Andreesson on twitter “what, if anything, would it take for you to change your mind on the future of BTC?” Andreesson answered: “For Bitcoin, some kind of fatal flaw in the core math and algorithms. (Which has not been found yet.) Or for Bitcoin, another cryptocurrency overcoming Bitcoin’s current network effect (uses/merchants/developers/miners). For cryptocurrencies generally, some fundamental flaw in public/private key encryption (not found yet). World’s best computer scientists & mathematicians have been trying to break crypto for 40 yrs, Bitcoin for 5. OK so far. It’s early days. I am not encouraging people to put grandma’s life savings into BTC.” Note the answer is clearly coming from a computer scientist’s perspective. This is a cool technology with huge upside potential, but we don’t know for sure where it’s going. So I won’t lose faith unless the technology itself doesn’t work. We’ll figure out the economics later.
Which begs the question. Could Bitcoin’s economics cause it to fail? One possibility is the economic basis for transaction confirmation (Bitcoin mining) could dry up if the value of Bitcoin falls too far. In my previous post I was leaning that way. But what changed my mind is an interesting speculation from Robert Sams at cryptonomics, where he argues Bitcoin could derive significant fundamental value from the network effects of being a highly used medium of exchange. This means mining itself doesn’t need to provide fundamental value. In that narrow sense we’d consider Bitcoin more similar to fiat money than software. In fact some advocates expect Bitcoin to eventually transition to a model where transactions become paid with very nominal fees passed all the way to the end user, a mechanism already potentially available though not currently required.
To sum up, it’s early days for a new technology. But one key takeaway from recent events is critiquing Bitcoin as “not a true currency”, or alternatively promoting Bitcoin as a “true replacement for existing currency” is missing the point. Bitcoin wouldn’t be potentially so disruptive, by definition, if it were merely another kind of currency. Instead it’s something both better and worse all at once. Perhaps over time it will evolve more of the trappings of a currency. But at a deep level it’s not the same thing. Personally I’m sticking with my “software powered gold” analogy. I would never invest or store money in gold, even software powered. Too volatile. But the businesses being built around it might have a real future. We’ll see.
This is part 2 of a two part series on Bitcoin. Part 1 here.
As mentioned above, this is a difficult topic. Here are some useful links for more background:
- Glenn Fleishman podcast hosted by John Gruber. Amazingly good introduction to Bitcoin technicalities. Note in typical fashion this episode of The Talk Show has a slow start. So for Bitcoin jump to the 27 minute mark and then listen until the 2 hour mark.
- Economists actually use the term currency and money in loose fashion. So while I’m arguing Bitcoin is not a “true” currency because is doesn’t say yes to all the boxes in my currency table above, in common practice some say Bitcoin is a kind of money. See for example Is Bitcoin Money?: What Economists Have To Say. So be warned. I think this looseness is part of the problem. In that survey I’m in the Scott Sumner camp, and want to reserve the term currency only for the complete package, as mentioned in part 1.
- Byzantine Generals problem. Wikipedia, as always, being helpful.
- Why do currencies need a central bank? History of Federal Reserve System is a good place to start. To me Bitcoin is not and never will be a complete true currency because it doesn’t have a central bank to stabilize prices and avoid panics, plus lacks a legal system with a court system behind it. But that’s fine. Doesn’t mean it’s not useful.
- What’s a medium of exchange?
- Robert Sams at cryptonomics. Linked to him above. Not many followers and the math is often over my head, so honestly I’m not certain he’s technically correct on all points. But what I really like about his Bitcoin blog is he’s asking the right questions. Even if his answers are necessarily speculative given the topic. An interesting thinker. Found him via Tyler Cowen.
- Ben Thompson’s post on Bitcoin mining economics can be paired with this Cryptonomics piece in a similar vein.
- Also related to mining economics is Bitcoin’s deflationary model, which I agree is a possible fatal flaw, not for cryptocurrencies in the general but for Bitcoin itself. Deflation is bad. As the fallout from the events of 2008 should remind us.
- And as already linked, my earlier part 1 to the above: “Bitcoin is a far better payment system than currency. And that’s just fine.“