Bitcoin's Consequences and Prospects

Although a very good cybercurrency can be created, it won’t necessarily be the victor of open competition with inferior cybercurrencies.

Bitcoins aren't money, which is a problem.

Bitcoins are not coins, despite their name. They are, instead, a form of digital payment. So you must put the image of metallic discs with "B"s instead of "$"s on them that is frequently associated with Bitcoin conversations out of your head. Although such items exist, they are not Bitcoins, but rather adorable Bitcoin storage devices or "wallets." Apart than that, I'm not going to delve into the mechanics of how Bitcoin works because that has already been handled by the other panelists in this session, and more competently than I could.

The fact that Bitcoins aren't real coins isn't a problem in and of themselves. However, according to economists' traditional definition of money as any universally accepted mode of payment, Bitcoins aren't money at all. Neither can the Bitcoin unit be claimed to act as a unit of account—a secondary function of money—as it might if it were widely used in payments and relatively stable in value. These facts definitely pose a difficulty for Bitcoin in terms of its supporters' desire to see it as a potential rival to the dollar. Unlike Bitcoin, Federal Reserve dollars, though we may not like them or the way they're administered, are undeniably money because they can be used for almost every purchase in the country, as well as many transactions outside of it.

Carl Menger, the founder of the Austrian School of Economics, described how any ordinary product may become money—that is, a widely accepted medium of exchange—by itself.

However, while Menger's theory, which requires no government action, may appear to provide hope to those who believe that Bitcoin will one day become money, further study reveals that Menger's theory provides more grounds for pessimism than optimism in this case. Indeed, the theory predicts that something like Bitcoin will be extremely improbable, if not impossible, to be used as a means of exchange in the long run.

This conclusion stems from Menger's assertion that money emerges from a state of barter, and that it does so as a result of individual traders' efforts to barter more effectively by exchanging what they have for something that appears to be more likely to be desired by those who have the goods that the traders truly desire. As merchants experiment with various forms of indirect exchange, a horse race develops, with certain indirect exchange methods involving certain items succeeding more frequently than others. The items that appear to be the most "saleable" become more frequently adopted as trade media, until one good stands out as clearly more saleable than the rest. You don't have barter at that time; you have money.

But consider this: who, at the start of Menger's process, would be so idiotic as to try trading whatever valuable things they have for something for which no one has any actual use—that is, for something for which there is no demand at all? (Remember that there is no demand for anything as a medium of exchange at the start of Menger's process; the only demand for items is that of people who want to own or consume it rather than exchange it.) So reasonable traders who want to experiment with indirect exchange will hunt for goods that are popular for reasons unrelated to their ability to serve as exchange media. Consumable commodities, such as tobacco, as well as ornaments and jewelry, such as cowrie shells and, of course, precious metals, are examples. Who, on the other hand, wants a jumble of digits that, unless they've been adopted as an exchange medium, have no other evident use? The solution appears to be that there isn't a single sane person in the world! So, aside from not being money, Menger's theory seems to imply that Bitcoins could never become money!

That's not everything. Menger's theory also suggests that once a sufficient number of individuals utilize something as a medium of trade, more and more people will wish to do the same. As a result, a bandwagon is formed, with everyone jumping on board. However, after a certain amount of money has been created, it is quite difficult for another to displace it, providing that the other begins as a valued item. As a result, even if Bitcoins were beneficial for purposes other than trading, they would be unlikely to supplant dollars. The unavoidable conclusion appears to be that Bitcoins are not only doomed to fail, but doubly doomed when it comes to becoming money.

Bitcoins may, in fact, become money in the future.

Despite what appears to be the consequences of Menger's theory, Bitcoins are being used as a medium of trade, albeit in a limited capacity. It's remarkable that they've managed to create a foothold despite almost impossible circumstances, so let's talk about how it happened.

Despite the fact that it is supposed to have been invented by "Satoshi Nakamoto," the name is a pseudonym that could refer to a group of computer geeks rather than a single one. Apparently, these geeks were initially just having fun with a simple (for computer nerds) game in which the winner was determined by gaining the most points for answering a math problem. Bitcoins were simply a form of digital play money used to keep score in this game: the more problems one solved, the more Bitcoins one received. Typically, play money remains just that: play money. However, in this situation, it began to be viewed as possessing qualities that would make it helpful not only for maintaining score among players, but also for purchasing and selling anything—particularly illegal items such as drugs—remotely and conveniently while remaining relatively anonymously. Such dealings were apparently limited to a small group outside of the initial players at first. However, the line between traders and players began to blur. People who had no interest in the original game and who may not have even qualified as geeks, computer or otherwise, were eventually trading for Bitcoin.

According to Menger's idea, if something manages to get any traction as a medium of exchange, it becomes more appealing to others. As a result, once Bitcoin's user base had become large enough, it began to expand at a quicker rate. Bitcoins are now accepted by over 75,000 merchants in the United States alone, including some significant ones, and they are quickly becoming the preferred method of remittance for overseas workers. I remember pointing out approximately two years ago that the number of Bitcoin-accepting shops had surpassed a thousand, and that it was on track to surpass ten thousand in the next year. This provides you an idea of how fast things are moving.

This acceleration might theoretically go quite far: far enough for Bitcoins to qualify as money. It has undoubtedly progressed far beyond what we experts ever believed was conceivable. Bitcoins have taught us all a good lesson: we should not presume that something isn't beneficial enough to become money just because we can't think of any other (non-monetary) purpose for it. The definition of usefulness, like the definition of beauty, is in the mind of the beholder.

The problem is that even if Bitcoins become money, they will not be particularly good money.

So, despite the fact that Bitcoins have a long way to go, they may one day become money. It's even possible, though extremely unlikely, that they may grow to be favored over dollars, resulting in the creation of a Bitcoin economy. Dollars would be useless in such system, either as a handy medium of commerce or as representatives of the unit of account, and we wouldn't have to worry about the Fed mismanaging the money supply. Instead, we'd have a highly regulated—indeed, predetermined—Bitcoin supply, with the supply rising at a progressively decreasing rate toward a cap of 21 million Bitcoins. As a result, hyperinflation, or even moderate inflation, would be extremely unlikely.

The good news is that this is the case. However, there is some terrible news. The bad news is that there's no reason to believe that either Bitcoin's purchasing power or the entire volume of Bitcoin expenditure, or "nominal income," will remain consistent. Of fact, the value of a Bitcoin varies a great deal these days. However, "value" in this context refers to the Bitcoin-to-dollar exchange rate. The only type of stability that matters in a Bitcoin economy is the value of Bitcoins in relation to products. Real demand for Bitcoins would be more steady in such an economy than it is currently, with speculative demand (as opposed to desire for making payments) playing a far smaller role than it does now. As a result, in a fully "Bitcoined" economy, Bitcoins' purchasing power would very probably be less volatile than the current Bitcoin dollar rate. As a result, it's a folly to presume that Bitcoin's instability as money will reflect or resemble its current instability as an aspiring money.

However, neither the purchasing power of Bitcoins nor the number of Bitcoin-denominated payments will be stable enough to qualify Bitcoins as sound money in anyone's opinion. The strict "protocol" that regulates the supply of Bitcoins—a protocol that raises Bitcoin "mining" costs in response to changes in mining activity and technology, but without regard to Bitcoins' purchasing power—would allow fluctuations in the pure transactions demand for Bitcoins to continue to influence their purchasing power because it makes no allowances for changes in real demand for Bitcoins, regardless of their source. Mining costs will approach infinity when the number approaches 21 million, and Bitcoin production will come to an end for good. The demand for Bitcoin transactions, on the other hand, is expected to rise in tandem with economic growth. A Bitcoin standard would thus likely to produce a rate of deflation at least equal to economic growth, with periodic episodes of more severe deflation accompanying every cyclical surge in money demand. Although (as I've shown before) deflation doesn't have to be associated with recession or depression as long as the rate of deflation mirrors an economy's (total factor) productivity growth rate, deflation in a Bitcoin economy is likely to surpass this safe limit on a regular basis.

Let's compare the effect of a Bitcoin standard to the traditional gold standard, which many regard as the best international monetary arrangement yet seen, not merely to the current dollar standard, which tends to be inflationary. The gold standard, unlike the Bitcoin standard, did not have a tightly set quantity of basic money. Instead, despite the widespread use of bank deposits and notes backed by fractional gold reserves as substitutes for actual gold coins, the supply rose throughout time. Furthermore, it tended to rise faster as gold's purchasing power increased, and vice versa. While the gold standard allowed for some deflation, it was not severe enough to stifle economic expansion (financial crises excepted). Furthermore, it encouraged more active gold prospecting and the use of previously uneconomical extraction methods, which tended to counteract mildly inflationary periods with mildly deflationary ones. This meant that the price level tended to remain highly stable over extended periods of time—stable enough, in fact, to allow people to trade fixed interest bonds with very long maturities without fear of losing money.

In short, a Bitcoin standard is likely to be inferior to the traditional gold standard, which, while superior to most other forms of money, was far from flawless. Furthermore, it may even be inferior than the dollar standard, if one accepts that the latter, while inflationary, may not be excessively so, and may at least prevent catastrophic deflation except in exceptional circumstances.

A tweaked form of bitcoin has the potential to be very good money.

Bitcoins are the only cybercurrency that has seen broad adoption so far. Other such currencies, known as "Altcoins," do exist, and it's possible that one of them, or possibly some yet-to-be-invented cybermoney, will prove to be even more popular, with attributes that will make it the best money ever.

To understand how the technology that underpins Bitcoin and other cybercurrencies could serve as the foundation for a really superior monetary standard, we must first consider the issues that plagued non-cyber money in the past. On the one hand, there are fiat currencies such as the dollar, whose quantities can be arbitrarily altered by a group of people making discretionary judgments. When discretionary management goes badly, the consequences can be disastrous. True, the dollar is better than many other fiat currencies in this regard, but it isn't particularly good. For instance, Fed officials persist on treating a two percent rate of inflation as rock bottom, despite the fact that it would halve the value of the dollar every 36 years. In practice, the Fed's approach means that we can normally anticipate the dollar to depreciate much faster than that, on top of having to deal with booms and busts caused, at least in part, by the Fed's proclivity for stoking the former while mismanaging the latter.

However, regular commodity monies, which have previously been the sole alternatives to fiat money, are likewise flawed, as the example of gold—perhaps the best of the bunch—demonstrates. Gold can devalue as a result of new discoveries, as well as a drop in non-monetary demand for gold, such as a general switch from gold to silver fillings.

To be fair, most gold standard critics who bring up these alternatives overestimate their historical significance. For example, despite a fivefold increase in European prices over a century and a half, the so-called "Price Revolution" that followed the Spanish conquest of New World gold and silver mines resulted in an annual inflation rate that was below the Fed's current objective. Nonetheless, just as fiat money is subject to the whims of central bank governors, the supply of any conventional commodity money must be subject to the whims of Mother Nature.

That gets us to the cool thing about Bitcoin and other similar cybercurrencies. In theory, the same experts who devised the Bitcoin supply protocol could devise a far more macroeconomically "smart" system that could serve as the foundation for a remarkably stable and well-behaved cybermoney. For example, the new protocol might allow for long-run growth of the money stock in line with greater real output (or perhaps increased labor and capital input), as well as cyclical changes depending on transaction volume feedback. As a result, the supply of such a "smart" cybercurrency would be impenetrable to manipulation while simultaneously being "elastic" in a macroeconomically beneficial sense. You simply can't ask for much more than that.

Problem: poor cybercurrency may drive good cybercurrency out of existence.

Unfortunately, I must end on a negative note because I have an issue. The problem is that even if a fantastic cybercurrency is established, it will not always triumph in free competition against weaker cybercurrencies. By the way, I say this despite being a huge supporter of currency competition in general, which I've spent a lot of my career defending, and despite the fact that I'd like to see Bitcoin and other digital currencies compete freely against established fiat currencies. That is, I am a strong supporter of a level currency playing field, with no restrictions that artificially raise the relative cost of using any particular type or brand of money, such as the recently enacted IRS ruling defining Bitcoins as a commodity and subjecting their sellers to capital gains tax.

The problem is that, even on such a fair playing field, a perfect cybercurrency, assuming one exists, would struggle to compete competitively. For the reasons I've already stated, it would have a difficult time competing with the current US dollar or any other well-established fiat currency. But the dilemma is considerably worse, because even if the finest possible cybercurrency simply had to compete against other cybercurrencies, such as Bitcoins, there is no reason to believe it would prevail.

Part of the difficulty is that Bitcoins already have a significant first mover advantage among cybercurrencies. But there's a lot more to it. To understand the root of the problem, we must look at Friedrich Hayek's theory of currency competition, as presented in Denationalisation of Money, the book that sparked the private currency movement. [4] In many aspects, Hayek's arguments in that book have proven prescient, particularly in terms of forecasting the potential of "private" fiat currencies. Of fact, as we've seen, and as Bitcoins indicate, the border between a commodity and a fiat currency is a lot blurrier than economists thought; however, despite their modest success thus far, Bitcoins and altcoins come very near to approximating what Hayek had long anticipated.

The problem is that Hayek assumed that competition among various "fiat" currency issuers would favor those offering currencies with the highest buying power, while driving out others. If you talk to economists, it all makes sense since they consider purchasing power stability to be indicative of a currency's soundness. The trouble is that it doesn't follow that currency consumers, or individuals who choose which currencies to accept in trade and hold among other assets, aren't inclined to take a macroeconomic approach as well. They will, first and foremost, prefer (as has been repeatedly stated) a currency with a large user base over one with a smaller base, ceteris paribus. Other things being equal, they are more inclined to prefer a cybercurrency that appreciates, the faster the better, since it resides in their computers' memory or another cyberwallet. Currency consumers, in other words, who are solely concerned with what is happening in their own wallet and not with the economy as a whole, may choose the currency that promises the most severe deflation!

In short, while a high-quality cybercurrency is possible, it is unclear whether such a cybercurrency would be able to supplant weaker rivals even if they all raced on an equal footing and (to use a metaphor) began the race lined up at the same starting gate. This means, ironically, that while supporters of private cybercurrency may take pride in the possibility that they have figured out how to build a better mousetrap than governments have, they may have to rely on at least one of those governments to embrace their invention—and even rule out potential competitors—in order for it to succeed.

So, I'm left with an issue, and it's a very bad one. I'm hoping Anita will be pleased. I, on the other hand, can't seem to shake the notion that I'm a little down.


(As many Alt‑M readers will know, my interest in Bitcoin goes back to its earliest days, and even before that: like my grad school mentor and regular Alt‑M contributor Lawrence White, I took part in the 1990’s “cypherpunk” movement that prefigured Bitcoin’s development. Not quite two years after Bitcoin’s January 2009 launch, when one Bitcoin was worth less than $5, I wrote “Synthetic Commodity Money,” one of the earliest research papers addressing the economics of cryptocurrency. That paper wasn’t published online until August 2014. Soon after that I wrote a second paper, “Bitcoin: Problems and Prospects,” for Hillsdale College’s 2014 Free Market Forum, which neither Hillsdale nor I ever bothered to publish. I publish it here for the first time, leaving it to my readers to decide whether, and to what extent, the opinions I express in it have withstood the test of time.–Ed.)


Anita Folsom, in inviting me to take part in this year’s Free Market Forum, originally suggested that I write about the problems of Bitcoin. Although I suppose I might have done so easily enough, I have chosen instead to review both Bitcoin’s problems and prospects. I’ve made this choice because, while I recognize Bitcoin’s shortcomings, some of which are indeed serious, and while I even go so far as to wonder whether Bitcoins will still exist when this paper appears in print, I nevertheless consider them a wonderful development, and one that holds out some enticing possibilities for the future of money.

** Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of USA GAG nor its advertisers. The author will not be held responsible for information that is found at the end of links posted on this page.

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