The Agenda

Thoughts on Bitcoin

Matt Yglesias is skeptical about Bitcoin. So is Matthew O’Brien, who compares Bitcoin to the Segway, a technology that at least some savvy investors assumed would be transformative, yet which turned out to be very much a niche product. Andrew Ross Sorkin feels much the same way. Actually, “skeptical” might not be the right word. “Contemptuous” is a better fit. Joe Weisenthal, meanwhile, is increasingly convinced of its potential, and Tyler Cowen sees bitcoin as (in part) a bet on China’s economic future. Jerry Brito of the Mercatus Center, a libertarian think tank, has written a provocative article (“Bitcoin: More than Money”) for Reason on bitcoin’s potential as a platform for decentralized cooperation of all kinds. Brito is also co-author, with Andrea Castillo, of “Bitcoin: A Primer for Policymakers,” a more comprehensive take on bitcoin and other virtual currencies.

Brito defines Bitcoin as follows:

At its core, Bitcoin is a completely decentralized ledger system. It can be thought of as a massive online version of an accountant’s book in which transactions are recorded by deducting from one account and adding to another. An accountant’s ledger can be used to keep track not just of dollars, but also cows or bushels of corn or anything else, and Bitcoin is just as flexible. That means it can serve as the backbone for any online transaction that relies on a ledger, such as property registration, futures swapping, and bonded contracts. Because Bitcoin is decentralized, these applications can exist largely outside regulators’ reach.

So what are the advantages of a ledger system over a conventional currency? The main advantage of a ledger system is that it reduces transaction costs. Brito explains this advantage as it relates to Bitcoin:

Until the invention of Bitcoin, online digital payments had to rely on trusted third parties, such as PayPal or Visa, to keep a ledger of account-holder balances, or a record of who owns what. For example, if I send you $100 via PayPal, PayPal will deduct the amount from my account and add it to yours.

Without such ledgers, digital money could be spent twice. Imagine that digital cash is simply a computer file, just as digital documents such as spreadsheets or photos are computer files. I could send you $100 by attaching a “money file” to a message. But just as with email, sending you an attachment does not delete that file from my computer. I could send the same $100 file to a second person, essentially spending the same money twice. In computer science, this is known as the “double spending” problem. Until Bitcoin it could only be solved by employing a trusted, ledger-keeping third party.

What makes Bitcoin revolutionary is that for the first time the double-spending problem can be solved without a third party. Bitcoin accomplishes this by distributing the necessary ledger among all users of the system via a peer-to-peer network. Every transaction in the Bitcoin economy is registered in a public ledger called “the blockchain.” Complete copies of the blockchain reside on the computers of everyone who uses Bitcoin. New transactions are checked against the blockchain to ensure that the same Bitcoins haven’t been previously allocated, thus eliminating the double-spending problem.

Transactions are checked by users called “miners,” who lend their computers’ processing power for that purpose. Miners essentially solve the difficult cryptographic math problems that verify transactions, and they are awarded newly created Bitcoins for their trouble. This is how new Bitcoins are injected into the money supply. As more users become miners and the processing power that is dedicated to mining increases, the Bitcoin protocol also increases the difficulty of the cryptographic problem miners must solve to verify transactions, thus ensuring that new Bitcoins are always mined at a predictable and limited rate.

This mining process will not continue forever. Bitcoin was designed to mimic the extraction of gold or other precious metals from the earth-only a limited, known number of the coins can ever be dug up. The arbitrary number chosen to be the cap is 21 million Bitcoins. This certainty and predictability appeals to many because it makes artificial currency inflation impossible. In most countries, a central bank controls the money supply, and sometimes (such as during the recent economic crisis) it may decide to inject more money into an economy. A central bank does this essentially by printing more money. More cash in the system, however, means that the cash you already hold will be worth less. By contrast, because Bitcoin has no central authority, no one can decide to increase the money supply. The rate of new Bitcoins introduced to the system is based on a public algorithm and is therefore perfectly predictable.

Yet as interesting as Bitcoin’s deflationary nature is, it is the decentralized design that makes the innovation truly revolutionary. It means you and I can transact online without PayPal or any other central authority between us, much in the same way we might exchange cash for goods on the street. This design has two important ramifications: First, because the ledger is decentralized, the Bitcoin protocol leaves governments with no intermediary to regulate or shut down. Second, the technology is potentially useful for many other types of transactions.

The value of a bitcoin is tied to the value of the transactions that will eventually take place in the Bitcoin economy, because a bitcoin is essentially the right to engage in transactions with other people who own bitcoins. The theory as to why we will eventually see a large volume of transactions is that it will be cheaper to transact on the ledger than it will be to transact off the ledger. One knock against Bitcoin is that people who own bitcoins will simply hoard them, as they have no good reason to use them in lieu of a conventional currency. This is the heart of O’Brien’s case against Bitcoin as I understand it, and it is a premise Sorkin endorses. But if it really is cheaper to operate in the (theoretically) friction-free Bitcoin economy, there is indeed a good reason to use them in lieu of conventional currency. Moreover, as the value of a bitcoin rises, it will grow more and more expensive for people to hoard bitcoins. At some point, people who own bitcoins will want to diversify away from them by purchasing other assets, just as at least some people who own valuable Apple or Exxon stock sell it every day. Suffice it to say, if the friction-free Bitcoin economy turns out to be a mirage, the value of a bitcoin will collapse. Much depends on whether we see further innovation in the Bitcoin economy, including financial innovation.

Regardless of what happens to Bitcoin, the idea of ledger-based money is going to be attractive to a lot of people. There are already a number of other ledger systems competing with Bitcoin, like Litecoin, and it is entirely possible that Bitcoin will be surpassed by one of its rivals. Perhaps the biggest barrier to Bitcoin’s success is that people see U.S. dollars, Euros, and a handful of other state-backed currencies as excellent stores of value, despite the fact that they entail somewhat higher transaction costs than ledger systems. (Keep in mind that citizens of other countries might nevertheless be wary of putting all of their faith in the governments of the U.S. and the Eurozone, or Canada or Switzerland or Norway for that matter, as they have very little ability to convince those governments to protect their interests, hence the appeal of a decentralized ledger system like Bitcoin.) It could be that the full potential of ledger systems will only be realized when a reasonably well-regarded sovereign government uses a ledger system as an alternative to a conventional currency. University of Michigan economist Miles Kimball has called for governments to embrace electronic currency on the grounds that it would allow central banks to set negative interest rates to fight recessions, an idea recently discussed by Danny Vinik as an alternative to Bitcoin. But Kimball’s e-dollars could easily take the form of a ledger system.

Many Bitcoin observers fixate on how it might be used to facilitate black market transactions. I don’t see that as particularly important, at least not in the long-run. What is really interesting is the potential of ledger systems to spur financial innovation. Brito and Castillo address this potential in their primer:

One of the most promising applications of Bitcoin is as a platform for financial innovation. The Bitcoin protocol contains the digital blueprints for a number of useful financial and legal services that programmers can easily develop. Since bitcoins are, at their core, simply packets of data, they can be used to transfer, not only currencies, but also stocks, bets, and sensitive information. Some of the features that are built into the Bitcoin protocol include micropayments, dispute mediations, assurance contracts, and smart property. These features would allow for the easy development of Internet translation services, instantaneous processing for small transactions (like automatically metering Wi-Fi access), and Kickstarter-like crowdfunding services.

Additionally, programmers can develop alternative protocols on top of the Bitcoin protocol in the same way that the Web and email are run on top of the Internet’s TCP/IP protocol. One programmer has already proposed a new protocol layer to add on top of the Bitcoin protocol that can improve the network’s stability and security. Another programmer created a digital notary service to anonymously and securely store a “proof of existence” for private documents on top of the Bitcoin protocol. Other programmers have adopted the Bitcoin model as a way to encrypt email communications. Another group of developers has outlined an add-on protocol that will improve the privacy of the network. Bitcoin is thus the foundation upon which other layers of functionality can be built. The Bitcoin project can be best thought of as a process of financial and communicative experimentation. Policymakers should take care that their directives do not quash the promising innovations developing within and on top of this fledgling protocol.

I’m thus disinclined to join the ranks of the Bitcoin-bashers. Bitcoin isn’t much now. But Bitcoin and its competitors could evolve into something really useful.


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