Will Bitcoin make the world go round?

The Bitcoin tribe is still a small one, and consists mainly of computer geeks, drug-dealers, gold bugs and libertarians. From the Economist Apr 13th 2013

Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative. But I am not familiar with the specific product to assert whether it is the best potential setup. And we need a long time to establish confidence. I only talk from skin-in-the-game. If I had money in Bitcoin, I would have reported it. But I don’t yet. I am waiting to understand it better, not with my brain, but with my experienceNassim Nicholas Taleb

Money is:

1. A unit of account

2. A store of value

3. A medium of exchange

Right now, Bitcoin is none of those things (in any serious sense).  From a tweet

______

A couple of years ago I heard An EconTalk podcast about a new electronic currency called Bitcoin. To be honest I found it all rather baffling and didn’t really think much about it until recently. However the Cypriot banking crisis has put Bitcoin in vogue. On Saturday March 16th Nicos Anastasiades, the Cypriot President announced a rescue strategy for the country’s banks that involved confiscating money directly from every single bank account in the country. The following Monday, the price of the Bitcoin rose from $45 to $55 on the major exchanges, and by Wednesday it had reached $65 dollars. There does seem to be a link between the events on the Mediterranean island and the performance of Bitcoin. In Spain the number of Google searches for Bitcoin has been increasing. Although the plan for Cyprus was eventually modified, the interest for Bitcoin remains. I was just looking at the exchange rate online one Bitcoin is now worth nearly 117 dollars. Has its time come?

Bitcoin is virtual currency that was introduced on January 3rd 2009. It is a cryptocurrency, a type of digital currency that is based on cryptography, making it difficult to counterfeit. Bitcoin is not the only virtual currency around – gamers on Second Life, a virtual world, pay with Linden Dollars. Their emergence shows that the creation of money is not, nor has ever been, a government monopoly. I have always found money and its creation one of the most challenging areas in the study of economics. Anything people come to view as money can serve some of money’s functions without any governmental authorisation. The classic example is the use of cigarettes in prisons as a medium of exchange.

Paper currencies have been accepted as money even when they no longer had government backing. When the first Gulf War concluded in 1991, dinars that had been withdrawn by the government of Saddam Hussein were used in Kurdish-controlled northern Iraq. They became known as “Swiss dinars” because they were printed with plates from Switzerland. Curiously, this illicit currency was soon worth far more than the government-backed dinars that Saddam was printing like there was no tomorrow. Swiss dinars would serve as northern Iraq’s fiat money for some ten years until a new national currency was brought in.

There is a strange mystery at the heart of Bitcoin. Who is John Galt? In Ayn Rand’s Atlas Shrugged that was the question. With the cryptocurrency we have a new question: Who is Satoshi Nakamoto? Bitcoin’s creator was a hacker(s) going under the pseudonym of Satoshi Nakamoto. From now on I will refer to him in the singular. Nakamoto no longer seems to be actively involved in the project but at the beginning he was behind much of the innovation. In 2008 he posted Bitcoin: A Peer-to-Peer Electronic Cash System on the internet, the foundational text of this virtual currency.

There have been a number of journalists seeking to unmask Nakamoto. The New Yorker named Michael Clear, a graduate student at Trinity College, Dublin, who is knowledgeable about economics, cryptography and peer-to-peer networks. Nakamoto’s. He is allegedly said to have said this to a journalist: “I’m not [Nakamoto], but even if I was I wouldn’t tell you.”

Fast Company’s investigation brought up circumstantial evidence that indicated a link between an encryption patent application filed by Neal King, Vladimir Oksman and Charles Bry. CNBC’s Rick Santelli says that many believe that it is Grigory Perelman, the eccentric Russian mathematician, who famously turned down the million-dollar Millennium Prize 4 he had won for resolving the Poincaré conjecture. Business Insider believes that it is “a small group of quants from New York or London, who are all experienced software developers. Whatever the truth may be, Nakamoto does not appear to be actively involved in the project. In April 2011, he told a Bitcoin contributor he had “moved on to other things.”

Gavin Andresen, the Chief Scientist at the Bitcoin Foundation, has described it as an attempt to bring back a decentralized currency of the people. It is not administered by a single authority and the currency is not subject to inflationary moves by a central bank. It enables instant peer-to-peer transactions all around the world, bypassing banks altogether. Unlike our beloved banks, there are low or zero processing fees. As it is stateless it is hard to tax, freeze or trace this money.

Bitcoin fluctuates like any other currency – its value is determined by supply and demand in the market. One Bitcoin can be divided to eight decimal places. 50 Bitcoins are created every 10 minutes. As such, this currency behaves much like gold and other precious metals. With Bitcoin, miners use special software to solve mathematical problems and are issued a certain number of Bitcoins in exchange. This is how one Bitcoin one website describes the system:

“Mining is an important and integral part of Bitcoin that ensures fairness while keeping the Bitcoin network stable, safe and secure.” The idea is to mimic digging gold out of the ground. In the beginning you find a lot, but then you work harder and harder, and go farther and farther, less and less to find. The rate of growth will gradually be scaled down, with a final limit of 21 million Bitcoins.

There are a number of problems that I can see with this cryptocurency. The number of people who accept Bitcoins for products or services is fairly small. It is growing every day as the system becomes more popular, but getting enough people to trust it is complicated. They are in a catch-22 situation. Merchants don’t want to accept Bitcoins till more people are using them, and people don’t want to use Bitcoins until more merchants and other people are accepting them.

The currency has been criticised as a tool of speculators and money-laundering.  Could it be another Ponzi scheme or a speculative bubble, like the mania for tulip bulbs in 17th Century Holland? There are also important security issues with the ever-present danger of hacking. I am suspicious of central government. There are many examples of governments debasing their currency or deliberately provoking inflation. However, are the alternatives going to turn out worse? I am not sure I would want to trust in the mysterious Satoshi Nakamoto,

According to philosopher John Gray Bitcoin represents a kind of cyber-anarchism.   Its proponents hope that internet will help them free themselves from government. Bitcoin’s users put their faith in the laws of mathematics. However, a virtual currency will never be able to escape the dangers of the real world. It is not difficult to envisage a number of negative scenarios. Bitcoin may crash and burn, be replaced by rival virtual currencies or be banned by governments because it is actually doing too well. For Gray, the freedom Bitcoin promises is illusory – the dream of finding some kind of technofix that can shelter us from power and crime and protect us from each other.

Having said that, I think that it is a worthy experiment. Anything that challenges the banks is a good thing. We do need new forms of money for the 21st century. However, I don’t think I’ll be putting my millions in there just yet. I can’t really get my head around it. I tend to be a late adopter with a lot of technologies. Indeed, I have never used PayPal. But I will be following this experiment closely. It’s going to be a fascinating ride.

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