Bitcoin: Scam or viable currency alternative?

Bitcoin: Scam or viable currency alternative?

There is a sense in which the entire Bitcoin debate is profoundly unsettling, highlighting the fact that most currencies today are just like it – fictional, fiat money, printed and distributed, but not backed by anything other than consensus.

Seeing as even US treasury department, the tax agencies in Canada and Ebay have taken Bitcoins somewhat seriously recently, the time seems ripe for an assessment of what Bitcoin is, and whether it belongs to fiction or reality. Maybe that is the reason why the idea has received a fair amount of attention lately. Whereas fiat currencies are underwritten by a sovereign state, Bitcoin is underwritten by a powerful code, a cryptographic scheme, but that aside the differences are minute.

The term and idea of Bitcoin was conceived in 2008, with a paper by a programmer named Satoshi Nakamoto (believed to be an alias), and the software to exchange the virtual currency entered the scene in 2009. Nakamoto’s purpose was to create an opportunity for people to

“exchange money electronically securely without the need for a third party, such as a bank or a company like PayPal. Bitcoin is based on cryptographic techniques that allow you to be sure the money you receive is genuine, even if you don’t trust the sender.”

The objective is achieved by means of a sophisticated code, of which there exists a private and a public key for any Bitcoin user. The public key serves as an address, thus facilitating transfer of money – Bitcoins – whereas the private key is stored in the computer of the individual Bitcoin user, and forms a mathematical connection with the public key, such that transfers are authorized if the two keys match. It hinges on the fact that the private key is un-guessable, un-hackable and that the code cannot be used to generate fake transactions. This is allegedly secured by means of Nakamoto’s powerful, cryptographic software.

Interestingly, Nakamoto deliberately designed an upper bound in the code, such that the total amount of Bitcoins in circulation will grow in time at a decreasing rate, but never exceed 21 million (a very interesting and different feature given the ongoing currency wars). At this point in time there are 11m Bitcoins, according to Bitcoin Watch, but this figure is updated as more are created. The rules governing Bitcoin are very firm and specified by the software, thus making any kind of central agency such as a Bitcoin central bank obsolete. This could be the most democratic currency of all.

Transfers are ‘peer reviewed’ or ‘supervised’ by the entire Bitcoin community, such that software clients not involved in the transfer verify it. In the process, all transactions are logged in a public register (which ought to dismiss the US Treasury’s worries about Bitcoin being used for money laundering). In fact, Jeff Garzik, one of the core developers of Bitcoin, argues that Bitcoin is trackable from inception through every single transaction, which is a lot more transparency than you get with any other existing currency. The Bitcoin equivalent of the printing press is the computer; creating Bitcoins is called ‘mining’, which denotes a process where an individual Bitcoin client competes with other clients to complete a cryptographic puzzle in order to update the aforementioned public log of transactions. Being the first to solve this puzzle earns you a 50-Bitcoin prize, which is intended as a way of distributing Bitcoins, and is expected to decrease as the amount of Bitcoin in circulation approached the upper bound, after which point mining is rewarded with a fee from the verified transaction that has been verified and logged.

So far, Bitcoins are not accepted very widely – you can purchase a nice, warm pair of alpaca socks, but none of the large retailers has warmed to the thought of Bitcoin as payment. However, at a time when currencies worldwide are under a lot of pressure, and monetary easing is performed multilaterally and repetitively, it is certainly worth the time to engage in the thought experiment of Bitcoins. As outlined, there is a limited supply of Bitcoins, and money market operations would be ruled out entirely. This would inevitably result in gradual deflation if Bitcoin was to succeed as a currency, as the growth in circulating Bitcoins would decrease, increasing the value of each unit. Russ Roberts, economics professor at George Mason University notes, “that (deflation) is considered very destructive in today’s economies, mostly because when it occurs, it is unexpected,” But he thinks that won’t apply in an economy where deflation is expected. “In a Bitcoin world, everyone would anticipate that, and they know what they got paid would buy more then, than it would now.” Another vocal Bitcoin believer is Chamath Palihapitiya, ex-Facebook executive, currently running a venture capital fund called The Social + Capital Partnership. He argues in Forbes that:

“I personally own Bitcoin in my hedge fund, I own Bitcoin in my fund, I own Bitcoin in my private account. It is a huge deal. It’s a huge, huge, huge deal. Because what you’re talking about right now is, for the next three to five years, an unbelievably better stored value. It is gold 2.0. Right? The value of gold that hedges the world economy, about $9 trillion, right? Thirteen hundred an ounce, of which only a hundred to a hundred and fifty dollars is the actual production value. So all the rest is imputed…

Well, guess what? I can do the same thing with Bitcoin only I can do it outside the purview of every single government.”

Undeniably, Bitcoin is a game and relies upon consensus just as much as fiat currency does. Its role as virtual currency alternative has been critically questioned, not least due to remarkably high volatility, suggesting speculation, as this Daily Chart from the Economist exemplifies:

But that might change if Bitcoin would become a widely used currency, and the share of speculation relative to actual use was to diminish. As emphasized by Roger Ver, the owner of an online Bitcoin store in an interview with economic blogger Mike ‘Mish’ Shedlock:

“It is important to realize that Bitcoin has two independent functions:

  1. As a currency
  2. As a payment system

To use Bitcoin as a payment system, it doesn’t matter if they are worth $1 or $100,000 each. You simply buy the correct USD amount, and send it to the recipient who immediately exchanges them back into whatever other currency they want.

I don’t think bitcoin’s usefulness as an unblockable, uncontrollable, potentially anonymous payment system can be disputed. Time will tell how useful the Bitcoins within the Bitcoin payment system become as an actual currency.”

Time will tell indeed.

Categories: Finance, North America

About Author

Mikala Sorenson

Mikala Sorensen is an Economist with regional expertise in Europe. She holds a first class honours degree in Philosophy, Politics and Economics from the University of York and a Masters in Economics from the University of Copenhagen. Having interned at the Danish OECD-delegation in Paris and currently working at the Danish Ministry of Finance, she specialises in politics and macroeconomics. Analysis for GRI is an expression of her own views.