Thursday, November 21, 2013

PSA: Bitcoin is neither a currency, nor harmless

Disclaimer: my views on currency are not representative of those of most economists. For the sake of clarity, I write as if my opinions were authoritative, but I encourage the reader to question them.

Bitcoin, often described as a digital currency, is swiftly gaining popularity and media coverage as a possible alternative to the fiat currencies issued by national governments.

A Bitcoin is produced by having a computer perform an intentionally difficult mathematical calculation. When the calculation is complete, a Bitcoin is created. The difficulty is meant to keep Bitcoins scarce, and thereby endow them with value.

A fiat currency, such as the Canadian dollar, is usually endowed with value by law that guarantees its acceptance for the settlement of debts within a country. Typically, the government has a monopoly on the production of currency. While some small countries outsource the production of actual coins and bills, the basic point stands.

Bitcoin works differently: anyone with time and a computer capable of performing the calculations can 'mine' them.

It is no secret that from a historical standpoint, governments are almost guaranteed to abuse their power to create currency.

Temptations include printing money to pay bills or sweeten a re-election, limiting the money supply for reputation reasons and using the money supply as a tool to perpetuate an elite's political power and/or otherwise unsustainable economic policies.

Misuse of currency can lead to real devastation - see Zimbabwe's recent history.

I am sympathetic to the desire to get away from all this and switch to a currency that governments can't (easily) tamper with.

Unfortunately, Bitcoin isn't the answer. It isn't even a currency, and the economic misconceptions it is based on can have perverse and harmful, if unintended, consequences.

When we use a national currency, there is an expectation that we will be able to exchange it for almost anything we should need or want - even foreign goods. This is often true even if the currency is very poorly managed - we'll just need more of it.

Why is this possible?

Few things are as certain as taxes. Governments typically require that at least a portion of taxes be paid for in the national currency. Every tax-paying entity in the country therefore has a demand for the country's currency, because they'd like to avoid being jailed for tax evasion.

A fiat currency is therefore backed by the entire tax-paying productive capacity of the issuing country. If the world at large is fond of maple syrup, then the Canadian dollar will have value because Canadian producers of maple syrup will exchange at least some of their crop for the currency.

This is why a fiat currency doesn't need to be backed by gold, or silver, or anything else. If the country produces gold, then it's already backed by gold (though not at a stable guaranteed rate). It's also backed by falafel, painkillers, cleaning services, computers and anything else sold or created by a tax-paying business.

The value of fiat currency doesn't depend on the government requiring it for taxes - that's just one example of many that I chose because it's easy to explain in a few sentences. I leave it as an exercise to the reader to find others (a quick web search will yield a few).

Once you have at least a few entities accepting the currency no matter what, acceptance tends to snowball. Why does your friendly neighbourhood drug dealer accept Canadian dollars if she doesn't pay taxes? Because she can walk over to a convenience store and exchange them for candy.

(Note: lots of Canadian drug dealers and producers actually DO pay taxes - Canadian tax forms allow for paying taxes on income from undisclosed sources. No one wants to be the next Al Capone - a criminal mastermind finally brought down on tax charges.)

If the Canadian government made a mistake and accidentally quintupled the supply of Canadian dollars overnight, they would still have value. You could still exchange them for maple syrup, you'd just need a lot more of them (once prices changed).

Now, to Bitcoin. Why does Bitcoin have value?

Its creator, as interviews show clearly, thought currency had value primarily because of scarcity. Rare things have value. He figured that if he designed a way for Bitcoins to always be scarce, that would guarantee their value.

Fair enough. That doesn't make it a currency, though, that just makes it a scarce good.

The toenail clippings of registered nurses are also scarce (and actually collected for a few research applications), but that doesn't make them generally valued, or something you'd take to the fast food joint to trade for poutine.

National currencies have value largely because we can trade them for stuff we want. This, in turn, is because there's always a currency accepter of last resort - the issuing government. If worse comes to worst, the Canadian government itself will always accept Canadian dollars in exchange for, say, a parking ticket.

Who's the accepter of last resort for Bitcoin?

No one, as far as I’m aware. If I’m wrong, then whoever it is stands up and promises to trade Bitcoins for real stuff (like pizza or software) no matter what and forever is being a bit silly. They run a very high risk of being left holding the bag if there’s ever a crisis of confidence in the market.

While a number of businesses - not all of them illegal - currently accept Bitcoin, there's nothing in place to keep things that way. (Bonus link: a university recently started accepting Bitcoin tuition payments.)

That's why Bitcoin is not a currency. There's no expectation of being able to trade it for almost anything you might need or want.

Store credit coupons such as Canadian Tire money are closer to being currency, because the store will almost always trade them for real stuff.

They're still not currency, though - you can't easily trade a hardware store’s store credit for rice or soap.

One of the things that makes a national currency special is that if a nation's citizens are alive, then by definition everything necessary for life is available in the country. Most or all of these necessities are typically available in exchange for the national currency, in both legal and black markets. (There are exceptions: during periods of hyperinflation, producers and merchants may insist on payment in more stable, ‘hard’ currency.)

Suppose that these problems went away, and tomorrow everyone started accepting Bitcoin.

Bitcoin would still be a bad idea, simply because of the way it's produced.

To produce a Bitcoin, you need to intentionally waste a scarce resource: computing capacity. The mathematical problems solved are difficult, but they're also intentionally useless.

Bitcoin is created through the virtual equivalent of digging holes in the desert and filling them up again. While the activity itself is completely useless, it wastes labour, shovels, water, transportation and so on.

Earlier this month, a technology company sold $3 million (US) of Bitcoin mining equipment in four days.

That's 3 million dollars - more than you'll probably ever earn in your life - being spent on machines devoted to solving useless problems. Three million dollars that could have been exchanged for just about anything on the planet, including malaria research, legal aid for women at risk, and so on.

As an economist, I'm trained to think about the efficient allocation of scarce resources among unlimited needs and wants. From this point of view, the method for creating Bitcoins is obscene. I struggle to find any perspective from which it is morally justifiable - maybe one of my readers can help me with this.

As if the waste of computing resources isn't bad enough, the mining method also creates perverse incentives. In a recent example, mobile game developers are pondering hijacking their players' computing capacities to mine Bitcoins for them.

Even if this is agreed to by the players, you're still slowing down useful machines in order to solve useless problems.

The situation isn't hopeless. There's at least one way to make Bitcoin more palatable: turn it into a reward for equally difficult, but useful computation.

Lots of basic research - gene-sequencing, parsing astrophysical data, brute force molecular pharmacology and so on - require a ton of computer power. Some researchers already farm out their calculations to volunteers. The most famous example is probably the SETI@Home program.

If Bitcoins were rewarded for crunching THESE numbers, then it could actually benefit society.

It would also partially solve the 'accepter of last resort' problem. An academic organization using Bitcoin miners for gene sequencing, for example, could accept Bitcoin payments for access to academic articles and databases that usually require payment in hard currency.

(Aside: it is true that by providing an incentive to solve mathematical problems that are currently difficult, Bitcoin mining encourages innovation. That is also why the technique could be usefully harnessed for the improvement of basic science by being applied to the solving of difficult problems that are also useful and relevant.)

Thus ends my PSA. In its current state, Bitcoin is not a currency, and is harmful. With any luck, this'll change, but for now, don't buy into the hype.


TG said...

Think about it this way: The computational power of the Bitcoin network helps secure the network and process the transactions. It's far from useless. It's the first time in Human history that you can transfer money quasi-instantly anywhere in the world, at all time for little to no fees without having to trust anyone.

Isn't that worth a lot to humanity ?

You need to think more outside of the box and deeper to dig Bitcoin's real innovation.

Bitcoin could enable a cashless world, think about all these trees cut down to print paper, all these ATM that have to be built, Bank vaults, Armored trucks transporting cash. How much Oil and how much man hour are wasted on that ?

And that's not even the tip of the iceberg of the possible that Bitcoin enables. This a revolution. And you want to spend a lot of time thinking about it and what it could imply for all of us.

Willem de Leeuw said...

USD3m (and probably the rest) is nothing in the scheme of things and relative to the other things humans waste their money on that could otherwise be spent on philanthropic things e.g., the latest Hollywood Marvel comic adaptation, cigarettes, booze, after-market exhausts, luxury cars and so on.

@ TG: Most banknotes are made from cotton and anyway, most paper is made from trees from managed forests. It's the bleach I'd worry about... ;) We'd probably waste a lot of man hours with Bitcoin trying to track down the dudes who anonymously stole it from you. If more people used credit and debit cards - and they slowly are - the need for ATMs, cash transport etc. would reduce, so Bitcoin/crypo-currency isn't the only way to achieve this.

Bitcoin is too insecure from theft, it's too risky without deposit insurance schemes and we use currencies today that can be materialised and de materialised at will.

TG said...

Willem, thanks for teaching me that about banknotes, I will look less stupid next time!

No objection to what you said except Bitcoin is cheaper to use than credit cards (0% or near 0% fees).

It's not controlled by 2 oligopolies.

It can be setup much faster than accepting credit cards.

You don't need a bank account (most of the world is still unbanked but everyone has a mobile phone).

There is no risk of identity thefts unlike credit cards when every time you use your credit card online or offline, the seller just have to keep your number to spend your money.

There is no risk of fraudulent chargeback for sellers.

Meanwhile the fact that you need to be technologically savvy to protect your bitcoin savings is easily explained by the fact it's only 4 years old and so far adopted only by geeks. Most of the ecosystem still has to been built on it for your average person. Like the Internet was hard to use securely and easily in the 80's.

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