Brother, Can You Spare a Bitcoin?

This relatively new phenomenon is definitely an alternative currency to those run by the central banks of the world. Like frequent flyer miles, it is purely electronic, but unlike frequent flyer miles, it has use with more than just one vendor. People can buy goods and services across the globe simply by sending bitcoin via the Internet from their electronic "wallet," as the bitcoin folk like to say, to any another electronic wallet. All the vendor has to do is set up the wallet and agree to accept bitcoins. The list of merchants who take bitcoins is growing rapidly, in part because people want to use them, in part because bitcoin charges the merchant a lower fee than most credit or debit cards. Even some pizzerias take them. The new currency has gained, quite literally, greater currency.²

With a limited supply, this increased usage has driven up the value of bitcoins when measured in other currencies. The dollar-exchange rate has, for instance, gone from $13 per bitcoin last January to a high of $1,200 late in 2013, though pricing is neither centralized nor is there an authoritative source. Such a price appreciation, and a good deal of volatility along the way, has attracted both investment and speculative interests. There is some suggestion, in fact, that most of the interest in bitcoin today is as an investment or as speculative, rather than for a commercial transaction. For the everyday investor, the volatility may look more like risk than opportunity. A further risk in bitcoin is the law. It is hardly settled and very well could change. Bitcoin also lacks a certain security that other investments or conventional currencies have. Of course, everything is subject to price fluctuations; but with bitcoin, the lack of registration could result in total loss. The only place to custody bitcoin is either on the owners' hard drive, the electronic equivalent of the mattress, or in a bitcoin wallet service. The failure of either could simply wipe away the asset without a trace, like cash in a fire. And several bitcoin wallet services have imposed this fate on holders simply by going out of business.

Against such risks, bitcoin does offer several attractions beyond the obvious chance of a handsome dollar return from a well-timed purchase. It is a clever, some say elegant, solution to a long-standing payments problem. Such innovation naturally attracts tech enthusiasts, if only for the affiliation. For more egotistical geeks, it offers another way to claim that the internet, they, and their sort will eventually rule the world. For those who seek privacy, bitcoin offers anonymity, like cash transactions, but with the added attraction that it can span the globe almost instantaneously. For those who distrust government and central banks, it offers an alternative to conventional currencies, the way gold does. But though bitcoin offers fulfillment on all these fronts, it still seems unlikely to go as far on any one of them as its enthusiasts like to claim.

There is no denying that bitcoin's founder, Satoshi Nakamoto (a pseudonym that roughly translates from the Japanese as "clear thinking in the basics"), is a person of genius. He or she has shown the world how to arrange a payments system without a central clearing house. Previously, all believed that a central clearing mechanism was essential to keep track of money flows and to ensure that holders could not spend their holdings more than once. Nakamoto, with a remarkable application of the otherwise commonly used public-key encryption, showed how wrong this presumption was. His or her system uses the encryption to protect the holdings and the anonymity of the transactions while at the same time making elements of the exchange public, in what the techies call a "block chain," which effectively is a record of all the movements of a particular pool of bitcoin. Others in the system can then examine these chains to verify the legitimacy of each new transaction. The system encourages people to do the intense mathematics of verification by awarding them new bitcoin. Because these mathematical puzzle solvers, called "bitcoin miners," are just others in the system, the payment network refers to itself as a peer-to-peer system.

Nakamoto's solution opened tremendous possibilities, at least in theory. Without the need for a central clearing house, he or she has invented a currency without the need for a central bank. In that sense, bitcoin takes on the quality of gold in the monetary system. Also like gold, the overall supply varies little. The bitcoin system limits the amount issued over time and also sets an overall limit on how many bitcoins can ultimately be issued. There can, in other words, be no quantitative easing or open market operations with bitcoin, no discretionary monetary policy at all, for that matter. Unlike gold, but like cash, public key encryption offers bitcoin transactions complete anonymity. There is, clearly, an appeal here to those contemplating illegal or illicit activity to whom the anonymity of cash has always appealed. But on a slightly higher plane, the anonymity and freedom from any central authority appeals to any who suspect the competence or integrity of monetary and other governmental entities, those, for instance, who worry that quantitative easing ultimately will lead to inflation.

But for all its appeals (and the hopes and expectations that have gone along with them), bitcoin has distinct limitations. The cap on the supply, currently set at 21 million units, constrains liquidity enough to raise questions about the currency's ability to challenge any but the smallest conventional currency. Were bitcoins used sufficiently to make a more important challenge, demand would so far outstrip availability that its exchange rate would rise into the stratosphere. Even if people then were willing to deal in fractional amounts, beyond the eighth decimal place to which bitcoin trades today, the system would still have a hard time meeting the liquidity and transactional demands of a normal currency, much less a major world reserve currency, as some enthusiasts have suggested it someday might. Gold has a similar problem as a substitute currency, but looks abundant by comparison to bitcoin.

Nor is the much touted and, for some, attractive anonymity secure. Right now, the public key approach seems to work, but the amount of theft alluded to in the bitcoin commentaries (there are no statistics) suggests that matters are not so well protected as they seem theoretically. And intrusive hacking technologies are always advancing. After all, Target thought its credit card records were secure. Efforts to hack into the system and peoples’ wallets would grow disproportionately as bitcoin becomes more popular and bitcoin, accordingly, becomes still more valuable. Meanwhile, such growth would almost surely prompt the authorities to direct their ample resources to discovering who is buying what from whom with bitcoin.

If this currency, however elegant its technical achievement, is fundamentally limited, the passion expended in discussions of it, both pro and con, makes an interesting spectacle and an equally interesting footnote to this discussion. Much of the debate on bitcoin actually reveals more about the political-economic biases of the debaters than about the subject. The libertarian crowd at the Cato Institute, for instance, or clustered around former congressman Ron Paul (R-TX) or Senator Rand Paul (R-KY), seems willing to ignore practical constraints in order to have something through which to criticize existing monetary arrangements. On the other side stands an angry Paul Krugman, the New York Times columnist.³

He is less than enthusiastic, and has actually entitled one of his recent columns, "Bitcoin Is Evil." There, and in his blogs, he makes two moral judgments, a strange thing indeed to do with a currency. Both judgments seem less than well informed. He claims that the award of bitcoin for solving mathematical puzzles is "socially wasteful." Never mind that people would have little to do were the economy to ban all socially wasteful activity—he misses the point that the problem solving is not a game but rather a way to facilitate the payments mechanism. It is, then, no more or less wasteful than check clearing. Krugman also criticizes bitcoin as unreliable because it is only as valuable as people think it is. Since this distinguishes it not at all from dollars or gold or any other asset, good, or service, it seems a strange argument for a noted economist to make. No doubt it is less a misunderstanding on Krugman's part than simply a handy way to criticize something he does not like, most likely because it offers people a way to sidestep government, one thing Professor Krugman clearly does like, very much.⁴

If bitcoin is not nothing, neither is it the revolution some fans claim nor the "evil" Krugman and others like him see. To the extent that it has revealed the lengths to which partisans will go in today's debates, it has provided the world with at least one valuable service. Certainly, getting an otherwise brilliant economist to make an undergraduate mistake has to be worth something. Otherwise, bitcoin will continue to provide an interesting outlet for an increasing number of transactions and an alluring source of interest. It is, however, not a challenge for conventional monetary or payments systems.

¹For more detail on the bitcoin, see, for example, the Wikipedia entry on bitcoin; Adam Serwer and Dana Liebelson, "Bitcoin, Explained,"Mother Jones, December 31, 2013; and "Bits and Bob,"The Economist, June 13, 2011.

²Anders Bylund, "Should You Buy Some Bitcoin Today?" The Motley Fool, December 26, 2013.

³Timothy B. Lee, "Here's What Paul Krugman Doesn't Get about Bitcoin,"The Washington Post, December 23, 2013.

⁴Paul Krugman, "Bitcoin Is Evil,"The New York Times, December 28, 2013.

© Lord Abbett

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