BitCoin - Good Idea or Disastrous Failure?

Network effects.

There are an infinite number of languages that we could be speaking, but we settle on the few we use because of network effects. There is an enormous value in establishing the first electronic currency because it’s the one most people will end up using. Early adoption gives an advantage. That value subsequently decreases for any additional electronic currency created because any new currency won’t have the established network that gives it value. Maybe two, or even three, will thrive but there’s not much hope for any past that.

The answer is, of course, somewhere in the middle. Bitcoins will never be the currency of the future. There will be increasing fees as mining stops generating free bitcoins. Deflation will make spending them unpopular, if they stabilize (and if they don’t stabilize, they would be a terrible currency). There is a cap on how many transactions can be processed per second that’s too small for a global currency. The blockchain will blow up like a balloon if bitcoin is adopted worldwide.

What bitcoin does well is sending dollars online. The volatility doesn’t matter if the seller immediately converts back to dollars through something like BitPay. If paypal is online credit cards, bitcoin is online cash. With Paypal, the seller assumes most of the risks with scams and mishaps, Bitcoin is the opposite. If the seller doesn’t ship, or you send your money to X01D334Q12 instead of X02D334Q12, your money is gone with no real way to get it back. If that’s something buyers are willing to put up with, there’s a chance it could find its niche there.

But there’s no reason we can’t have ubiquitous and seamless electronic transfers of dollars or euros in the same way, it’s just that we don’t quite yet have that infrastructure built out. Within five or ten years all this stuff should be available for your credit card or debit card. Once that happens there’s no need for a buyer to go online, buy bitcoins for the transaction, send the seller bitcoins, and the seller immediately sells the bitcoins for dollars. You can skip two steps if you can just send dollars.

This will happen anytime some financial service thinks it’s worthwhile to make happen. The only reason it’s awkward currently is that the vast majority of our transactions are with businesses that are already set up to take electronic payments, and the ones that aren’t are generally face to face and those are handled by cash and checks. I almost never need to send $50 cash to some guy in Indonesia. I might need to give the babysitter 20 bucks, but I can just hand her a 20 when she arrives.

So this function of bitcoins is only temporary as we work out the electronic infrastructure. Admittedly a temporary one-off boost like this might give bitcoin enough of a foothold to keep it alive a lot longer than it otherwise might. Witness how fax machines are still a thing.

A deflationary currency would be horrible for a national currency in a nation with a growing economy (and I assume we prefer growing economies).

Deflationary currencies promote saving (or perhaps a better term is hoarding). Inflationary currencies promote spending and investment. For a national economy, the ideal is a balance between these.

But bitcoins aren’t the currency for a national economy. They make best sense in a world with multiple currencies. Currently, the supply is not limited, yet the value is growing, dramaticaly. I attribute this to irrational exuberance, and I expect to see a number of corrections. Down the road, when the currency supply is fixed, it’ll find a free-market balance between its usefulness for hoarding versus its usefulness for spending.

That is, if people don’t buy it, it’ll lose value. If stops increasing regularly in value, people won’t be so inclined to hoard it, and will sell it.

I expect to see pretty significant fluctuations. But I don’t expect to see it drop through the floor to uselessness until it’s superseded by something that’s technically better (like litecoins, possibly) and which becomes more popular.

I doubt we’ll see it being effectively blocked by governments.

bingo: only the market governs its value.

Only sometimes. Most of the time, that makes it less reliable, as the government prints too much of it.

If it stabilizes, it won’t be deflationary. If it continues to increase in value, it certainly won’t be called a failure.

Jeff, you ignorant slut.

This should have been “Too often” rather than “Most of the time.”

It’s deflationary by design, by stabilize, I just meant volatility equivalent to other currencies. If it keeps shooting up like it has been, it won’t work as a currency. It might be a way to transfer dollars, but nothing will be denominated in bitcoins, since their value changes so fast.

Yes, no one is going to use bitcoins as a unit of account if the value relative to goods and services fluctuates wildly day to day. That’s an important attribute of money. Good money should serve as a medium of exchange, a store of value, and a unit of account. And if the value shoots up and down it isn’t a good store of value either, since you don’t know if the bitcoins you buy today are going to be worth twice what you paid for them, or half what you paid for them, or 100 times or 1/100th. As a medium of exchange that isn’t so important if you can convert them to hard money seamlessly, but it’s a big problem for other uses as money.

I disagree. The instances where runaway inflation occurs are the very rare exception, not the norm with government backed currency.

It’s not “deflationary by design”. It’s a fixed-supply currency, and whether it rises in value or falls depends only on demand.

It becomes deflationary only if the demand keeps rising. As long as that happens, it certainly can’t be called a failure.

It becomes inflationary if the demand tails off. I bet this will happen eventually. The question is, when? I wouldn’t trust Bitcoins for a 50-year investment. But whether it can last 5 or 10 or even 20 years is another matter entirely.

Both of these statements depend on your definition of “inflation” and “deflation”. The most common definitions are that inflation is when the prices of goods keeps rising; deflation when they keep falling. However, there are (IMHO nut-case) fixed-money-supply hawks (opponents of the Fed system) who define inflation as an increase in the supply of currency and deflation as a decrease. Clearly, bitcoins does not fit this definition of deflationary either.

If you have a definition for deflation that you can cite to back up your claim that bitcoins are intrinsically deflationary, I’ll enjoy learning about it. However, I think you’re mistaking the definition of deflation for the simple fact that any growing national economy that’s based on a fixed currency will experience deflation (which will stall growth). So, folks can say “fixed currencies are deflationary” in that context and be correct. That’s just not the correct context here.

I agree with you that nothing is likely to be denominated in bitcoins, not for the forseeable future. Maybe that means it fails as a currency, and to that extent I agree that it’s different than any currency that’s the basis for any economy. You could say the same thing about gold.

Bitcoin is surprisingly resistant to quantum computer attacks, actually. The public key for an address isn’t published until the money from that address is spent, and since the usual recommendation is to create a new address for each transaction, even an attacker with a quantum computer would need to crack the public key within a few minutes of its publication and then perform a successful double-spending attack, which is already quite tricky in its own right. And while a quantum computer could potentially use Grover’s algorithm to mine blocks more efficiently than a regular CPU, this would not necessarily break the system but would merely be another escalation in the mining “arms race” which was deliberately designed into the protocol.

I have to say, while I wouldn’t be willing to bet too much right now on whether the Bitcoin experiment will succeed (meaning it actually becomes a generally accepted medium of exchange for on-line purchases by “regular people”), it certainly is an incredibly clever design. There have been other attempts to design cryptographic money (e.g. the work of David Chaum) but they still required a central “bank” to keep track of people’s accounts and to back them with gold or with fiat money. And those other designs were much, much more complex than Bitcoin, which can actually be understood quite easily by someone who understands a few basic concepts such as cryptographic hash functions and public/private key encryption.

The fact that making the protocol de-centralized without allowing a hostile party with a lot of computing power to easily commit all kinds of mischief, requires an “arms race” in investment of computing power, is Bitcoin’s greatest weakness right now. Would be great if a more elegant solution could be found for that. But in the meantime, it’s already an incredibly powerful proof-of-concept, and it might even have a fighting chance of proving itself to be more than that…

By ‘having the backing of an economy’ I mean that people who hold US dollars value them because they are used as a universal medium of exchange in a country of 300 million people in the most productive country on earth and there is a rational expectation that country will continue producing into the foreseeable future. After all, Turkmenistan and Zimbabwe also have central banks that produce their currencies.

Right. And those economies are much smaller, with less demand for their currencies. Therefore those currencies are worth less, other things being equal. It all gets back to supply and demand.

Of course that doesn’t mean that you might not need a lot of currency X to buy one of currency Y, but in the aggregate, the currency which supports the larger economy MUST have the greater aggregate value simply due to supply and demand.

That gets magnified the more that currency is used in int’l trade.

It doesn’t have to be runaway inflation.

This inflation calculator says the US dollar has lost 49% of its value in the past 25 years, and 87% over 50 years.

What govt-backed currencies have lost less than, say, 25% of their value over the past 20 years? (Googling suggest that Japan might qualify.)

Consistent inflation doesn’t make a currency unreliable. In fact, moderate inflation is best for the economy.

I think the government putting money in boxes, burying the boxes, and inviting people to dig up the boxes to find the money makes more sense than BitCoin.

Here’s a good articlethat explains the disadvantages of a deflationary currency like bitcoin. It even provides a chart to prove that bitcoins are being used less as the value increases. It plots the ratio of the value of bitcoin transaction to the total value of all bitcoins. And you can see from the chart that the ratio is declining.

The problem I see with this argument though is that it’s potentially a transient phenomenon. One of two things can happen. Either people will stop spending bitcoins and the value will eventually plummet, or the price will eventually stabilize. In either case, there will eventually be an incentive to not hoard bitcoins. Obviously if the price declines, people will try to spend then and if the price stabilizes, there will be no disincentive to spending them.

The only real danger I see is that if the price spikes to a point where bitcoins essentially become unavailable, it will make it very easy for it to be displaced by one of the many other digitial currencies available.

The article mentions the fact that what is needed is a type of bitcoin central bank to help stabilize the price vis-a-vis other currencies. One of the possible benefits of something like Ripple XRPs is the fact that the sponsors will retain a controlling interest of about 1/3 of the 99B in XRPs they have created. I don’t know what their intentions are for that interest, but they could, if they so choose, use that to act as a central bank.

The best inflation is inflation that keeps up with how fast the economy is growing. Since our economy has a long-term growth trend, even accounting for depressions and recessions, nonzero inflation is required to keep it healthy.

Of course, you can’t tell that to some people, because they have a religious objection to inflation and demand that prices rising is terrible even if their paychecks have risen fast enough to keep pace. You can make demands of people and you might win, but making demands of reality is rarely fruitful.

Anyway, bringing this back to Bitcoins, they can’t possibly be intended as the sole currency of any economy. It’s going to be impossible to make them after a certain point, meaning a Bitcoin-denominated economy will hit a wall. Subdividing them will help, but it’s an invitation to hoard. A good currency gives rational people no incentive to hoard large amounts of it, because a good currency makes investment a better option than hoarding.

This is, in fact, where inflation comes in, bringing my post full-circle: Inflation works as a disincentive to hoard, by eating away at the real value of hoarded currency. The only way to avoid this is to invest your money at a rate somewhat higher than inflation. If your currency is deflationary, investments have to be much higher-return to discourage hoarding, which means they’re riskier, which further incentivises hoarding. Finally, the economy is going to continue to grow, leading to a Red Queen’s Race where a currency has to inflate somewhat simply to avoid being deflationary. This can’t happen if you can’t make any more of a given currency; every possible subdivision is still going to be deflationary, and encourage hoarding.

Actually, the reason the fed targets 1-2% inflation rather than 0% inflation has nothing to do with long term growth trends but the fact that targeting is a very inexact art. If you undershoot a target of 0% then what you get is deflation and deflation can be more pernicious than inflation in terms of economic growth since declining prices tend to cause people to defer purchases while increasing prices tend to accelerate purchases.

On the other hand if you target 1-2% inflation and you undershoot your goal slightly, the odds are you will still have at least SOME inflation and will probably avoid any significant DE-flation.

But it doesn’t make the currency a reliable place to stash wealth.

In theory, the interest rate you get should include inflation plus the risk free rate which is generally considered what is paid on govt notes of similar maturity.

Right now, the rate on a 1 year note is just above 0% (.13). Inflation is at about 1%though. The best you can do on a money market or savings account is about a half a point. And the best on a 1 year CD is maybe a full point.

So at the moment, you’re not even keeping up with inflation by staying in cash and that’s probably true of many times in history.

That’s why it makes more sense to try to invest sensibly in a diversified portfolio that combines a balanced mix of asset classes and only keep as much of your money in liquid assets (no, not scotch) as is prudent for your circumstances.