It is a brilliant marriage of technologies that will make any true geek slobber. It's like the computers and economics had a baby, who then married cryptography and math, and had an affair with finance and politics. Moreover, it appeals to the geek's secret belief that most of the world's problems can be solved with technology.
But what are the characteristics and consequences of Bitcoins? Can it ever be more than a geek's wet dream?
A Bitcoin Primer
First, let's take a quick glance of how it works. Bitcoin runs on a decentralised peer-to-peer network. Everybody connecting to the network receives a copy of the "ledger", which is a file containing a record of all the transactions made with Bitcoin. Each person has one or more "wallets" that show how many Bitcoins have been transferred to you. To transfer Bitcoins you create a message with the number of Bitcoins to transfer, an address for the receiving wallet, sign the transaction with a private cryptographic key from your wallet and broadcast it to the network so that it can be included in the public ledger. New Bitcoins are handed out as rewards for verifying and underwriting the ledger - called "mining" - and happens according to predetermined rules.
Since it is enscribed in a ledger, everybody can check the ownership of the Bitcoins. But it still retains some anonymity, because one seldom knows who an address key belongs to.
Instead of giving the details of how it works and how to use it (you can read more about it here, if you want), I would like to focus on what the implications are and whether it is in a position to grow beyond the niche market it serves.
Bitcoin Strengths
So far, it is hard to see what all the fuss is about: payment over the internet is not exactly a something new. But Bitcoin has a few compelling advantages over the established methods, such as:
- Easy transactions over the internet
- Enables anyone to send and receive payments over the internet
- No transaction fees
- Nobody can block a transaction
- No chargebacks
- No private information needs to change hands
- Predictable coin generation rate
Money is a representation of value. It is popular to say that it has two purposes: to facilitate trade, and as a storage of value. But those are not really distinct: storing value simply means facilitating trade across different time periods, and facilitating trade means simply serving as an abstract representation of other valued objects.
In traditional currency systems, money is issued by some authority. Usually, the central authority is following some kind of charter and is dedicated to keeping the system stable and predictable. Sometimes they mess up, intentionally or unintentionally, and cause hyperinflation or deflation. The results of these missteps have been depression, revolution and war, and the examples throughout history are abundant.
The issuing of Bitcoins, on the other hand, does not rely on a central authority. Bitcoins come into existence at a predetermined rate, about 50 per 10 minutes or so at the moment, and the total amount of Bitcoins is limited to 21 million. The Bitcoins are given as rewards to those verifying and underwriting the transactions that are being broadcast on the network, and can in principle be any one of the connected nodes.
A lot of ink has been spent on the limit of 21 million Bitcoins. In general, central banks issue currency with the aim of causing a modest amount of inflation - it is believed that this inflation can be beneficial for economic growth since it gives people an incentive to spend their money sooner rather than later, and it reduces the burden of debt through time - which is also an incentive to spend more money quicker because you will receive less goods and services in exchange for your money if you postpone the spending.
With an upper limit of 21 million Bitcoins, deflation will be the inevitable result as ever more goods and services need to be represented with the same pool of Bitcoins (assuming that Bitcoin survives). Deflation is believed to incentivize hoarding and discourage borrowing and investment. After all, why buy something today, when I can buy more for the same amount tomorrow?
On a personal level, it could seem like deflation is a good thing - your savings increase in value over time. And looking at modern consumption-based society, perhaps it would even be a good thing for the planet to get some saving going on? Besides, those with savings are often seeing the growth of their savings outstrip inflation already, so they are experiencing a kind deflation. Furthermore, people with debt are normally paying interest which is higher than the inflation, so it seems they don't see any bottom-line benefits at the end of the day anyway.
I am trying to make the point that deflation already exists, all things considered. Increasing savings and slowing down consumption could be good things for the planet, but good for the planet may not be good for the economy - at least not short term. A deflationary spiral can apparently lead to depressions, mass unemployment and economic stagnation, such as the Japanese "lost decade".
Let's take a look at it from yet a different perspective: if you provide a good or a service in exchange for any kind of money, then that money must eventually be spent on something - otherwise you have, in a very real sense, provided your good or service for The longer you can postpone your spending in a deflationary environment, the more you can receive in return. But this possibility already exists for most people, as an interest-bearing bank account will normally give you an interest higher than the inflation rate. Has that stopped people from spending? Of course, this argument assumes the deflation rate is moderate. Investment may also continue, as many holders would probably prefer chasing higher returns than passively growing their real value by waiting for deflation. Modest deflation seems more likely to cause a shift in interest rates, rather than spark hoarding, panic and depression.
That may not have been the thoughts of the creators of Bitcoin, and tomorrow they may not even be my thoughts anymore either, but at the moment it makes some sense. And it hardly seems likely that Bitcoin will have any such influence on the economy anyway. I'm not trying to make any particular point for or against inflation or deflation, or even Bitcoin - I simply intend to share my thoughts on the characteristics and consequences.
What will determine the success or failure of Bitcoin?
Bitcoin has many, many challenges ahead if it is to expand outside of the current niche.
Currently, it appears to be most popular for unlicensed gambling, unlicensed trading and drugs. The appeal for these players is obviously that there is no central authority to deny your payments, and that payments are largely untraceable. This shady business puts the whole technology in a bad light, and makes legitimate users wary. So Bitcoin has a serious image problem, and desperately needs legitimacy any way it can get it.
Bitcoins are surrounded by an aura of mystique and geekiness. That may be appealing to some of us, but is probably repelling many others and making their heads spin with the explanations found on the web. The message of Bitcoin needs to be seriously simplified for the mainstream.
Currently, the exchange rate to traditional currencies is prohibitively volatile. If you could buy bread and milk with Bitcoin, that might not be such a big concern. But in general you can't, and you need to exchange it for a more widely used currency for it to be useful. So this is a combined challenge, since the lack of goods and services priced in Bitcoin forces all the users to use an exchange - and then suddenly volatility is a huge issue. Also merchants who price their goods in Bitcoin need to eat, and often change the prices in response to changes in the exchange rate.
An objection that is often raised is the disproportionate amount of Bitcoins hoarded by the early adopters, and it is easy to see why somebody would distrust such a system. What can be done about it? Can someone press the great big reset button? Would we want that to happen? Important as it may be now, this issue is likely to decrease with time as the early adopters cash in and set their Bitcoins free. But this still represents a serious challenge for the legitimacy of the currency.
More than a geek's wet dream?
Bitcoin is already a success. It serves a niche market quite well, and is so far an interesting experiment that is fun to follow and tinker with. Lucrative for some, waste of effort for many, but it offers a fascinating exploration of technology and economy for the open-minded geek.
Despite the serious impediments to going mainstream, it seems to be reaching a wider audience every day. Press coverage has been generous, and every mention of Bitcoin in the right context lends it a little more legitimacy.
The greatest potential for Bitcoin at the moment, is as an in-game currency in online games. If games would standardise on using Bitcoin in their games, Bitcoin would immediately gain access to a large amount of technology-friendly users that would boost the legitimacy and the usage of the currency. The currency would spread like wildfire. However, very few game creators would be interested in connecting the in-game economy to the outside world, even though this could give both the release and Bitcoin a great boost.
Bitcoin is without a doubt a promising and exciting technology, but will I ever be able to buy milk and bread for Bitcoin? Not anytime soon. At least not until Bitcoin sheds the "underground" image, simplifies the message and finds a solution for the high exchange rate volatility.
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