Posted in: United States

Bitcoin and the Future of Money

By | September 16, 2014

In the eyes of some, government-backed currencies are coming to an end. To this small group of true believers, central banks like the Federal Reserve destabilize the economy and will bring an end to the supremacy of the dollar. Bitcoin, a completely virtual cryptocurrency, has captured the imaginations of libertarians and gold-standard lovers the world over as the dollar’s long-term replacement. Bitcoin was born into a world that had already begun to move away from paper transactions. Without the influence of governments or central banks, bitcoin truly operates like a free market system. However, despite having a passionate following, security concerns and volatility have plagued bitcoin. As a result, the cryptocurrency has little chance of replacing any national currencies. Nevertheless, virtual payment services like PayPal and bitcoin will likely continue to grow, as the economy moves increasingly toward a nearly paperless world. They may even push paper currency to the brink of obsolescence.

Behind the Code

After the economic collapse of 2008, confidence in the financial system dropped to all-time lows. The public lost all trust in the financial community, and many thought they could not rely on the government to rein in wrongdoing. Both sides found fault with the actions of the Federal Reserve: conservatives argued that quantitative easing risked inflating the dollar, while liberals worried that the Fed had not gone far enough.

In 2008, Satoshi Nakamoto published the now famous “Bitcoin: a Peer-to-Peer Electronic Cash System.” In the paper, Nakamoto describes a completely decentralized online currency that works on a peer-to-peer computer network. Complex mathematical procedures allow the generation, or “mining,” of coins. The system is designed with an absolute maximum of 21 million bitcoins, and it becomes progressively more difficult to keep the overall supply stable within those parameters. Unlike currencies controlled by central banks, no one can devalue bitcoin by flooding the market. All transactions denominated in bitcoin are logged and public to prevent double-spending.

Bitcoin pic 9-16

Bitcoin’s popularity has continued to grow. Indeed, several large companies, including eBay, Overstock.com, and Virgin Galactic have begun to accept bitcoin as a form of payment. The increasing legitimacy bitcoin has achieved should prompt further discussion regarding its merits and drawbacks.

For Freedom and Efficiency

The absence of a central bank like the Fed that prints fiat money separates bitcoin from virtual payment services like PayPal. This keeps supply fairly stable, which in theory keeps inflation low. Unlike the fiat money that most people use on a regular basis—and that PayPal transfers—bitcoin has inherent value due to both the difficulty of mining and the scarcity of coins. Similar to currencies backed by gold, holding coins has value regardless of government action.

Virtual currency advocates note that services such as PayPal create significant inefficiencies in the market. First, transaction costs place a silent burden on the market that does not exist with paper transactions PayPal charges a flat fee of 30 cents per transaction plus a percentage of each transaction. Though this may seem small, these fees can add up over time. Costs like this ultimately limit economic activity, especially for micro-economies, where the fees become even more pronounced.

The peer-to-peer network eliminates these transaction costs and makes trade easier. Small businesses benefit from this the most. PayPal’s banking or transaction fees can be prohibitively high. The peer-to-peer network of bitcoin eliminates this barrier.

International trade also benefits from the universality of bitcoin. Trading across currency lines forces people to pay taxes on both ends, as well as any additional costs from using wire transfers or services like Western Union. Bitcoin bypasses this confusion, bringing down barriers between markets.

But that is where the unique advantages of bitcoin end. All other benefits could easily be achieved by the economy moving from paper money to plastic. In theory, operating without a central government gives bitcoin the ability to operate as a pure free market system. Aside from the dangers of using a currency that exists outside of the law, this only counts as a benefit for those who do not believe in the effectiveness of central banks. Independent central banks provide critical services to an economy like stabilizing prices. Moreover, the majority of Americans view the Fed’s job performance as ranging from fair to excellent. This paints bitcoin’s market as a small fringe group of those who miss the gold standard.

Furthermore, if bitcoin’s user base grew enough to pose a threat to a company like PayPal, PayPal could lower its transaction costs to remain competitive. This assumes that the people using these services both know and care about these transaction costs.) Such an act would magnify the benefits of having government protection and limit the only clear “benefit” of bitcoin.

Printing money creates another drag on the economy. David Wolman, a contributing editor at Wired, notes in this book The End of Money, “Because the cost of making a coin or banknote is (usually) less than the face value of the object itself, the supplier of the money gets to keep the difference.” This phenomenon is called seigniorage. In the case of the United States, the Fed keeps all excess revenue from producing currency. According to Wolman, this amounted to $70 billion in 2010 and 2011. Moving away from paper currency eliminates this inefficiency permanently.

This does not even take into account the cost of holding physical money. The unbanked community in the United States, according to the FDIC, has grown to 43 million people. This means that 43 million people nationwide do not use banks or financial institutions to manage and save their money. Without access to a bank, these people rely on check cashing services and cash-only transactions to survive. Aside from the danger of operating exclusively in cash, check cashing services can charge fees anywhere between 1.5 percent and 10 percent, according to the Boston Fed.

People who do not use banks typically cannot afford to open savings accounts or have a credit card. According to the World Bank, three quarters of the world’s poor are unbanked. Even some who can afford to open a bank account abstain because of the associated costs. Bitcoin could provide the unbanked with a low-cost financial refuge. Peer-to-peer transactions and bitcoin denominated banks would allow the unbanked to have a safe, low-cost way to manage their wealth. Assuming the backing of a financial system, bitcoin could ultimately help bring many out of poverty by letting capital flow more easily.

Looking at the comparative advantages of bitcoin over hard currency shows why the technology has grown in popularity so quickly. As Wolman told the HPR, “PayPal transactions have a lot more friction … than BTC [bitcoin] ones. Fees and chargebacks [for merchants] are especially significant. The no-middleman nature of a BTC transaction not only reduces friction but strikes an important psychological chord, at least for a certain segment of the population.” Bitcoin, with its dedication to decentralization, inspires a select group—and confuses or scares everyone else.

The Drawbacks of Decentralization

What supporters see as bitcoin’s greatest strength, decentralization, also creates its most serious problem. Bitcoin prices have been unsustainably volatile. In 2013 alone, the value of bitcoin increased 86-fold and then quickly fell 70 percent in just four months. David Yermack, a finance professor at NYU’s Stern School of Business, notes in “Is Bitcoin a Real Currency” that the cryptocurrency “behaves more like a speculative investment than a currency.”

The values of currencies typically do not fluctuate so extremely, making transactions consistent: what costs one dollar today will probably cost a dollar tomorrow. In a system where bitcoin fuels the market, the price of goods will vary widely as the value of bitcoin rises and falls. Even if prices do not change with the value of bitcoin, consumers will hoard coins as the value rises and flood the market as it drops. Both situations would wreak havoc on the marketplace. Alternatively, an economy operating completely in virtual currency using PayPal could work much as it does today. The Fed could still expand or contract the money supply to respond to market conditions, thereby allowing the economy to thrive.

Safety risks also pose a major obstacle to the growth of bitcoin. All markets need both the rule of law and secure property rights in order to thrive. Bitcoin, in many ways, lacks both. In an interview with the HPR, Yermack argued that a decentralized currency cannot support an economy: “An important facet of any piece of property, including currency, is the ability of a government to enforce property rights—for example, by foreclosing on and reassigning property when somebody defaults on a loan.”

The government does not have the same power with bitcoin because a currency without government backing also lacks government protection. As Yermack observes, “If a government is not empowered to determine ownership and resolve disputes about title to an asset, it greatly compromises the utility of that asset for ordinary commercial purposes.”

The ability to print more money, even though it inspires images of inflationary oblivion, can also help strengthen an economy. Placing a hard cap on the total possible number of bitcoins also places a cap on the size of the bitcoin economy. A world that used bitcoin as the official currency would suffer from falling prices and pay cuts as the population continued to grow but the money supply dried up. This deflationary nightmare should cause as much fear, if not more, than the inflationary fear associated with deficit spending.

Securing bitcoin after mining has also proven difficult for many. In February 2014, the Japanese-based Mt. Gox bitcoin exchange folded after word of a massive theft got out. According to reports, 744,000 bitcoins were stolen, representing 6 percent of all bitcoin in circulation. Dell SecureWorks researchers have found nearly 150 different malwares designed to steal bitcoin. Making matters worse, the notorious online black market Silk Road used bitcoin as the primary medium of exchange for anything from child pornography to illegal drugs. Bitcoin appears to pose a security risk for consumers and law enforcement alike.

Bitcoin proponents see questions of bitcoin security as exaggerated or misguided. When asked about the safety of bitcoin, Wolman keenly distinguished issues with “wallet and like service providers being hacked, not Bitcoin itself.” These wallets are online services that store bitcoins and allow the holders to spend them.

At the beginning, all online monetary programs need to build the trust of the public. “How did the original team at PayPal build that trust? The least wordy answer is that they delivered a real value proposition that consumers recognized, while sufficiently minimizing risk,” says Wolman. Bitcoin now must overcome a severely troubled beginning, and the many security breaches may prove insurmountable.

However, technology only improves with time. As Peter Russo of CoinDesk told the HPR, “Disruptive technologies—whether they be wearable computers, 3-D printing or bitcoin—don’t happen overnight, and many experts estimate it will take between 5 and 20 years for bitcoin to reach mass adoption.” In time, bitcoin may find a solution for its volatility and security issues; but the time it takes to do so could prevent bitcoin from ever becoming mainstream.

Virtual Currency Base

When viewed holistically, bitcoin is best understood as a commodity instead of a currency. The classical economic definition of money is a medium of exchange, storage of value, or a unit of account. Volatility alone precludes bitcoin from serving any of these purposes. Bitcoin cannot store value when its value changes so often, and the fact that regular goods have odd bitcoin values makes it an unusual unit of account at best.

But if bitcoin does not truly operate as a currency, why do so many people use it? The lack of regulation has certainly spurred much of the support for the technology. Many libertarians, who see government intervention in markets in any form as anything from problematic to a moral affront, have flocked to bitcoin as the physical manifestation of their philosophy. Bitcoin can operate as the perfect test case to show the world that free market economics will work assuming no government intervenes.

As with most new technologies, the bitcoin community also skews in favor of millennials. In part, this reflects the growth of libertarian thinking among millennials. However, ideological shifts only partially explain a much broader point: plastic is just more convenient. Physical money needs to be stored and can incentivize petty crime like robbery. Virtual money, denominated in dollars and other government-issued currencies, becomes easier to use everyday. The growth of businesses like Square only shows how easy to use debit and credit cards have become.

“Everyone knows that most U.S. dollar transactions already use virtual currency, by way of credit cards, debit cards, bank transfers, and so forth. This is the case in all developed economies, and it seems likely to become even more true over time,” says Yermack. In 2012, all online commerce totaled over $200 billion, and this figure is poised to grow to over $350 billion annually in 2016.

Examining PayPal helps to understand the consumer side of virtual currency. PayPal has over 110 million users, 88 percent of whom are under 55 years of age. This means that this population only stands to grow. Critically, only 16 percent of PayPal’s customers report earnings over $75,000 a year, showing that online payment services do not only benefit the wealthy.

Moving Forward

The world is irrevocably moving away from physical money. As technology becomes increasingly integrated into our everyday lives, virtual currency will continue to grow. Of course, the fact that virtual currency is a good idea in principle does not mean that any virtual currency will work. Still, bitcoin has some advantages. The lack of transaction costs and the potential to uplift the unbanked seem particularly enticing. Moreover, security and volatility concerns may subside.

Bitcoin is still very young and has the potential to change into something entirely new. Many envisioned PayPal as a way for people to move money out of countries where it might be seized. Wolman may be right in saying, “PayPal then had a lot of the same … zeal that [bitcoin] has today. Maybe in 10 years, [bitcoin] will be as relatively mainstream as PayPal is … or [maybe] not. Maybe [bitcoin] will flop in a year.” Bitcoin faces an uncertain future and may struggle to expand its appeal beyond the fringes. In any event, it seems increasingly likely that the sun will ultimately set on paper money.

 

 

 

 

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