BitCoins: All Buzz, No Substance

Recently there has been a bit of buzz surrounding an electronic currency called BitCoin. I was intrigued because BitCoin is based on a combination of technologies — peer-to-peer networking and public-key cryptography — which yield a highly resilient, secure, private infrastructure for exchanges. Despite these advantages, there are several fatal flaws with BitCoins that will make them a very poor currency.

To explain why, we need to understand something about how something becomes a money.

Imagine three of us are stranded on an island. Each of us specializes in producing a different good. I catch shrimp, you harvest coconuts, and the third resident of the island (let’s call him George) weaves baskets.

Now, I would very much like to trade my shrimp for George’s baskets, but there’s a problem: George is allergic to shrimp. Am I cursed to forever remain basketless? No. I know that George likes your coconuts, so the next time I see you, I trade for more coconuts than I plan to use myself. I can now offer George something he wants, coconuts,  in exchange for a basket.

A transformation has taken place. Whereas originally coconuts were desired only for their use value, the value they have because people can use them to satisfy hunger, for instance, and their exchange value, the value they have because people think other people will accept them in a trade.

A given good’s exchange value has a tendency to snowball. If I believe that a larger number of people are willing to trade for a good, I am more willing to trade for that good myself. Eventually, we expect a single good or a handful of goods to emerge as the predominant media of exchange; they are then called monies. Historically, goods such as cigarettes, precious metals, shells, and many others have emerged as monies.

People’s willingness to treat an item as money is based on experience. They forecast that a good will be accepted in trade tomorrow because it was accepted in trade the day before and the day before that. If we follow this chain back in time, eventually we arrive at a point where the commodity is has not yet been used as a medium of exchange and is only wanted for its use value. The principle that the value of a currency can be traced back to a time when it was not yet a currency but just a commodity like any other is called the regression theorem, and interested parties can read more about it in Human Action Ch 17 § 4.

Typically once a commodity becomes a money, a variety of certification agencies will emerge. Suppose for example that our money is gold — examples of certification might be an imprint on a gold coin stating its weight and where it was minted, or a piece of paper entitling the bearer to a certain amount of gold at a trusted repository. This certification makes the commodity an even better money than it would have been without the certification. The certification is bundled with the commodity and traded, but is in principle distinct; the coin and the stamp in the coin are different “things.”

Now let’s consider BitCoins specifically. The BitCoin software operates by keeping a very secure, very resilient record of who owns electronic tokens called “BitCoins,” and be recording an a very secure, very resilient way when transactions occur using these tokens. As a reward for people who offer electricity and computing power to maintain the network that performs these tasks, they will occasionally be granted a new BitCoin in a random but predictable way (similar to how batters in baseball get hits in a random but predictable way).

So what is a BitCoin? A BitCoin is a highly trustworthy certificate — or at least it would be, if there were any commodity to certify. A BitCoin is a little like a very well sealed, very well documented box with nothing inside. Now, if there were a way to put something in the box, BitCoins could become a very good currency, but the current incarnation of the technology does not allow for this to occur. A good analogy for a marketplace using BitCoins would be to imagine a group that plays “catch” with an imaginary “ball” (a game I remember playing a few times back in elementary school), except that instead of playacting, the group actually believes they are playing catch.

I have ignored the role that governments play in the monetary system and several other complicating factors, but none of these are essential to the question and do not end up changing my opinion on the matter. In the long run, I have two predictions: first, BitCoins will not be used in a statistically relevant proportion of transactions; second, the market value of BitCoins will drop to zero.

Editor: Grant responds to some of your objections in a new blog post. Read it here.