The Problems with Bitcoin

| Originally published on on January 4, 2014 |

There are a number of things that Bitcoin doubters bring up (and rightly so) and that will need to get ironed out if Bitcoin, in one form or another, will end up being successful. Here is a quick initial rundown of the major issues (in no particular order):

1) High volatility – This is a big issue right now for Bitcoin as a currency and a form of payment. Just in the last 3 months, the value of 1 BTC has gone from $121 to a high of $1,147, down to $522 and now back up to $870 (see chart below from Coindesk). 

Coindesk price chart

There is no way that an asset with this level of volatility can achieve widespread use as a store of value or a medium of exchange in the short term, although it is clearly a dream for traders and speculators (assuming the liquidity is there for them to get in and out).

But high volatility today doesn’t mean it will always be like this, and it would be an interesting excercise to look at the volatility history of comparable assets (especially early in their lives) and also to understand what could reduce the volatility to a palatable level.

2) Deflationary bias – The Bitcoin currency, as defined today, has a limited supply: the total number will never exceed 21M. This is just how the system itself works, with the “mining” of Bitcoin becoming progressively harder so that less and less are created over time, and with the last Bitcoin being created sometime in the year 2140 (although the growth will slow to a crawl by the late 2020s). 

Now, depending on who you ask, this is either one of its most attractive points or its fatal flaw. Libertarians love the fact that supply is limited and there is no possibility of a central bank increasing supply and “debasing the currency”. Others worry that a currency with limited supply will be deflationary, meaning that as the economy and spending around it grows, each unit will be in more demand and therefore become more valuable. Since people know that their currency will be worth more tomorrow, they will delay their spending, which will cause the economy to slow down to a crawl.

Unfortunately, like many other things in economics, there will be no absolute answer to this issue. But we’ll at least look at the stronger arguments on each side.

To be clear, if everyone were to conclude that having a limited supply is a bad thing, the Bitcoin algorithms could be changed to allow for a certain amount of inflation (e.g., 3% growth in supply per year). In fact, I’m fairly sure that there are some alternative cryptocurrencies that have baked such an allowance into their algorithms/protocol. However, this is clearly not a trivial change and what is probably not in the cards is a centralized body (like a central bank) that makes decisions on the amount by which to change the supply as that would change the whole tenor of Bitcoin as a decentralized system.

3) No intrinsic value – This is a big one for Bitcoin doubters (including Krugman himself!). Bitcoin is most often compared to gold or to a currency like the dollar, and the argument is that both these intruments have some intrinsic value backing them. In the case of gold, this is the fact that gold has industrial uses and can also be used in jewelry. In other words, people will always like gold (and presumably be willing to buy it from you) because it is shiny and they can do things with it. In the case of the dollar, the US goverment demands, through its laws or even its military, that you pay your taxes in dollars, hence dollars are in demand and there is some value there. 

Bitcoin, on the other hand, seems to have no intrinsic value. After all, they are just bits and any value exists only in the mind of those speculating in it. 

We’ll evaluate both sides of this soon.

4) Anonymity – Bitcoin has, rightly or wrongly, been associated with illegal transactions, most famously with the Silk Road market where people could purchase all sorts of illegal items and services. The larger fear is that since Bitcoin is anonymous, wider adoption will mean easier access to illegal services.

There are some problems with this objection, namely that Bitcoin is not entirely anonymous and that there is already ample access to illegal services with cash, but we’ll also explore this in more detail.

5) Competition – There also seem to be some doubts around Bitcoin due to how easy it is to create clones or competitors. I read this most recently in a blog post by Tyler Cowen.

It’s true that it is relatively easy to create alternative cryptocurrencies (see Dogecoin and Coinye as prime examples), but I find this argument somewhat baffling as it seems to ignore the basic network effects that set in over time with any system like this. However, I admittedly have not thought about it enough.

As a side note, a cryptocurrency is not only a 2-sided network like all other payment systems (having to attract both buyers and sellers), but in fact a 3-sided network since miners are needed to make it all work. Without the miners having something to gain, the transactions are not verified and the decentralized promise of the network fails to take hold.

6) Regulation – What will goverments do about Bitcoin? This is probably the most unpredictable of all these issues. Over the last year the responses have been varied: Germany gave Bitcoin the go-ahead as a unit of account, China was apparently giving tacit approval (and was credited with the huge runup in November/December), but has now prohibited payments in Bitcoin and deposits into the Bitcoin exchanges (also credited for the “crash” in late December). Meanwhile, Bitcoin companies in the US have had problems opening bank accounts and face a large regulatory overhead, but for the most part are making unimpeded progress.

So that’s a quick rundown of the major problem areas that get bandied about when discussing Bitcoin.