The Bitcoin economy

The electronic currency Bitcoin has been in the news quite a bit lately since its value has risen from about $10 a year ago to over $650 today, hitting a peak of over $1000 less than a month ago. I remember hearing Gavin Andresen, who is a Principal of the Bitcoin  Virtual Currency Project (no single person nor entity issues or governs Bitcoin) talk about Bitcoin on Econtalk two years ago and was astonished at how little he knew about basic economics much less monetary policy. Paul Krugman criticized Bitcoin today in his New York Times column and Timothy Lee responded in the Washington Post.

The principle behind Bitcoin is actually quite simple. There is a master list, called the block chain, which is an encrypted shared ledger in which all transactions are kept. The system uses public-key cryptography, where a public key can be used to encrypt a piece of information but a private key is required to decrypt it. Bitcoin owners each have a private key, and use it to update the ledger whenever a transaction takes place. The community at large then validates the transaction in a computationally intensive process called mining. The rewards for this work are Bitcoins, which are issued to the first computer to complete the computation. The intensive computations are integral to the system because it makes it difficult for attackers to falsify a transaction. As long as there are more honest participants than attackers then the attackers can never perform computations fast enough to falsify a transaction. The computations are also scaled so that Bitcoins are only issued every 10 minutes. Thus it does not matter how fast your computer is in absolute terms to mine Bitcoins, only that it is faster than everyone else’s computer. This article describes how people are creating businesses to mine Bitcoins.

Krugman’s post was about the ironic connection between Keynesian fiscal stimulus and gold. Although gold has some industrial use it is highly valued mostly because it is rare and difficult to dig up. Keyne’s theory of recessions and depressions is that there is a sudden collapse in aggregate demand, so the economy operates at below capacity, leading to excess unemployment. This situation was thought not to occur in classical economics because prices and wages should fall until equilibrium is restored and the economy operates at full capacity again. However, Keynes proposed that prices and wages are “sticky” and do not adjust very quickly. His solution was for the government to increase spending to take up the shortfall in demand and return the economy to full employment. He then jokingly proposed that the government could get the private sector to do the spending by burying money, which people could privately finance to dig out. He also noted that this was not that different from gold mining. Keyne’s point was that instead of wasting all that effort the government could simply print money and give it away or spend it. Krugman also points out that Adam Smith, often held up as a paragon of conservative principles, felt that paper money was much better for an economy to run smoothly than tying up resources in useless gold and silver. The connection between gold and Bitcoins is unmissable. Both have no intrinsic value and are a terrible waste of resources. Lee feels that Krugman misunderstands Bitcoin in that the intensive computations are integral to the functioning of the system and more importantly the main utility of Bitcoin is that it is a new form of payment network, which he feels is independent of monetary considerations.

Krugman and Lee have valid points but both are still slightly off the mark. I think we will definitely head towards some electronic monetary system in the future but it certainly won’t be Bitcoin in its current form. However, Bitcoin or at least something similar will also remain. The main problem with Bitcoin, as well as gold, is that its supply is constrained. The supply of Bitcoins is designed to cap out at 21 million with about half in circulation now. What this means is that the Bitcoin economy is subject to deflation. As the economy grows and costs fall, the price of goods denominated in Bitcoins must also fall. Andresen shockingly didn’t understand this important fact in the Econtalk podcast. The value of Bitcoins will always increase. Deflation is bad for economic growth because it encourages people to delay purchases and hoard Bitcoins. Of course if you don’t believe in economic growth then Bitcoins might be a good thing. Ideally, you want money to be neutral so the supply should grow along with the economy. This is why central banks target inflation around 2%. Hence, Bitcoin as it is currently designed will certainly fail as a currency and payment system but it would not take too much effort to fix its flaws. It may simply serve the role of the search engine Altavista to the eventual winner Google.

However, I think Bitcoin in its full inefficient glory and things like it will only proliferate. In our current era of high unemployment and slow growth, Bitcoin is serving as a small economic stimulus. As we get more economically efficient, fewer of us will be required for any particular sector of the economy. The only possible way to maintain full employment is to constantly invent new economic sectors. Bitcoin is economically useful because it is so completely useless.