Monday, February 17, 2014

A Bit of Contemplation on Bitcoin's Viability as an Alternative Currency

A week ago, hackers exploited a flaw in the code to attack Bitcoin exchanges. In spite of the technical difficulties at Mt. Gox, which is a Bitcoin exchange based in Tokyo, it looks like that will not impede the growing trend of Bitcoin. My libertarian friends have really been enthused about the prospectives of Bitcoin, but up until now, I never really took the time to understand it. What exactly is Bitcoin? Why is it so alluring for my libertarian friends? Does it have a future in the currency market?

For those who were wondering Bitcoin is (see primers from Federal Reserve Bank [FRB] of ChicagoMercatus Center, and Congressional Research Service), Bitcoin is a fiduciary cryptocurrency using a decentralized system known as peer-to-peer (P2P), which means that there is no third-party intermediary. Up until 2013, a bitcoin was a worthless currency. After that, the price for a bitcoin increased substantially (see chart below), and has shown exceptional price volatility ever since, which has brought in some doubts about its long-term stability, especially if it causes a speculative bubble. So why use it in the first place?

For one, it has relatively low transaction costs. The joy of the P2P system is that the lack of an intermediate. Paypal and credit card companies charge larger transaction fees to validate electronic transactions. The lower costs can be offset either by its volatility or by the period of time it takes for the transaction to complete (FRB, p. 3). Those who want more privacy, particularly those looking to avoid identity theft, would derive benefit from the Bitcoin system. Bitcoin currency is also exceptionally portable, divisible, and scarce. The value of Bitcoin market has peaked $20B to date (CRS, p. 3), which exceeds that of some small, developing countries. Bitcoin can also provide better access to financial instruments, which can alleviate poverty in developing countries (Mercatus, p. 14). 

Aside from the previously mentioned transaction times and volatility (CRS, p. 7), the latter of which can be mitigated by the possibility that the Bitcoin's fluctuations are merely a stress-test, there are some downsides to Bitcoin. First, the currency's anonymity, or more specifically, pseudonymity, encourages tax evasion and money laundering (Mercatus, p. 23). Maintaining the Bitcoin's advantages while diminishing criminal use will prove to be a challenge. The Bitcoin "mining" process has its environmental costs. Also, it has a long-term deflationary bias (CRS, p. 7), a lot of which has to do with the system being arbitrarily set up a ceiling to only produce 21 million bitcoins (conversely, the idea here is to make sure that [hyper]inflation is avoided, not to mention incentivizing long-term investment), which will theoretically never hit the ceiling due to Bitcoin's divisibility. Additionally, the Bitcoin code and network is opaque and vulnerable, much like we have seen with Mt. Gox, which makes me question its reliable store of value and overall security (CRS, p. 8). Its relative intangibility renders bitcoins prone to loss. Bitcoin is still so new that it is currently not legal tender in any country, nor is it recognized as an official currency by any regulatory authority. 

A currency that can compete with the monopoly of central banks has its appeal. It would be nice to see a competitive market in the currency market. The creation of Bitcoin illustrates the demand and desire for people to have the economic freedom to liberally transact. However, Bitcoin is still too new to determine its longevity because it is a disruptive innovation. It will take a few years after the Bitcoin system can work out the kinks, after which it will be much easier to discern whether bitcoins will become a currency in the global finance system or will be relegated to the dustbin of economic history.

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