Thursday, April 4, 2013

Why Bitcoins Aren't Money

Below, Gabe Stein has some important observations about bitcoins, why it isn't money now and what would have to occur for it to be considered money. Note: Although he doesn't focus on it, he does recognize the problem of government regulation, In my book this is the greatest threat. If government stops the exchange between dollars and bitcoins, it's game over for bitcoins.

Many commenters on a recent Hackernews thread on the subject noted that Bitcoin shows similarities to commodities like gold or silver in that it fluctuates with more volatility than the Consumer Price Index, but still holds value relatively well. Says user disintermediate:.

The best you could hope for would be a similar volatility to a commodity like gold or silver. So products and services will never be priced in Bitcoin while there is a better alternative like the dollar which is relatively stable.

There’s a lot of truth to that. Although you can buy some goods and services directly with Bitcoin, it would be nearly impossible to create a CPI for it. There just aren’t enough merchants listing prices in Bitcoin to create a basket of goods. Unless you fill that basket with drugs.

That doesn't mean it will always be that way. For Bitcoin to be considered money in the traditional sense, it must function in three ways:

It must be a reliable store of value. Bitcoin's history of wild price fluctuations have lead some to question its value as an investment vehicle, but its recent use as a hedge against currency fluctuations suggests that it is a starting to fulfill this function.It must be freely exchangeable for goods and services, a function called medium of exchange. Right now, you can freely trade Bitcoin for other currencies, but only a few merchants will accept it directly in exchange for goods. If the market for Bitcoin expands, it will increasingly take on this role.It must be a unit of account. At the most basic level, this means that its holders must believe that one Bitcoin will always equal one Bitcoin. That sounds straightforward, but given its decentralized system, there's no guarantee that this will always be the case. It's unlikely, but if a hacker were able to manipulate the blockchain to convince the network that each existing block is worth one tenth of one Bitcoin rather than one, it would fail at this function.

Despite at least partially fulfilling all three roles, Bitcoin still doesn't behave like money. The reason why may be simply that people are waiting to see how it matures. How will we know when it reaches this point?

Three Signals Bitcoin Is Acting Like Money

Whether it fulfills its role as an asset or a new form of money, trust in the stable value of the Bitcoin is paramount, and right now Colas says it’s far too volatile to be accepted by the mainstream. For that to happen, Colas is looking for three signals that Bitcoin is ready for prime time:

A mechanism to short-sell Bitcoin. Exchanges are just now starting to support Bitcoin loans to enable margin trading. If these features catch on and larger exchanges (principally Mt. Gox) start to adopt them, Colas believes the market will be much healthier.Whether the Bitcoin ecosystem survives an onslaught of attacks sure to head its way as the value of the currency increases. “The bigger problem Bitcoin faces from cyber security standpoint is how safe are these wallets, especially the online wallets? As the value grows it becomes more and more lucrative to target them with real breaches, not just DDoS attacks,” says Dourado.A 30- to 60-day slowdown in volatility, which depends largely on Bitcoin remaining secure, since the total quantity of Bitcoins grows at a fixed rate.
What Could Go Wrong?

Plenty, including security compromises and ham-handed attempts at regulation on the part of governments. But Bitcoin has factors working in its favor. For one, its engineers have solved the “double spend” problem that usually accompanies a decentralized currency; let’s say you complete two electronic transactions at the same exact time, which party gets the money? Explains

If we avoid the problems of centralization and resolve on a decentralized system, we face a different but equally severe set of problems: without centralization, in a distributed system in which no party has veto power (and any party can be anonymous or a mask for another party), how and who decides which of 2 conflicting transactions is the real transaction? Must a distributed system simply allow double-spends, and thus be useless as money? No. The under-appreciated genius of Bitcoin is that it says that the valid transaction is simply the one which had the most computing power invested in producing it. Why does this work? In the Bitcoin distributed system, there are many good parties at work producing new transactions, and they will independently latch onto one of the two competing transactions produced by an attacker and incorporate it into future transactions; the amount of computing power necessary to out-invest those other parties quickly becomes too enormous for any one entity to invest. Within hours, one transaction will be universal, and the other forgotten. Hence, Bitcoin is an acceptable cypherpunk currency: it is decentralized, parties participate out of self-interest, and it is economically infeasible to attack Bitcoin directly.

Deflationary pressure is another trap. While deflation might seem like a good thing at first--it increases your buying power before prices adjust--it could be death for a nascent currency. As user delowe puts it:

Deflation makes it more profitable to do nothing than to invest. When this happens, people react by not spending money. The market [for the currency] dies.

Deflation has other non-optimal effects too; it causes debt to grow in relative value, meaning that borrowing activity slows, and it destroys your buying power by devaluing your wages.

Read more here.


  1. The allure of Bitcoins is obviously due to the fact that our current currency is manipulated by a monopoly government entity and makes it illegal to have free-market alternatives.

    Bitcoins attempts to side-step that issue using the internet and encryption. One problem from a libertarian perspective is they are using the government created internet in order to try and circumvent that very same government control.

    As I stated in Wacko Interventionist Idea of the Week: An Email Tax( ), there needs to be a modification of TCP / IP protocols in order to truly protect private interests. The internet and its protocols need to be private in order to ultimately protect privacy.

    The mere fact that the government owns the internet means that eventually if it ever becomes a threat to government's monopoly over currency, Bitcoins will be compromised in some fashion.

    A perfect example of this is if you have something like iMessage using its own proprietary protocols ( ) in such a fashion that the Fed can't break it, it simply brute force's the issue by going directly to the ISPs, or to Apple, or confiscation of the device itself.

    Until the internet is privatized, nobody is safe, not even Bitcoin.

  2. "...if a hacker were able to manipulate the blockchain to convince the network that each existing block is worth one tenth of one Bitcoin rather than one, it would fail at this function."

    This indicates a profound misunderstanding of Bitcoin's inner workings. Its a common misunderstanding but it's one that blocks adoption because it shows the natural human fear of the unknown.

    If a "hacker" could convince the Bitcoin network that the block reward was less than it actually is, then that would tell us that the various encryption algorithms used by Bitcoin (and banks, the government, corporations and all of us on the internet) are no longer secure and everything has to start from zero again. In such a case, Bitcoin's demise would be a footnote to the fact that the rest of modern banking and telecommunications were also compromised and no longer usuable.

    As far as people not adopting Bitcoin: you're doing all of us in Bitcoin world a favor by assuring a steady supply of cheap coins before Bitcoin hits critical mass in Asia, Europe and South America. Many of us have already made 8-10 times our money back on coins we bought at $2-5 last year.

    By this time two years from now, assuming that the powers that be don't drop nukes on the major network access points in order to stop Bitcoin, Bitcoin will be worth what it is now, squared. Laugh if you want, but $5 coins last year compared to $125 now is a cubed price increase.

    So yes, keep feeding people bad information about Bitcoin and keeping them away if you like. It helps keep the price down for the rest of us trying to take a piece of the world back from the centralizing powers.

  3. Check out this article:

    1. > one cannot force a money on society it must develop spontaneously via exchange on the free market.

      That describes Bitcoin.

      Hayek called for denationalized money, revocation of government monopoly over money supply, and competition in private issuing of currency. Hayek would have been all over Bitcoin, assuming he understood the principles of computing science.

      Judging by Bitcoin's engineering, it seems computer scientists have a better grasp of economics than economists do of computer science.

  4. You missed my point. This is the important quote from Rothbard:

    Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a “claim on society”; it is not a guarantee of a fixed price level. It is simply a commodity.

    Bitcoins are not a commodity and do not have any intrinsic value. They have just as much intrinsic value as the worthless paper fiat dollars in your wallet right now.