"No external technological or physical event could cause Bitcoin inflation, and since no one is in charge of Bitcoin, there is no one tempted to inflate 'from within.'"
Bitcoin is an ingenious peer-to-peer "virtual" or "digital currency" that challenges the way economists have traditionally thought about money. Its inbuilt scarcity provides an assurance of purchasing power arguably safer than any other system yet conceived.
But to understand these claims, one must first understand the basics of Bitcoin. My conclusion is that, in principle, nothing stands in the way of the whole world embracing Bitcoin or some other digital currency. Yet I predict that, even with the alternative of Bitcoin, people would resort to gold if only governments got out of the way.
The Basic Structure of Bitcoin
According to its official website: "Bitcoin uses peer-to-peer technology to operate with no central authority; managing transactions and the issuing of bitcoins is carried out collectively by the network."1 Anyone who wants to participate can download the Bitcoin software to his or her own computer and become part of the network, engaging in "mining" operations and helping to verify the history of transactions.
For an interview with Gavin Andresen of Bitcoin on its operation and history, see Andresen on BitCoin and Virtual Currency. EconTalk podcast, April 2011.
To fully understand how Bitcoin operates, one would need to learn the subtleties of public-key cryptography. In this section, I'll focus instead on an analogy that captures the economic essence of Bitcoin, while avoiding the need for new terminology.2 Interested readers can find various online articles that explain how a network of computers implements Bitcoin.3
Imagine a community where the money is based on the integers running from 1, 2, 3, ..., up through 21,000,000. At any given time, one person "owns" the number 8, while somebody else "owns" the number 34,323, and so on.
In this setting, Bill wants to buy a car from Sally, and the price sticker on the car reads, "Two numbers." Bill happens to be in possession of the numbers 18 and 112. So Bill gives the two numbers to Sally, and Sally gives Bill the car. The community recognizes two facts: The title to the car has been transferred from Sally to Bill, and Sally is now the owner of the numbers 18 and 112.
In this fictitious community, an industry of thousands of accountants maintains the record of ownership of the 21 million integers. Each accountant keeps an enormous ledger in an Excel file. The columns run across the top, from 1 to 21 million, while the rows record every transfer of a particular number. For example, when Bill bought the car from Sally, the accountants who were within earshot the of the deal entered into their respective Excel files, "Now in possession of Sally" in the next available row, in the columns for 18 and 112. In these ledgers, if we looked one row above, we would see, "Now in the possession of Bill" for these two numbers, because Bill owned the numbers before transferring them to Sally.
Besides documenting any transactions that happen to be within earshot, the accountants also periodically check their own ledgers against those of their neighbors. If an accountant ever discovers that his neighbors have recorded transactions for other numbers (i.e., for deals for which the accountant in question was not within earshot), then the accountant fills in those missing row entries in the columns for those numbers. Therefore, at any given time, there are thousands of accountants, each of whom has a virtually complete history of all 21 million numbers.
In our analogy, we are dealing with the end state, after all of the bitcoins have been "mined." This will occur in the year 2140, when 21 million bitcoins will be in circulation. In the real world, when people want to buy something using Bitcoin, they transfer their ownership of a certain number of bitcoins to other people, in exchange for goods and services. This transfer is effected by the network of computers performing computations and thereby changing the "public key" to which the "sold" bitcoins are assigned. This is analogous to the accountants in our story entering a new person's name in the column for a given integer.
Where Does Encryption Come In?
As our analogy has illustrated, far from being hidden or encrypted, Bitcoin's transactions are very public indeed. This is what gives the system its resilience and why its proponents say that no person or small group is "in charge" of Bitcoin.
The encryption involved in Bitcoin concerns the identification of the legitimate owner of a particular bitcoin. In our analogy, remember that Bill wants to sell the integers 18 and 112 to Sally for her car. The accountants can look in their public ledgers and see that "Bill" is, in fact, the current owner of both 18 and 112. Yet, for the system to work, there must be some way that the real Bill can demonstrate to all of the accountants that he is the same person referred to in their ledgers. To prevent an unauthorized party from fraudulently spending his bitcoins, this mechanism must be such that only the real Bill can convince the accountants that he's the right guy.
Without delving into the mathematics, suffice it to say: There is a way that the legitimate owner of a bitcoin can publicly demonstrate to the computers in the network that he or she really is the owner of that bitcoin. Only someone with the possession of the "private key" will be able to produce a valid "signature" that convinces the computers in the network to update the public ledger to reflect the transfer of the bitcoin to another party.
"Mining" New Bitcoins
Although we glossed over the details, the process by which computers in the network verify transactions is intimately related to the increase in the quantity of bitcoins. When Bitcoin was first implemented in early 2009, computers in the network—dubbed "miners"—received 50 new bitcoins when performing the computations necessary to add a "block" of transactions to the public ledger. Currently, the reward has dropped to 25 new bitcoins per block, and the amount will continue to be halved every 210,000 blocks (which will predictably occur about every four years because the computational difficulty of the mining task is periodically calibrated to the recent computational power of the network). Eventually, probably in the year 2140, the number of new bitcoins awarded per block will be rounded down to zero, thus capping the total quantity of bitcoins in existence (at 21 million).4
In principle, the developers of Bitcoin could have released all 21 million units of the currency immediately with the software. Yet that would have almost certainly killed the project in its cradle. With the current arrangement—where the "mining" operations needed to keep the system running simultaneously yield new bitcoins to the machines performing the calculations—there is an incentive for owners to devote their machines' processing power to the network. If people want to pay fees on the side to expedite the verification of a Bitcoin transfer, they can do so, but (in this early phase) the network eventually will get around to processing a transaction even if the parties involved have attached no extra fee. Such a feature is an ingenious way to encourage the widespread adoption of Bitcoin.
Guaranteed Scarcity: Bitcoin's Supreme Virtue
Economically, the chief attraction of Bitcoin is its mathematically guaranteed scarcity. Even a pure commodity like gold could eventually flood the market if a vast new stockpile—perhaps on the ocean floor or an asteroid—were discovered, or (more fancifully) if the "replicator" technology of Star Trek ever became reality, such that a machine could turn baser matter into gold bars.
A solution to this problem is an intangible money, such as Benjamin Klein's and Friedrich Hayek's idea of privately issued, competing fiat currencies.5 Here, the danger is that the issuing institution—once it had gotten the world to accept its notes or electronic deposits as money—would face an irresistible temptation to issue massive quantities.6
Bitcoin has no such vulnerability. No external technological or physical event could cause Bitcoin inflation, and since no one is in charge of Bitcoin, there is no one tempted to inflate "from within." If the computers in the Bitcoin network endorsed an illegitimate creation of new money, it would be akin to a majority of grammar teachers suddenly agreeing that "ain't" is acceptable usage.
Some critics argue that Bitcoin's fixed quantity would imply constant price deflation. Although this is true, everyone will have seen this coming with more than a century's notice, and so long-term contracts would have been designed accordingly. Also keep in mind that people could trade claims on fractional units of the fixed stock of bitcoins. (In fact, the Bitcoin protocol itself allows for the transfer of units as small as one one-hundred millionth of a bitcoin.)
Is Bitcoin Fiat? Could It Ever Be Money?
Whether to call Bitcoin a "fiat" currency depends on the definition. If "fiat" means a currency that is not legally redeemable in some other commodity, then yes, Bitcoin is a fiat currency. But if "fiat" means a currency relying on government fiat to define what will count as legal money, then Bitcoin is not.
More substantively, some critics (who are often proponents of hard money such as gold) object that Bitcoin is in a perpetual "bubble" because it has no "intrinsic value." Yet these critics often seem to overlook just how much the exchange value of gold and silver is (and was) due to their use as media of exchange. Thus, if Bitcoin is currently in a bubble, then, by the same token, gold bullion in the year 1900 (say) was also in a massive bubble because it was trading for a far higher exchange value than could be explained merely by its industrial and ornamental uses.
Some critics rely on the work of Ludwig von Mises and his "regression theorem" to argue that the world will never embrace Bitcoin as a true money. According to this argument, Mises demonstrated that all money—even today's fiat money—must have been, at some point in the past, linked to a commodity that was useful in the days of barter. Since Bitcoin has no such history, the critics argue, we have the authority of Mises himself to show that Bitcoin will never be more than a fad.
This article won't address the question of whether this is a valid interpretation of Mises' writings. Instead, I will make the modest point that if Mises is used to rule out Bitcoin's acceptance as money, then it seems that Mises has already lost. If this logic is correct, then Bitcoin should never have been adopted as even a medium of exchange because it served no useful role as a regular commodity. (Recall that money is simply a medium of exchange that is accepted by everyone in the community.) But Bitcoin has already surpassed that hurdle, as there are websites on which people from all over the world exchange their bitcoins directly for goods and services.
Bitcoin is an ingenious concept that challenges the way economists have traditionally thought about money. Its inbuilt scarcity provides an assurance of purchasing power arguably safer than any other system yet conceived.
Critics argue that because of its lack of commodity backing, Bitcoin is doomed to eventual failure. Yet the popular versions of these arguments either would apply just as well to gold or have already been proven wrong by the use of Bitcoin as a medium of exchange among a small (but growing) group of users.
Having said all of this, I still think that gold remains the preeminent money for humans at this stage of the globe's economic development. If governments around the world got out of the way, humanity would (I predict) once again embrace gold, not Bitcoin, as the true free-market money. But this is just a personal judgment call. We need to let the decentralized market test tell us what is the best money, or monies.
The analogy developed in this section is my own, but my understanding of the cryptographic aspects of Bitcoin is due to extensive discussions with software developer Silas Barta. In a joint article, Barta and I introduce the analogy, but dwell more on the encryption mechanics rather than the economics. See Robert P. Murphy and Silas Barta, "Bitcoin From an Austro-Libertarian Perspective, Part I," April 15, 2013, Free Advice blog post, available at: http://consultingbyrpm.com/blog/2013/04/bitcoin-from-an-austro-libertarian-perspective-part-i.html.
A simple introduction to the whole system (and its new terminology) is from the Bitcoin website itself: http://bitcoin.org/en/how-it-works. For an in-depth yet readable introduction to the encryption techniques involved in Bitcoin, see Silas Barta, "Explaining—not setting—Bitcoin straight," June 10, 2011, Setting Things Straight blog post, available at: http://blog.tyrannyofthemouse.com/2011/06/explaining-not-setting-bitcoin-straight.html. Finally, the original paper explaining the theory of Bitcoin is available. See Satoshi Nakamoto, (2008). "Bitcoin: A Peer-to-Peer Electronic Cash System," available at: http://bitcoin.org/bitcoin.pdf. (Note that "Satoshi Nakamoto" is a pseudonym.)
The technical details of mining are available at the Bitcoin wiki: http://en.bitcoin.it/wiki/Mining. The projected quantity of bitcoins over time is also available at the Bitcoin wiki: http://en.bitcoin.it/wiki/Controlled_Currency_Supply.
Klein, Benjamin, "The Competitive Supply of Money," Journal of Money, Credit, and Banking, Vol. 6, 1974, November, pp. 523-553 and Hayek, Friedrich. (1978 ) The Denationalisation of Money—the Argument Refined. (London: The Institute of Economic Affairs, Third edition.) Available at: http://mises.org/books/denationalisation.pdf.
See Selgin, George and Larry White. (1994) "How Would the Invisible Hand Handle Money?" Journal of Economic Literature, Vol. XXXII (December), pp. 1718-1749.
*Robert P. Murphy is a Senior Fellow in Business and Economic Studies at Pacific Research Institute, and an economist with the Institute for Energy Research where he specializes in climate change economics. He is the author of The Politically Incorrect Guide to Capitalism (Regnery, 2007).
For more articles by Robert P. Murphy, see the Archive.