BitCoin: Can this work?

A reader of The Long Run Blog sent Brett an email asking what he thought about a site called BitCoin. His question:

I know you’all aren’t software engineers (I am), so you can’t comment on whether or not the underlying cryptography that makes Bitcoin work is solid (it is, as far as I can tell). But I would be curious to know what you think of the general idea: could a currency not backed by a government take off? What do you think of Bitcoin’s economic design (21million bitcoins total, created over the next 100 or so years, with more created in earlier years)?

As far as I can tell, BitCoin is a P2P, distributed computing type competitor to PayPal. In the PayPal model, everyone logs into a central server. PayPal moves money around the various accounts and you can take money out of the system by having PayPal deposits it into your bank account. Because PayPal needs to buy servers and pay salaries, PayPal takes a percentage cut. However, what if computer resources, hosting, and labor were all crowd sourced? Well, that’s the BitCoin model. But there’s one small difference. Well, there are two small differences. Wait. There are three small differences. Wait. Not all of them are small.

One, as you run your node, BitCoin pays a small fee into your account for use of your hardware and bandwidth. PayPal doesn’t pay me anything.

Two, while PayPal lets you pay merchants and send people real money. As in US dollars, Canadian dollars, British Pounds, Euros. BitCoin only lets you pay in a currency invented out of whole cloth. The BitCoin. To get real money, you have to find someone who wants to trade real money for BitCoin. There are some secondary sites where you can place offers for coins and people set the price they want to sell their coins at. So, to get BitCoins you have to either earn them by keeping your node going or buying them from someone else. How do you buy BitCoins online? Well, err, Paypal.

Three, while any government can increase arbitrarily the supply of dollars, euros, etc., BitCoin swears it will cap the circulation of BitCoins to 21 million. It will generate a lot of BitCoins in the initial phase and then taper off.

It’s a little odd a system that bills itself as not needing a central authority actually does need a central authority like PayPal. At least in the initial stages. I guess the BitCoin people envision a future where people are selling goods and services for BitCoins and then using BitCoins to buy stuff. So you might sell used books or get Google to pay your adsense dollars in BitCoins. Maybe. One day. We’ll tackle that in a bit.

But to the first question can a currency not backed by a government work? The short answer is sure. Gold is not backed by any government. No government determines its value. Theoretically no government determines its supply, although gold producing nations can produce more/less depending on government regulation. As we saw in the USA, governments can simply make it illegal for citizens to buy/sell gold. Ignoring a few realities, I will happily accept gold for any services rendered (that’s a hint, Brett). I’ll take dollars too.

Pizza is another great currency. I can easily trade pizza for labor, notably when I move. My friend Olivia can trade cute facial expressions and non-committal compliments for a broad range of goods and services from me.

Gold and womanly wiles have long been forms of universal currency. Pizza is a more recent one but not as universal as we might think. In Korea, pizza won’t purchase labor from independent amateur movers (i.e., your best friends). A dish called jajangmyeon (noodles in black bean sauce) is the currency of that realm.

Anyway, what I’m getting at is money is anything you and I both agree has some value, some utility and we agree to exchange it. Money (“any article or substance used as a medium of exchange”) should not be confused with “legal tender” (“currency in specified denominations that a creditor must by law accept in redemption of a debt”). It’s helpful to think of US dollars or Euros as an expedient. The government wants taxes. It doesn’t want to waste time taking chickens from you and pizza from Brett and approving smiles from my friend Olivia. It would take a great deal of time to figure out what all these things are worth from day to day. So just pay up in US dollars. We all pretty know what a dollar will buy. About half a cup of coffee at Starbucks. We can all make reasonable predictions about what a dollar will buy a year from now. Even in the face of uncertainty we only have to hedge against one form of money, not 85 different forms of money. See. It’s efficient.

Since we all have to pay taxes, I generally don’t mind my employer paying me in the approved legal tender the government views as fair payment for the services it renders to me (defense, my local subway system, health care). Back during the dot.com boom, I knew people who made deals to take the greater portion of their salaries in stock options and not US dollars. That was perfectly legal. To them, slips of paper with Amazon.com or InfoSpace had value (and greater future value than the US dollar) and they were happy to trade labor to get those slips of paper.

Where some people get in trouble, like the Liberty Dollar folks, is if you try to claim it is real, legal tender or intimate it. The Secret Service seems to have a very encompassing definition of “intimate” so you really need to be careful. It’s like those Passport to Fun things you might get at some amusement parks. They’ll have some legal disclaimer that they’re not actual passports and you think “what retard would ever think that?” but you just want to be careful.

So to the original question “can currency not backed by the government work?” Yes. As demonstrated. Can BitCoin work specifically? Yes, if people agree to accept BitCoin in return for goods and services. The list of vendors who will accept BitCoin is pretty thin. It seems to me you need a lot of vendors offering an interesting range of products and services for this currency to survive. If leaving my computer on for 3 weeks will generate enough coin to be able to buy something from a vendor selling a product I want, sure I’ll do that. If I have to give someone real money to get coins in my account and none of the current vendors offer a good or service I want, I won’t use the service.

To put it in software terms, it’s like introducing a new operating system. The new operating system seems to solve all kinds of problems but no one will use it unless there’s a whole ecosystem of third party software and hardware makers. Few developers will invest time and money to turn out software and hardware unless they see a lot of users or many users in the near future. That’s exactly the problem BitCoin has to solve. It’s not an engineering problem. It’s a psychological problem. It’s a problem many very rich companies with a lot of money and smart people have failed to solve. It’s a problem others have solved by either noticing an un-served niche or simply backing up into it. Lots of cybercash companies died on the vine during the dot.com boom but PayPal took off. Why? PayPal was quick and easy and let anyone with a credit card engage in ecommerce.

Now what about this plan to limit the coins to a maximum of 21 million? Is that a good idea. This appeals to people who like the idea of the gold standard. You can’t expand the supply of gold very easily or very quickly. Whereas an irresponsible government can simply print money. If you have too much money chasing after too few products you get inflation. Some people think the million dollars they have saved for retirement will be worthless by the time they retire because the government will create too much additional money. I can see this coin cap being a marketing element to appeal to the people uncomfortable with inflation, the government’s ability to turn on the printing presses, and a money supply that can’t be easily expanded.

I think the consensus of the Long Run Blog is a little inflation isn’t a bad thing. If you know your money is worth a little bit less each year, you’re not inclined to simply throw it under your bed. You invest it. This provides money for new businesses. A lot of inflation, however, is a bad thing for reasons I think are obvious to any reader. People worried about inflation become a victim of the fallacy of the excluded middle. Something is all bad. None of it is all good. But there’s the possibility a middle position can be a net positive.

Now, what happens if BitCoin really takes off and you have 21 million coins and 500 million users? That’s .04 coins per user. Does that sound useful? No one is going to use the system if it can’t expand its money supply. Coins only have value if they’re an efficient medium of exchange. If it becomes a huge bother to obtain a rare stock of coins, people will stop using the system. The value of the coins you do hold will lose value. You might have solved the problem of creating inflation because an irresponsible government creates too much new money but you’ve not solved the problem of having no clue what your coins can buy tomorrow or a year from now.

The Internet and Utopian Money Systems

I don’t want to poison the well but having lived the upswing and downswing of the dot com days, I saw a lot of utopian talk about how the Internet breaks all kinds of rules about money, commerce, and finance. The poster child for a “this time things are different” attitude espoused by some is the (defunct) web site Stock Generation. Read Wired’s excellent post mortem.

I’m not saying BitCoin is a scam or pyramid scheme or anything similar. I’m just saying be wary of people who make utopian pronouncements about money and how the Internet defies conventional wisdom.

– Karl Mamer