Enthusiasts expect bitcoin to become a new privatized money, perhaps even replacing government money. The system will keep track of cash balances and transactions in such a way as to prevent fraudulent double-spending of the same units. Operating without any centralized recordkeeping (as by a bank or government), it will enhance financial privacy. It will employ an advanced technology called blockchain. As the Federal Reserve Bank of St. Louis Review (first quarter 2018) said, to really understand bitcoin and its many imitators requires combined knowledge of cryptography, computer science, and economics.
I lack this knowledge. Some points, though, are clear enough. A workable monetary system requires a unit of account and a medium of exchange. Prices, values, debts, claims, and cash balances are expressed, and accounting is conducted in the unit. The medium is something routinely used for receiving and making payments; in the United States it is currency and bank accounts denominated in dollars. Each transactor needs to hold some of the medium of exchange because receipts and expenditures are uncertain in exact timing and amount and are not closely synchronized.
The bitcoin unit goes undefined by anything and lacks redeemablity.
A suitable unit of account has an at least roughly stable value, which may be achieved in either of two ways. First, the unit may be defined by a quantity of some good or basket of goods, with the definition kept operational by two-way convertibility between money and the defining good or basket. Under the gold standard the US dollar was defined as the value of 1.5046 grams of pure gold. Under such a system the money supply adjusts almost automatically to the defined value. Alternatively, the value of the unit may be managed by central control of the money supply. The price level then adjusts to rough proportionality with the money supply, as explained by the quantity theory of money.
The bitcoin unit goes undefined by anything and lacks redeemablity. Its quantity grows in a strange way called “mining.” As a reward for taking part in the system’s decentralized record-keeping and especially for solving increasingly difficult mathematical problems, miners obtain new bitcoins. Their final amount is limited to 21 million. Who knows what happens then? Meanwhile, bitcoin-mining destroys real wealth by consuming vast amounts of electricity to operate huge computers.
Wild fluctuations in bitcoin’s undefined value rule out its use as unit of account and so, almost completely, as medium of exchange. Who wants to hold amounts of such an unstable asset for receiving and making payments? The occasional business firm “accepting” bitcoin promptly sells it for standard money rather than adding it to its transactions cash balance. A video by a Wall Street Journal reporter shows the great effort and extra costs of buying a pizza with bitcoin in New York City.
The final amount of bitcoins is limited to 21 million. Who knows what happens then?
Why, then, does anyone hold bitcoin? Some libertarians hold it to express disgust with government money and a hope for some kind of private and privacy-preserving alternative. (But other and academically respectable proposals for privatized money are available.) Some enthusiasts buy it as an investment or speculation. (Saying so in no way denies that speculation generally serves sound economic functions and that the distinction between it and investment is fuzzy.)
Prudence recommends that anyone considering an investment should ask how the desired gain might come as a share of real wealth — desired goods and services — created by his own and others’ investment. Even a gambling casino creates wealth in the perhaps questionable form of hopes, excitement, and entertainment. Gain on an investment or speculation with no prospect of creating wealth must come as a transfer from losers.
Meanwhile, bitcoin-mining destroys real wealth by consuming vast amounts of electricity to operate huge computers.
How, then, might promoting bitcoin create wealth? The advantages of a sound nongovernmental monetary system could count as wealth, but as a “public good” in the technical sense of something whose benefits cannot be withheld from people not paying for it — such as national defense or policing. Furthermore, competition from bitcoin’s surviving imitators would dilute any profits. More optimistically, experience with bitcoin might spur profitable improvements in its blockchain technology, which is already being extended beyond monetary uses.
Bitcoin might even evolve, after all, into a workable privatized money, quite in contrast with our current system. But how? Ayn Rand would dismissively reply: “Somehow.”
A final comment may be unfair, but I cannot resist making it. Excitement over bitcoin reminds me of the dotcom boom of the 1990s and even more so of the British South Seas bubble of 1720. For little more reason than that stocks kept going up, speculators drove prices still higher — until the crash came. Meanwhile, stock in dubious new enterprises sold readily. Charles Mackay (Extraordinary Popular Delusions and the Madness of Crowds, 1848) writes of one promoter who disappeared with the proceeds of successfully issuing stock in something described as “A company for carrying on an undertaking of great advantage, but nobody to know what it is.”