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A Christmas guide to bitcoin

The holidays are upon us which may involve awkward conversations with relatives who have completely different perspectives on life, politics, and business. If you are reading this, chances are you work in the venture capital or technology industry. And so possibly some of your relatives will start asking for your opinion about Bitcoin (so that they can give you theirs, obviously).

Bitcoin for me has always been a complicated concept to grasp, but something about it never felt quite right to me. The debates around Bitcoin (BtC) have been a great opportunity to learn more about the role of money, and more broadly even about central banking and macro economic policy. The below points are not meant to be neutral, by the way. After doing some research, I found myself firmly in the “flawed but nonetheless worthwhile experiment” camp. This post is about some of the things I learned, with a focus on the deflationary aspect of Bitcoin because I think it is the most important argument, and the least understood. Because besides being needlessly environmentally damaging, and a cesspit for criminal activity and money-laundering, the interesting point about Bitcoin is about the following:

Why artificially created scarcity of BtC is a drawback, not a benefit

Bitcoins are purposefully designed to be scarce, by an artificial mining system using resource-heavy computing power (which coincidentally gives Bitcoins a bad carbon footprint, but more on that later). Bitcoins are a kind of virtual gold, a semi-natural currency.

Monetary conservatives like this artificial scarcity of Bitcoins. They see a “natural” currency as better than a “managed” one. Their view is that money should be kept in fixed supply. You will hear arguments coming from their side such as “printing money is not the solution to our economic problems” and “inflation is a secret taxation by the government”. So those who are in favour of taking us back to the gold-standard very much like the idea of Bitcoins, with the added benefit that it takes the control of the money supply out of the hands of central bankers. Power to a few the people.

Monetary progressives see the gold standard as a relic from the 17th century (Keynes’ words). They don’t feel the money supply should be kept within an arbitrary bandwidth (arbitrary being the rate at which gold is dug up or at which Bitcoins are “mined”). The optimal money supply fluctuates and this optimal supply can spike when the economy is in a slump. We can witness this fluctuation in real life as big increases in the money supply in Japan never caused inflation and are not causing inflation in the US or Europe (this can be explained using the IS-LM model for example, which economy students learn in their first year).

It is an important nuance that the progressive’s argument is not that printing money is the only solution to our economic problems, but rather that the optimal amount of liquidity flowing through the economy fluctuates depending on the state of the economy (say, a recession, a de-leveraging phase, or a boom with full employment). You could say money is like a lubricant for the economy, and when the cogs are turning slow, it needs more oil. It’s hard to come up with a suitable analogy. Luckily, an excellent analogy already exists: Krugman has a classic analogy of a babysitting coop explaining why an economy with too little or too much money in circulation simply won’t function at full capacity.

The problem with a fixed supply of bitcoins, is that it makes them inherently deflationary, which can make them vulnerable to deflationary slumps, hoarding, and speculative bubbles. All these potential problems have arguably already materialised within the Bitcoin economy (in real terms, the Bitcoin economy has been in a recession for a while now).

But there are more considerations (draw-backs) too, which have been elaborated on by others but a brief summary follows below.

Mining Bitcoins requires a serious amount of computing power, causing its electricity consumption to soar. Just like gold mining, this creates serious environmental damage, with questionable benefits to offset that damage. Hence the emergence of a Bitcoin mine in Iceland, where electricity prices are lower. Also, malware has emerged to steal computing power from user’s around the web. This in turn, is attracting more criminals (it’s like counterfeiting money, but Bitcoin’s probably accessible to a whole new group of counterfeiting criminals). The self-inflicted hurdles to create Bitcoins may seem a bit like self-chastisement.

Bitcoin’s lack of regulation makes it the perfect companion for criminal activity. Criminals, gangs and terrorist organisations already use a variety of natural currencies to consummate their transactions including stolen artefacts, or generally anything untraceable for that matter, and Bitcoins are a perfect high-tech addition to move large amounts of money across the globe at the push of a button.

But for me the most important issue remains the dubious underlying monetary logic. The bottom line is that Bitcoins seems to be mainly ideologically driven. And business and ideology don’t mix.

Below are a few excellent articles on the subject:

Alex Payne, former CTO at Simple (article from 18 Dec 2013)

Charlie Stross (article from 18 Dec 2013)

Paul Krugman (article from 22 Dec 2013)

The top two articles also include several links to other interesting articles.