Bitcoin: reality or illusion?

The principles behind Bitcoin make it as ‘real’ as any other major currency

Author: David Orrell, author and economist
August 13, 2014

Is Bitcoin real money? Not according to Alan Greenspan, who recently described the entire phenomenon as a ‘bubble’. The People’s Bank of China concurred that it isn’t a currency with ‘real meaning’ and backed that up by banning financial companies from making Bitcoin transactions.

Of course, this raises a number of questions, such as what is the meaning of ‘real meaning’? Why is Bitcoin a bubble, but not the housing market in 2006? And what exactly is a Bitcoin anyway? The main feature of Bitcoin, which distinguishes it from conventional currencies such as the yuan or the dollar, is that it is produced and maintained by a network of computers, rather than by a central bank. The other main difference is that you can’t use it to buy much, and you certainly can’t pay your taxes with it.

In other respects, though, Bitcoin is not so different from conventional currencies. Bitcoin is a ‘virtual’ currency, in the sense that it only exists as a string of digital information that you can download to a ‘digital wallet’. But the British pound or US dollar are also best described as virtual currencies. As outlined in a recent paper from the Bank of England, the vast majority of money is created by private banks, and ushered into existence by pressing a button on a keyboard. The central bank plays a relatively small role in the money supply process, primarily by setting its own interest rates.

The difference between Bitcoins and state-backed currencies is therefore smaller than appearances suggest

The difference between Bitcoins and state-backed currencies is therefore smaller than appearances suggest. Both are virtual currencies that run on computer networks. Mobile phones, for example, are increasingly used as a kind of electronic wallet. The primary advantage of Bitcoin, though, is that it was designed from the outset to work this way.

Block chain
For example, while we are all used to making purchases over the internet, the process is clunky and involves a number of middlemen, such as credit card companies, who charge transaction fees. These middlemen are necessary in order to make sure that the money has left your account and is deposited in the store’s account. Unfortunately the process is not completely secure, which is why most credit card fees go to paying for fraud.

A main challenge of digital transactions is how to avoid things like double spending. One reason the music industry is in so much trouble, for example, is that it is possible to send a digital copy of a song to somebody else, while keeping your own copy. If this were to happen with money, it would be great for a while, but would soon lead to chaos, since you could spend your paycheck as many times as you wanted (I have tried this and it doesn’t work).

The main innovation of Bitcoin is that transactions are recorded on a secure, anonymous, public ledger, known as a block chain, which is maintained by a network of computers that make such shenanigans impossible. Unlike digital music, you can’t share your Bitcoins with a friend, or eat out on them multiple times. And without middlemen, transactions are faster, cheaper, and more secure.

Maintaining the block chain requires a lot of number crunching. The task is carried out by a network of computers that communicate through a shared protocol, and is currently rewarded by the granting of Bitcoins. Just as traditional currencies used to rely for their backing on supplies of gold, today people ‘mine’ for digital gold. According to some estimates, the electricity used to mine Bitcoins would power some three million homes.

The issuing of new coins will end when the total number reaches 21 million, which should happen some time around 2140. After that, mining will only be rewarded by a regular transaction fee. One of the attractions of Bitcoin for many people is that its value can’t be inflated away by turning on the digital printing press, as governments are wont to do.

Real meaning
So why would Bitcoin not have ‘real meaning’? According to Greenspan, the main problem seems to be that it is not produced in the normal way through a central authority. “I do not understand where the backing of Bitcoin is coming from,” he has said. “There is no fundamental issue of capabilities of repaying it in anything which is universally acceptable, which is either intrinsic value of the currency or the credit or trust of the individual who is issuing the money, whether it’s a government or an individual.”

But why should only a government or monarch be able to back a currency? Bitcoin is backed by something equally significant, if more distributed and amorphous: its network of users. The only thing that makes the US dollar ‘real’ is that it is accepted by the government as an official means of payment. The main thing that has dissuaded potential Bitcoin users is the currency’s volatility, and its connection with anonymous transactions. But volatility may come down as the user pool grows larger and more diverse, and as new tools for insurance and currency hedging become available. And associations with things like crime or drug running never put people off the hundred-dollar bill.

In any case, the most disruptive feature of Bitcoin is not its status as a potential rival for mainstream currencies, but the technical innovation of the block chain, which allows for anonymous and secure transactions over the internet. The potential for such a system was foreseen by Milton Friedman, who said in 1999: “I think that the internet is going to be one of the major forces for reducing the role of government.

“And the one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the internet you can transfer funds from A to B, without A knowing B or B knowing A, the way in which I can take a 20 dollar bill and hand it over to you and there’s no record of where it came from.” No wonder central banks don’t think the Bitcoin is real.