Wednesday, December 12, 2012

Is Bitcoin the Future of Currency?

Bitcoin is a private digital currency that was developed in 2009 as an alternative to the major currencies of the world. It is not centrally managed, but it is issued through a small number of licensed websites. The coins are ‘mined’ by individuals who solve difficult proofs-of-work. These algorithms are generally to be released in a certain pattern that will have them all published by 2140.

One of the largest exchanges and banks of Bitcoins is the website It is also one of the most infamous. In June 2011, the website was hacked and the accounts of its users were compromised. This led to a reported ฿500,000 stolen. This hack led to a suspension of trading and severely damaged the reputation of Bitcoin. The hack also coincided with the largest bubble in the currency’s trading history with exchange rates over $30/฿1.

Table 1
Central banking is all about communication. Central bankers attempt signal their currencies value, or to signal changes in their currency’s value. This is similarly true for alternative currencies such as Bitcoin. Because Bitcoin emerged without a reputation, a large part of its first signal was and is signaling the public on its process, and the value supposed by that process. A large part of the attractiveness of Bitcoins is both their scarcity and the mechanism that ensures their continued scarcity. Bitcoins are only created by creating new blocks. The proofs which create these blocks are designed to become more difficult if they are being found more quickly than the design approves. Bitcoins ultimately have a grand total, when there will not be additional ones created. This is meant to signal a firm scarcity that is guaranteed by the logic in the computer programming.
The Central Bank of Bitcoin tells what the final number of Bitcoins will be. This is somewhat unique in the currency world. Even the gold standard does not pretend that there is a known fixed amount of gold, nor that the price of gold will not float (if not relative to the currency) relative to all other products and market factors. The final number of a fiat currency is always (impractically) infinity. Monetary policy makers always have an infinite amount of currency to perform currency operations. This makes attempting to work against the Central Bank a hopeless task in a fiat currency, which has its own value. In practice, currency’s collapse long before infinity and the downfall of fiat currencies are often attempting to inflate away national debts or economic depression. This is because while country’s with fiat money supplies are not subject to runs on a gold standard, they are still subject to balance of payment deficits which are often (at root) caused by severe national debts.
While managers of fiat money do not publish the final number of currencies that they will create, or know the final number of currencies that they create; they do carefully track the amount of money in the economy. They also keep careful track of the monetary base. In the United States, the recent increase in the monetary base was a large cause of fear for inflation, as it tripled in the course of a couple years. Many individuals have predicted strong inflation of the U.S. dollar because of this factor. This inflation has been, in part, tempered by a fall in the velocity of money (Table 3), and by paying interest on excess reserves, which has kept large sums of money out of actual circulation (Table 4) and other factors.

 Table 2

These predictions of inflation are based on fiat money’s price being a function of supply and demand. If demand remains static and has a 45 slope, the price should fall by two/thirds. However, there are many things that go into the demand for currency. One is the velocity of money, which has fallen considerably during recession and has continued through the recovery (table 4). Another is a lurking variable within the supply, excess reserves being held by banks at the Federal Reserve. At the moment, the U.S. dollar has somewhat low inflation, even below the inflation target set by the Federal Reserve of 2% (annual).

Table 3

Table 4

There are three essential purposes to money: a medium of exchange, a unit of account, and as a store of value. Inflation hawks are essentially concerned about the latter. Bitcoin is created as competition primarily on these grounds. They are concerned almost exclusively with controlling the supply, but claim that because the currency is infinitely divisible, “there is no fear thatwe won’t have enough Bitcoins to deal with an ever expanding economic base of Bitcoin-denominated transactions.” This could also be described as attempting to make the most out of deflation. Deflation is terrific if you are currently holding that currency, but this end game only lends more credence to criticism that Bitcoin is ultimately more of a Ponzi scheme than alternative currency.

One of the major problems with Bitcoin is that despite the fact that it is upfront about the total number of Bitcoins that can be created, and about the mechanism by which new Bitcoins are created, it is very opaque about everything else. Its’ founding and transactions were and are completely anonymous which is attractive for some, but can also be a source of information asymmetry. Secondly, because its trade is so limited outside of the few exchanges, one can argue that it is not even meeting the first definition of money: a medium of exchange. Indeed even on the most popular Bitcoin trading website, daily trading volumes are typically below฿100,000. These low volumes, and low numbers of exchanges have created interesting results. There are different values for Bitcoins on different exchanges. On November 28, 2012: has a spot price of $12.125/ ฿1, bitstamp.nethas a spot price of $12.16/ ฿1, has a spot price of $12.2/ ฿1, has a spot price of $12.32/ ฿1, and the largest exchange mtgox.comhas a spot price of $12.32/ ฿1 as well. All of these exchanges are on the internet, and there are low transaction costs associated with Bitcoins. It stands to reason that a properly functioning market would eliminate these obvious opportunities for arbitrage easily. It seems to me that these are not perfectly efficient markets, but perhaps there are frictions that are not obvious.

So Bitcoin may not may not be ready for prime time yet, it is continuing and that is its own victory. It has been modestly succesful so far and because of the improbability of that success makes it all the more amazing.

Works Referenced:
Koss, Chris and Mike Koss.  “A Bitcoin Primer.”  January 1, 2012.  Web. (last retrieved 11/28/12).
Mick, Jason.  “Inside the Mega-Hack of Bitcoin: the Full Story.”  The Daily Tech.  June 19, 2011.
Web.  (last retrieved 11/28/12).
Mishkin, Frederic.  The Economics of Money, Banking, and Financial Markets.  New York: Pearson.  2006.
Print. (7th Edition)
Nakamoto, Satoshi.  “Bitcoin: A Peer-to-Peer Electronic Cash System.”  White Paper.  (last retrieved 11/28/12).
Thornton, Henry.  An Inquiry into the Nature and Effects of the Paper Credit.  Philadelphia: James
Humphreys.  1807.  Print.  “Mt. Gox.”  <>.  Web.  (last retrieved 11/28/12).
European Central Bank.  “Virtual Currency Schemes.”  Frankfurt: European Central Bank.  October 2012.
FRED.  Saint Louis: Federal Reserve Bank.  <>.  Web.  (last retrieved

1 comment:

  1. >>It seems to me that these are not perfectly efficient markets, but perhaps there are frictions that are not obvious.

    Most exchanges have a trading fee of around 0.5% and additional fees for cashing out dollars or euro. Rest assured that there are hundreds of bots who immediately arbitrage at every oppurtunity.