Is Bitcoin money?

June 12, 2013

A post by Stan Zin

Bartering for goods and services is a hard way to live your life. A person carrying an “I will work for food” sign is a universal symbol of despair rather than prosperity. But perhaps networks and digital computers have the ability to change this situation.  Is that what Bitcoin can do for us?

The main problem with barter is the “double coincidence of need.” If you’re the poor soul carrying the sign you’re probably hungry and need food right now. But before you can get it, you have to match up with a person who happens to need your work. You could starve to death waiting and searching. It would be much more convenient to exchange work for something durable, portable, and hopefully valuable to others, shop around for food at your leisure, then ultimately exchange that object for the food you need. We typically call that object “money” and we can imagine lots of different physical objects that could serve that purpose, eg, gold, coffee beans, cigarettes, etc, and in fact all of those things have at one time or another served as money. But now that we have networked computers, couldn’t an electronic barter system achieve the same thing without the need for some physical object in the middle?

Here’s an idea. Let’s create a giant Google spreadsheet that contains a list of all of our names, that anyone can access whenever they like. When I create some value for you, we put a -1 next to your name and a +1 next to my name. When I want to buy lunch, I subtract 1 from the number next to my name and add 1 next to Sammy’s Halal. That is, every transaction is recorded as a debit from one number and a credit to another. Why the number 1? No reason. In fact, we would likely want to negotiate the amount of the transfer for each transaction as with any barter system to reflect the relative value of the goods or services being exchanged. All we now need to do to make this work is get everybody to agree to buy into the system.

But before I buy into such a system, I need a number iron-clad guarantees:  (1) I want to know that lots of others have bought into the system so that we’ve actually solved the double-coincidence problem;  (2) I want the system to be secure and free from fraud so that someone can’t just arbitrarily create big numbers in their account or move numbers from my account to theirs; and (3) I don’t really like the thought of everybody knowing all of my business, so I would insist on some confidentiality. Who could we trust to deliver such a generally accepted, fraud resistant, and confidential system? For better or worse, we trust the government. Our modern monetary systems are actually a lot like the giant spreadsheet I just described, with government running the book.

If that’s the case, can our monetary system be any more reliable and trustworthy than the government institutions that run — or at least oversee — this beautiful economy-wide spreadsheet? Hmmm, no!!! History is chock full of examples of governments defrauding their citizens by manipulating the monetary system, and also the elaborate and costly measures private citizens take to try to insulate their wealth from such government theft. Wouldn’t it be nice if we could have all of the benefits of a government run monetary system but without the risk of that same government corrupting that system? In other words, how do we cut out the middleman from that Google spreadsheet metaphor? Bitcoin’s answer? Peer-to-peer computing and crytography. Does it work?  Could it work?

Here’s the deal. Rather than working with a centralized spreadsheet, imagine that when I do work for you, you send a string of characters to my computer. When I buy lunch from Sammy’s Halal, I re-send that string of characters directly from my computer to Sammy’s computer. Two obvious and related questions: How do I know that you didn’t just make up that string of characters? And how does Sammy know I didn’t just make up that string of characters, or that I’m trying to pass along a string of characters that you just made up? One of the features of Bitcoin is that these strings of characters are created and distributed in a random and verifiable fashion.

To get the system started, you would enter a lottery with a winning prize of a new Bitcoin string of characters. Lottery tickets aren’t free, of course, you have to buy them. But if you have to buy them with US dollars, then we’re back playing the government’s game again. Instead of dollars, what you have to do to acquire a Bitcoin lottery ticket is use up a lot of computer capacity and electricity to solve a hard numerical problem. (Even though Bitcoin is a tiny fragment of economic exchange, it is estimated that $147,000 worth of electricity is consumed every day by computers trying to generate Bitcoin lottery tickets, which provides a huge incentive for people to steal both computing power and electricity from somebody else to enter Bitcoin lotteries.) Rightful ownership of these newly minted Bitcoins is established through encrypted “signatures” that are attached to the string of characters with each transaction, so that as Bitcoins circulate in their peer-to-peer fashion, one can still verify their legitimacy and preserve anonymity.  That is, you can verify that a Bitcoin was legitimately acquired and exchanged without revealing anything about who acquired them or who has exchanged them before they reached you.

What would I personally worry about when trading something I value for a string of characters called Bitcoins? Three obvious things:

1. Could the system be hacked and hence defrauded? Yes, of course. Is that easy to do? It’s certainly not easy for me since I know very little about crytography and peer-to-peer computing protocols, but how do I know that some evil genius teenager isn’t out there “counterfeiting” Bitcoins? Fears of Bitcoin hacking have created substantial uncertainty in the willingness to exchange Bitcoins for real value, hence the value of a Bitcoin to its owner. Moreover, don’t the best cryptographers in the world with the biggest and fastest computers in the world work for government intelligence agencies? I don’t want to sound paranoid, but if I’m doing this because I don’t trust the government, aren’t I playing right into the government’s strong suit?

2. If I accept a Bitcoin, how readily can I exchange it for something I need to buy? Right now the numbers are pretty small, something like 1,000 internet venders who will accept Bitcoin as payment, and most of those are pretty sketchy to say the least.

3. Can’t I always accept a Bitcoin then exchange it for US dollars that are readily accepted by everyone? You can try, but that kind of anonymous exchange of US dollars (or any other legitimate currency) is illegal for a wide variety of reasons. Moreover, relying on a government-backed legal-tender monetary system to provide legitimacy and integrity is anathema to the Bitcoin philosophy, and puts us right back where we started.

In the end, Bitcoin is an interesting and provocative experiment in peer-to-peer computer transactions coupled with sophisticated encryption technologies.  Does it work as an acceptable form of “money”? No. Could some kind of system like Bitcoin ultimately solve the three problems listed above? Who knows? However, it’s certainly an interesting and important question. Maybe when we solve that problem, we can apply the solution to decentralize all government decision-making, and build new institutional arrangements that allow TFP and economic prosperity to grow without bound. We should get the government working on that right away!
Update (Aug 8 13):  Stan sends this piece on competing e-currencies.

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