What is Bitcoin?

A digital currency, or cryptocurrency. Like other currency, it has value that people ascribe to it, based on its finite supply. Unlike other currencies, Bitcoin is 100% digital, limited in supply by the cryptographic algorithms it uses.

Bitcoin is not the only cryptocurrency

There’s litecoin, a digital currency that has gained some steam but garnered far less attention, and the humorous meme-based currency dogecoin, among others.

What makes Bitcoin so exciting?

It’s anonymous, not controlled by a central authority, and can be transferred an intermediary.

So what’s the catch?

There are a few problems. Many stem from the same features that make Bitcoin so appealing in the first place: anonymity, and lack of regulation. Most of the actual purchases made with Bitcoin are illegal. Perhaps you’ve heard of the Silk Road, a site that served as a kind of anonymous Amazon.com peddling mostly drugs, as well as credit card skimmers and other illegal goods. The Silk Road used Bitcoin as it’s currency of choice. The NY Times has a great breakdown of the Silk Road and its alleged mastermind.

Another problem, or benefit, of Bitcoin, depending on who you ask, is it’s lack of regulation or laws. Bitcoin exchange Mt. Gox recently went under, leaving an unkown number of people in the lurch, without the money the deposited. There’s no FDIC for Bitcoin, and hacking has been a frequent problem for Bitcoin exchanges. In other words, there are no gaurantees.

Still, these are not necessarily deal-breaking problems for Bitcoin. The market and sites that deal with Bitcoin will almost certain mature and become more secure over time. People will inevitably find worthy, legal uses for Bitcoin, and authorities will crack down on illegal ones, as they have already started to. The real question is whether Bitcoin itself is built to be a stable medium of exchange.

The central problem with Bitcoin.

Most currencies, like the US Dollar, are ‘controlled’ by a central bank. That control is usually exercised through the setting of interest rates, which in turn affects the degree to which banks will loan out money. The more loans there are, the more money there is floating around in the world (money supply). Any central bank must weigh two major factors when deciding money supply: unemployment and inflation. If there is too little money, if the value of money is going up (or even just staying strong compared to other investments), people will hoard it, rather than spend it to purchase goods or hire employees. Thus, unemployment goes up. If there is too much money, its value goes down, people’s savings are destroyed, prices go up too fast. You may have heard of the most extreme cases of inflation in places like Zimbabwe and Weimer Republic-era Germany.

Most bitcoiners are of the libertarian bent and feel that an unelected board of bankers is an inherently misguided way to control the money supply. Bitcoin supply is instead governed by an algorithm. Computers plug away at Bitcoin’s cryptography, and the Bitcoin protocol rewards these ‘miners’ with new bitcoins. The output of bitcoins is controlled by an algorithm that outputs coins with less and less frequency, making mining an increasingly difficult proposition. There is a hard limit on the total number of bitcoins that will ever be mined at about 21 million.

Why is that bad?

Imagine a world in which we had the same amount of dollars in circulation as we did in 1920. All new economic activity (and population) since that time would be fighting over that same number of dollars. Dollars, therefore, would become very valuable, far more than they are today. Therein lies the problem: If dollars are valuable and only going to get more valuable, people have incentive to hoard them: Writing loans, paying workers, buying goods: none of these activities make much sense when you can just keep your money in the bank and expect it to get more and more valuable. This is deflation, it is part of the problem that Japan has faced during its lost decade. Because the Bitcoin supply is finite, deflation is inevitable.

We’ve already seen the problems of Bitcoin as a currency: its value has fluctuated wildly from a high of over $1000, to around $600 today. A currency with such wildly fluctuating value makes for a poor medium of exchanges, but an excellent medium for speculation, which likely drove much of Bitcoin’s initial run-up. If Bitcoin does continue to catch on, however, it will inevitably fall into a deflationary trap.

So what does it all mean?

Bitcoin is interesting right now, but far from a viable currency. It will continue to be a source of frenzied speculation among investors, but I remain skeptical of it’s ability to become a viable currency. Bitcoin will also serve to inform people of the concept of digital currency. While the Bitcoin protocol itself may be flawed as a currency, the larger ideas behind it remain very compelling.