Bitcoins are interesting as a social phenomenon as well as an economic one, but we are not likely to know exactly what changes, if any, this innovation will play in peoples lives until much more time has passed.
That may be true with any innovation, steam engine, oral contraceptive or hula hoop. But it is especially true for something the usefulness of which is rooted in human confidence. That can only be acquired over time, at least for most people.
The idea of a new, private, electronic currency fascinates many, especially the technologically savvy and libertarians who distrust government involvement in the market. There is considerable overlap between those two groups. But the very limitations that its designers put on producing more Bitcoins means that this particular new currency long will remain a curiosity for the average person.
Bitcoins are touted as a new form of money. So to understand them it is good to review the basic economics of money.
There is no commonly used exact definition of money, but all econ students learn that money has three functions: It is a store of value, a medium of exchange and a standard of value. It serves as a durable asset to preserve buying power from one time period to another, as a way to buy things or make other payments and as a common denominator of the value of things. Money is anything that is generally accepted or used to carry out these functions.
Historically, money came in the form of standardized units of some scarce metal. Today it commonly is paper bills and base metal coins, or deposits held within regulated financial institutions. But it can also be in electronic form, held on primitive devices like stored-value cards or more sophisticated ones like Bitcoins.
Regardless of its form, certain conditions must hold for money to have value and fill the functions above. The most important is scarcity. If the quantity of money produced is not limited relative to the size of the economy in which it is used, the money will lose value. The next most important factor is general acceptability. Large numbers of people must use the money in making payments or as a store of value. There must be a broad consensus that the money has value for it to serve in exchange and for it to remain valuable.
Money usually is issued by governments or central banks and thus is legal tender, but that is not a necessity and not nearly as important as scarcity and general acceptability in determining value. There is no economic reason why we cannot have private, non-governmental money. Even something as mundane as cigarettes filled the functions of money in prisoner-of-war camps or in post-war Europe.
Bitcoins strongest claim is that its scarcity is supposedly inherent in the mathematical algorithm designed to create it. There is no Bitcoin central bank that has the discretion to engage in quantitative easing that would rapidly reduce its scarcity and hence its value. The new money similarly is supposedly counterfeit-proof through the monitoring of Bitcoin transaction ledgers by miners, the tech-savvy people who bring the currency into circulation. If true, that licks a historic problem with paper and coins.
Bitcoin began with the promise of ensuring anonymous electronic transactions, something credit cards and banks cant guarantee, and took off precisely because of public fears that actions by the Fed and other central banks would reduce the buying power of the U.S. dollar and other major currencies.
Buy the new inflation-proof Bitcoin, the reasoning went, and you are protected regardless of what Ben Bernanke or anyone else does. As a way to avoid the dollar, Bitcoins are safer and easier for transactions than using physical commodities or even gold as a hedge against commodities. Even if only a fraction of merchants accept them in payment for goods, small quantities can be exchanged for dollars for immediate expenditures, while the bulk of ones wealth remains in inflation-proof Bitcoins.
At least that is the theory.
That remains an article of faith for Bitcoin devotees. But others, including me, are skeptical. The guaranteed scarcity and proof against counterfeiting depend on what is now foolproof encryption technology remaining uncrackable forever. But the cat-and-mouse history of codes and ciphers teaches us that what is considered unbreakable at one point in time may not be so a few years later. The ability to make a lot of money by finding some way to mine Bitcoins faster and easier than its designers intended is a powerful incentive to innovation in both hardware and software. Similarly, potential counterfeiters have an incentive to find some way to break the code. The so-far-so-good argument for the safety of Bitcoins is about as sound as when applied to falling off a skyscraper. Until you hit earth things may seem just fine.
Of course, there are similar incentives to hack into FedWire and other electronic funds transfer systems that deal in conventional U.S. dollars or other currencies. No large scale successes at that have yet emerged. But the limited quantity of legitimate Bitcoins may prove an Achilles heel in that it would not take a large quantity of semi-illicit new production or outright counterfeit coins to sink its value.
Indeed, the past few weeks have shown that glitches in authorized, established exchanges can foster dramatic changes in value relative to conventional currencies. Perhaps these are just minor teething pains, as advocates argue. But they may also be a harbinger of scams to come.