On Bitcoin

There have been quite a few mentions of bitcoin recently in the press, especially on slashdot. This virtual currency phenomenon is quite fascinating. Based purely on mathematics, the virtual bitcoins are created by searching through vast quantities of numbers looking for those with just the right properties. Each bitcoin (or portion of a bitcoin) is assigned to one and only one ECDSA public key, and only the user that knows the corresponding private key has the ability to give the bitcoin to someone else. Transactions are tracked by a loose collection of peer-to-peer servers, each of which takes in a block of transactions and attempts to compute a nonce value that gives rise to a hash with a certain number of leading zeroes. Once one of the servers finds such a nonce, it distributes the resulting block to the other servers and the process of looking for a new block including later transactions begins. The servers are motivated by the collection of transaction fees that are indicated by the spender in each transaction; essentially, this fee acts as a “bounty” for including the transaction in a record block. There is also currently a fixed amount of bitcoin awarded for each new block, although this will eventually go away. At that point, there will be only a fixed number (21 million) bitcoins in circulation and the transaction servers will run solely on the transaction fees.

I say the phenomenon is fascinating because, although bitcoins are just numbers with no intrinsic value outside the fact that they are mathematically interesting, there are people out there that will buy your bitcoins for real money. As of this writing, each bitcoin is worth approximately $18.40. Why is this happening?

Much has been made of the recent speculative bubble in bitcoin and the inevitable comparison to a Ponzi scheme has been made many times. Some have argued that the instability might make bitcoin unsuitable as a currency because it is not a reliable store of value.  (Btw, that last link is a hidden service on Tor. You won’t be able to view it unless you have Tor installed). The Keynesian argument is trotted out that deflation in a currency leads to hoarding and a slowdown in economic activity which leads to a further increase in the value of the currency. A tax on money holdings is one proposal designed to encourage spending and get the economy moving again.

The decentralized nature of bitcoin leads to a somewhat-anonymous system. While it is true that every transaction is tracked in the block chain history, there is no completely reliable way to tie individual users to individual transactions. It’s as if the whole table of everyone’s bank accounts and transfers between bank accounts were exposed to the world; however, every user can potentially have an infinite number of bank account numbers and there is no cumbersome know-your-customer regulations required when opening a new account. This privacy feature has led to the use of bitcoins to buy and sell illegal drugs, for example. (Sorry, another Tor hidden service.)

Lack of a central authority also means that there is no enforcement mechanism for debts. This is a key difference from fiat currencies which are all about debt. It is really the debt that weighs down an economy during times of deflation, as the payments become more and more difficult to make. It is the use of government force, including the power of taxation, that gives fiat currency its value.

This is where the arguments against bitcoin on the basis that it is inherently deflationary break down. Bitcoin is outside the control of any government and there is no way to force anyone to give their bitcoins to someone else. Based purely on the mathematical rules laid out by the bitcoin founder and followed by the vast majority of transaction servers, each fraction of a bitcoin is owned purely by the public key on record in the block chain. If the owner is careful to hide his real identity there is no way to force him to give up his bitcoin. It is a purely cash-on-the-barrelhead economy. Neither a borrower nor a lender can you be.

So from where exactly does bitcoin derive its value? We once used gold for money, and its value currently far exceeds any industrial demand for it as a pure commodity. Bitcoins seem to satisfy all the major requirements of money: they are scarce, standardized, easily divisible, and unforgeable. The only thing missing is any kind of tangible value outside of their use as a medium of exchange. But then, we currently use paper and electronic fiat currency about which the same observations can be made. Is bitcoin subject to speculative fluctuations? Yes, but then, so are many other commodities. Maybe that’s the price of freedom. Whether a virtual currency free of violence will have any value years from now is hard to tell. It may go the way of wampum and seashells that were once used for exchange. Then again, the phenomenon might just be here to stay.