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December 6, 2013

Why Bitcoin Will Fail

Terminal Flaws of Crypto Currencies

Most assaults on the viability of Bitcoin, such as this recent prediction that Bitcoin will fail published by the NY Times, focus on the fact that the currency is not issued by any government and therefore has not authoritative value. This critique is nonsensical. The lack of government control over the issuance of Bitcoins is exactly the feature that makes a crypto currency most attractive and most viable. In fact, the very first currency used on a widespread basis, gold, was not created by any government.

Like Bitcoins, gold became a medium of exchange based on a new technology called a touchstone. This device was nothing more than a polished rock, but its effect was revolutionary. Rubbing a piece of pure gold on a touchstone, unsurprisingly, creates a yellow streak. But if gold mixed with something else is rubbed on a touchstone, you get a differently colored streak. In other words, if someone tried to pass off "diluted" gold to you, you could rub it on your touchstone and catch the fraud.

This capability immediately allowed for the standardization of metals, and with the generation of confidence in a standard and easily-transportable medium of exchange, commerce exploded. Naturally, central authorities realized the value in controlling the medium of exchange... for the purposes of taxation and other means of confiscation... and either issued gold currency or collected the gold in order to issue paper against the metal. Once confidence in paper was established, gold backing was no longer necessary, and the means of wealth confiscation became more subtle and more powerful.

Bitcoin was designed to be digital gold. The creation of Bitcoins is asymptotically limited because their creation becomes logarithmically more difficult over time. Likewise, the extraction of gold from the Earth is naturally more difficult over time. Neither Bitcoins nor gold can be created at will by a central authority. Both are durable and both can be divided infinitely... Bitcoins digitally and gold by the appendage of a unit of currency.

And herein lies the fundamental flaw of Bitcoin: Bitcoin is redundant and has been so for 5,000 years. The value of Bitcoin would go to zero upon the creation of a gold-backed currency by any respected authority. The primary impetus behind Bitcoin's popularity is its independence from authority, driven, of course, by novelty. But gold sports the psychological advantages of tangibility and history. Would you prefer a currency backed by a piece of metal that will never change or by a set of digital cryptography keys? Would the general public even accept the latter? Furthermore, no one will ever create a second or third gold, but competing crypto currencies are possible, if not inevitable. One digital currency could usurp another or at least dilute its value.

Bitcoin does possess advantages, however. First, a gold-backed currency is still subject to fraud if the issuing authority manages to create more paper than is backed by specie. Such frauds were at the core of financial panics in the century leading up to the creation of the Federal Reserve. This type of abuse would be considerable more difficult to execute today since computers can facilitate the audit process, but the threat is more poignant than with Bitcoins. Second, no individual has any motivation to store Bitcoins in a vault or turn them into pretty trinkets. This feature would keep the currency in circulation, theoretically providing a more stable value over time.

Nevertheless, Bitcoin faces another, more pernicious, foe due to its potential challenge of central authority. Our money masters fought for centuries to control the world's medium of exchange. They will not forfeit that control in the name of an intellectually cool idea. Were Bitcoin ever to become a real threat to central control, the digital currency could easily be undermined by the imposition of an excessive transaction tax or simple force of law.

Bitcoin is not going to zero tomorrow. In fact, I believe the currency will enjoy all the benefits of the depreciation of the world's fiat currencies in coming years. Ironically, the destruction of fiat... the primary motivation for Bitcoin's creation... will also be its undoing because a better, golden alternative to paper money already exists.

 

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