Bitcoin: the Money of the Future?

Proponents of Bitcoin like to suggest that it will be the money of the future. Critics point to its price volatility, the evidence of a Bitcoin bubble and other problems. Both sides make valid points.

Bitcoin is a crypto-currency, a highly anonymous, self-regulating computer currency based on strong cryptography. To quote its designer, Satoshi Nakamoto: “The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…”

For example, sterling has lost 98 per cent of its purchasing power since the Bank of England was nationalised in 1946. The total amount of Bitcoin, however, is limited by a digital production process analogous to precious metal mining and which can stop its value from being eroded by systematic over-production and debasement.

The high level of anonymity allows Bitcoin users to carry out financial transactions beyond government control: this not only makes government prohibitions of drugs and the like more difficult to enforce, but also raises the prospect of the potential restoration of the right to financial privacy which is under attack from many quarters – especially the governments of the world’s leading economic powers.

Bitcoin uses a peer-to-peer network that is designed to prevent various forms of fraud such as “double spending” and, as a result of the peer-to-peer network, there is no single point of failure. The absence of a single point of failure makes it very difficult to bring the system down.

Governments will almost certainly try to attack Bitcoin but, even if they shut down individual sites, the Bitcoin community would simply carry on.

So will Bitcoin be the innovation that transcends state money that has let us down so badly over the last 70 years?

Bitcoin certainly has some of the characteristics of successful money. It is becoming fairly widely acceptable, even if it is not generally acceptable. Any new money has to start somewhere and Bitcoin can be used easily enough in many pubs and to buy pizzas. It can even be used to pay university fees. It is certainly portable and can be used to settle accounts easily.

However, the big problem with Bitcoin is that it is an unreliable store of value. Take 2013, for example. Bitcoin’s value on 8th April was $215. It was $63 eight days later and $1,200 seven months later. This volatility is partly because Bitcoin is new and there is a strong speculative demand from buyers.

There are, though, more fundamental problems that cause the value of Bitcoin to fluctuate. The algorithm that controls supply prevents the amount of Bitcoin from expanding to meet increases in demand. This inelasticity in supply leads to price variations and also encourages speculation and excessive volatility, all of which render it unreliable as a store of value.

So, despite its success to date, it is unlikely that Bitcoin will be the money of the future. Indeed, the pioneers in any industry are rarely the ones who last long term: remember Betamax from the early days of the video industry?

Nor is being the first mover necessarily an advantage in the longer term: design flaws in the model are set in concrete and competitors can learn from them.

The crypto-currency market is an open one and new competitors are rushing into the field.  Most of these will soon fail, but, as competition develops, no-one can predict which crypto-currencies will be best suited to the market and achieve long-run success.

Nor can we predict the precise form they will take, not least because developments in underlying technology are themselves highly unpredictable: who would have predicted the smart phone 20 years ago?

The likely scenario is that is that Bitcoin will eventually be displaced by better crypto-currencies. These would avoid the boom-bust cycle to which Bitcoin is prone.

We will be using these crypto-currencies on the super-smart phones of the future or whatever replaces them, and the demand for government money might disappear altogether.

So is Bitcoin the money of the future? Probably not, but crypto-currencies might be.

This article was originally published in CityAM.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

Kevin Dowd is Professor of Finance and Economics at Durham University.