I have my doubts about Bitcoin

Almost every week some reader asks me to write about Bitcoin, currently the most popular so-called crypto currency and the first one to possibly reach something like critical mass. I’ve come close to writing those columns, but just can’t get excited enough. So this week when yet another reader asked, it made sense to explain my nervousness. Bitcoin is clever, interesting, brilliant even, but I find it too troubling to support.

But first, why should you believe me? You shouldn’t. Though I’m year after year identified by the Kauffman Foundation as one of the top 50 economics bloggers in America, that only means I get to hang out occasionally with the real experts, eating Kansas City barbecue. Unlike them I’m not an economist, I just play one on TV. So don’t take my word for anything here: just think about the arguments I present and whether they make sense to you.

For those who don’t follow Bitcoin, it is both an electronic payment system and a currency invented by someone somewhere (nobody really knows who -- the inventor uses a pseudonym that makes some folks think he/she is Japanese but again nobody really knows). Bitcoin’s design purposefully keeps control out of the hands of central banks and governments, avoiding the threats of shutdown and confiscation.

Creating new Bitcoins can only happen once data miners have solved an algorithm called SHA256. It’s simply "here are some bytes, find a SHA256 hash of this byte array that is less than this tiny number. To make it more difficult, we progressively make the tiny number, tinier". There can be only 21 million Bitcoins ever found or mined, though once found, Bitcoins can be divided into 10^8 small subparts called shitoshis which are what’s actually used for buying things.

Bitcoins are not backed by any underlying commodity or government. There’s no full faith and credit clause behind them, but on the other hand Bitcoins are inflation-resistant because of constrained supply and can’t easily be counterfeited, either.

What makes Bitcoins have value is our assigning value to them. If I sell my house for a Bitcoin that doesn’t make a Bitcoin worth as much as my house but it creates a plausible value that can be confirmed if I can in turn use the Bitcoin to buy something else of equal or greater value to my house. And that’s the direction this currency seems to be heading, because it is being accepted some places for commerce.

If accepting Bitcoins for payment makes no sense think of those people who start with something mundane then trade and trade and trade until they have turned a paperclip into a house. This is no different.

Much of the attraction of Bitcoins comes from the efficiency with which they can be traded (by e-mail, even anonymously with no postage, taxes, or other fees attached) and their resistance to government meddling. Bitcoins are the bearer bonds of cyber currencies.

All this is good we’re told. Bitcoins are in some ways analogous to gold, which is also seen as having enduring intrinsic value.

So why then do I have doubts? I’ll lay out a bunch of reasons here in no particular order.

1) Bitcoins consistently cost more to generate, find or mine, than they fetch on the open market. People way smarter than me have figured this out and you can see their analysis here (it’s for Litecoins, not Bitcoins, but the same forces are at work). So maybe Bitcoins are analogous to gold, but gold that’s worth less than the cost of production.

This is further confirmed by the robust cottage industry in Bitcoin mining hardware. Mining Bitcoins means running millions of calculations until one of a finite number of successful answers is found. These calculations were first done on CPUs then GPUs then FPGAs and now ASICs. For under $200 you can buy a screaming little Bitcoin mining machine but it won’t earn you $200 in Bitcoins unless they dramatically increase in value down the road. This happens from time to time (the increase in value) but it still doesn’t make sense to build when you can buy for less. So Bitcoins as a production commodity make no sense.

You have to ask yourself why people would sell Bitcoin generators? Why don’t they just use the generators themselves to find more Bitcoins? Because it consistently costs more than a dollar to mine a dollar’s worth of Bitcoins, that’s why and the comparison to gold falls apart.

This is a familiar story with mining. Remember during the California Gold Rush the great fortunes made were those of Crocker (a banker, not a miner) and Stanford (a storekeeper and again not a miner). The only great American fortune ever based on gold mining, in fact, was that of William Randolph Hearst, whose father started the Homestake Mining Company that endures today. Notice, however, that Hearst (the son) wisely decided to diversify his fortune into media and starting small wars.

2) Bitcoins, while possibly uncrackable are definitely not unhackable. Mining Bitcoins requires the validation of 90 other random miners before your Bitcoins are judged real and assignable, but what’s to keep me from owning 90+ Bitcoin mining accounts and gaming the system? Admittedly it’s not that easy: In practical terms I’d need a majority of the world’s mining nodes to make that scam stick and in a rapidly growing market that kind of concentration is difficult to achieve. But it can be done -- especially if nation-states are involved. What if China or Russia or the NSA threw its financial and computing power into BitCoin hacking -- how long would it take them to accumulate more than 50 percent of all mining nodes? What if Amazon Web Services simply assigned all unoccupied EC2 cores to this task? This is plausible enough that I think we have to expect it will be at least tried.

The Bitcoin hack, then, isn’t cornering the market in a classic sense but cornering enough nodes to control the voting.

3) Bitcoin, as the first crypto-currency, is the one that will be tested in court. Simply outlawing Bitcoins in one country won’t have that much effect on the concept, but given there are other crypto-currencies around, it might hurt Bitcoin, itself. I’d assign the tactical advantage to Litecoins, which are cheaper than Bitcoins and may be able to leverage its second-mover advantage and take the day. Google didn’t invent the search engine nor did Microsoft invent the spreadsheet, remember.

The Winklevoss brothers, who reportedly own one percent of all Bitcoins, should be concerned about being too concentrated in the currency.

4) But my biggest concern about Bitcoin stems from what’s otherwise seen as the currency’s greatest strength -- its rational foundation and apparent immunity from government meddling. To hear Libertarians talk about it, the success of Bitcoin will free us forever from the IRS, Treasury Department, and the Federal Reserve. Bitcoin, as a currency without an associated bureaucracy, is immune to political meddling so no stupid government monetary programs that backfire or don’t work are possible. Bitcoin supposedly protects us from ourselves.

That’s fine as far as it goes, but the Bitcoin algorithm has left no place for compassion, either. Governments and treasuries in times of crisis sometimes make decisions that appear to go against the interests of the state. We saw many of those around 2008 -- admittedly heroic measures taken primarily to fix dumb-ass mistakes. Bitcoin, for all its digital purity, makes such policies impossible to implement, taking away our policy safety net.

Maybe that’s actually a good thing, but I for one am not yet willing to bet on it.

Reprinted with permission