By Yanis Varoufakis
This article first appeared in April at the website of Yanis Varoufakis, an economist who holds professorships at the University of Texas and the University of Athens. Hear him discuss Bitcoin in a December interview with RT here.
1. What is Bitcoin? What Makes It a Very Special Form of Digital Currency?
Bitcoins are digital units of currency that one can use, on the Internet, to purchase a limited number of goods and services. The digital nature of Bitcoin is not what makes it novel and unique. There are, indeed, a large array of digital currencies, including dollars, euros, frequent flyer points, Amazon points etc. Starting with standard (fiat) money, more than 90% of dollars, euros, yen etc. are, indeed, digital. When your bank gives you a loan, for instance, it appears as digital money in your bank account. And when you use debit/credit cards or Internet Banking in order to transfer it to someone else’s account, from whom you are buying a good or service, your dollars, euros and yen come and go as mere digital currency units. Only a tiny portion of standard money takes a paper or metallic form.
Similarly, when an airline grants you frequent flyer points, that you can add to by using a particular credit card or redeem on some flight, upgrade or duty free item, it is creating a digital currency that you are accumulating for the purposes of using it in the future in order to purchase goods or services. Similarly, when the European Union created its carbon trading scheme, to be used by corporations and traders, it concocted a digital stock of carbon dioxide, divided it up in small bundles, distributed them to corporations (attaching to each such bundle or unit a quantity of carbon dioxide that the bundle’s owner could emit) and then set them free to trade these bundles (or pollution rights) amongst themselves in the hope that this digital market would generate a price for carbon dioxide such that corporations would have an incentive to produce less of it and sell (to less efficient firms) the balance of their bundles. Had this scheme worked, these bundles of carbon dioxide would emerge as a digital-only currency.
So, Bitcoin is not novel because it is a digital currency or because it is a ‘made up’ currency. Digital, ‘made up’ currencies are everywhere. What is, however, genuinely novel and unique about Bitcoin is that no ‘one’ institution or company is safeguarding the so-called Ledger: the record of transactions that ensures that, when you have spent one unit of currency, there is one less unit of currency in your (digital) wallet.
Put differently, take gold sovereigns as an example: By their physical, metallic nature they constitute a private and excludable media of exchange, in the sense that if I use one to pay Mary for a car that she is selling, I shall end up with one less such unit in my wallet. The great challenge of creating a non-physical, wholly digital, currency is the pressing question: If a currency unit is a string of zeros and ones on my hard disk, who can stop me from taking that string, copying and pasting it as often as I want and become infinitely ‘moneyed’? If I can do that, then it is as if all of us have a printing press in our living rooms, in which case we would have the makings of instant hyperinflation.
Until Bitcoin’s emergence, the conventional wisdom was that to make a non-hyper-inflationary digital currency possible, a Ledger of Transactions, keeping track of each unit that you and I spent, must be kept by some Central Bank or corporation. E.g. the Fed or the ECB or indeed Visa keeping track of our digital dollars, or euros. Or British Airways or Lufthansa or Amazon maintaining a Ledger of the ‘frequent flyer’-like points that they administer. Bitcoin, quite audaciously, broke the back of this assumption.
Bitcoin was born the day in 2008 some anonymous computer geek using the unlikely Japanese pseudonym Nakamoto posted an algorithm (on some obscure listserve website) that made something remarkable possible: It could generate a string of zeros and ones that was unique, ensuring that, before it could be transferred from one computer or device to another, a minimum number of other users had to trace its transfer and verify that it left the device of the seller (of some good or service) before moving to the device of the buyer. Moreover, the algorithm was written in such a way as to guarantee a steady ‘production’ of these strings—or bitcoins—over time, which, along with the computing power devoted by users in order to help track transfers, could collectively to maintain The Ledger. Lastly, to cap the supply of bitcoins, and thus safeguard their value, the algorithm guaranteed that the maximum number of these strings could only grow (given the algorithm’s structure) to 21 million units by the year 2040. Once it reached that quantity, its ‘production’ would cease and the users of bitcoins would have to do with these 21 million units. Meanwhile, before that date, and before the maximum bitcoin supply is reached, the ease with which users could ‘mint’ or ‘dig up’ fresh bitcoins (by making computer power available to the bitcoin community) would be inversely related to the total quantity of bitcoins already ‘created’ or ‘extracted’ from the algorithm.
In a sense, the designer of the Bitcoin algorithm (who has, by the way, dropped off the radar some time ago) seems to have designed the new currency on the basis of faith in the crudest version of the ‘monetarist’ Quantity Theory of Money—the idea that the value of money depended solely on the quantity of money supplied to the public. Thus, they aimed at creating the digital equivalent to… gold. Come to think of it, Bitcoin was, indeed, modeled on gold.
2. Bitcoin as a Digital Simulation of Some Precious Metal (e.g. gold)
What is the great merit of gold? Its scarcity! The fact that, once humans, for some strange reason (most possibly related to gold’s perpetual glitter and scarcity) started using it as (a) a means of exchange and (b) a store of value, gold became a currency and its smallest possible, meaningful, quantity became a currency unit. The designer of Bitcoin’s algorithm tried his damndest to emulate gold. Just like gold, which one presumes to be in fixed supply under the Earth’s surface, Bitcoin is also limited, artificially (through the design of its algorithm) to a plateau of 21 million units. And just like gold, there are two ways in which bitcoins can be acquired: One is to buy them using dollars, chickens, silk, honey, whatever… The other is to ‘dig’ for them like 19th century gold diggers dug for gold. To that extent, Mr ‘Nakamoto’ designed his brilliant algorithm in a manner that allowed for ‘bitcoin digging’. This is how he did it:
The uniqueness of Bitcoin, as alluded to earlier, is that no centralized institution (private or public) is the custodian of the Bitcoin transactions’ Ledger. So, who is? The answer is a spectacularly liberal-cum-communitarian: “We all are!” By that, what I mean is that the Bitcoin algorithm is written in a manner that makes it possible (indeed demands) that the whole community of Bitcoin users has access to, and polices, the Ledger of Transactions (which ensures that I cannot cut and paste my one bitcoin a large, or indeed infinite, number of times).
In this sense, bitcoin users must make computing power available to the Bitcoin users’ community so that everyone can ‘see’ the Ledger, in order to ensure perfect community ownership of the transactions’ record, as opposed to trusting some government agency (e.g. the Fed) or some private corporation that may have its own agenda. Naturally, as the Bitcoin economy, and the number of transactions grows exponentially, the amount of computing power that is necessary for one individual to devote to the ‘Bitcoin community’ in order to ‘mint’, or ‘unearth’ a new bitcoin rises exponentially with time. This increasing complexity also acts as a legitimizer of the notion that new bitcoins are delivered to the accounts of the users that put increasing computing power at the Bitcoin community’s disposal.
3. Bitcoin’s Two Fundamental Flaws
As with all things digital, there are a number of concerns to do with security; namely with the fear of hackers and e-spivs (traditionally, slickly dressed men selling purportedly authentic goods at bargain prices). Imagine a world that has shifted entirely to Bitcoin. Would we not live in fear that some ingenious hacker will get the better of Nakamoto’s algorithm and manipulate it to his benefit? Would it be wise for humanity simply to assume that the Bitcoin algorithm is un-hackable (especially so in the absence of some authority that can intervene and save the day if something horrible happens to the algorithm)? Besides, even if the algorithm is safe, there is always the danger of waking up to the realization that one’s bitcoin stash was e’looted during the night. And if one entrusts one’s stash to some company with better firewalls and computer security, what happens (in the absence of a Bitcoin Central Bank) if that company goes broke or simply disappears into the Internet’s darker crevices (along with its customers’ bitcoins)?
These concerns would probably suffice to put a dent in Bitcoin’s prospects. But they are not the main drawbacks of the currency. No, there are two insurmountable flaws that make Bitcoin a highly problematic currency: First, the bitcoin social economy is bound to be typified by chronic deflation. Secondly, we have already seen the rise of a Bitcoin aristocracy (a term ‘coined’ by Greek blogger @techiechan) which, besides the issues of distributive justice which it raises, evokes serious fears about the capacity of very few entities or persons to manipulate the currency in a manner that enriches them at the expense of financial instability. Let us look at these two problems in some detail.
First, deflation is unavoidable in the Bitcoin community because the maximum supply of bitcoins is fixed to 21 million units and approximately half of them have already been ‘minted’ at a time when very, very few goods and services transactions are denominated in bitcoins. To put simply, if Bitcoin succeeds in penetrating the marketplace, an increasing quantity of new goods and services will be traded in bitcoin. By definition, the rate of increase in that quantity will outpace the rate of increase in the supply of bitcoins (a rate which, as explained, is severely constricted by the Nakamoto algorithm). In short, a restricted supply of bitcoins will be chasing after an increasing number of goods and services. Thus, the available quantity of bitcoins per each unit of goods and services will fall, causing deflation. And why is this a problem? For two reasons: First, because an expected fall in Bitcoin prices motivates people with bitcoins to delay, as much as they can, their bitcoin expenditure (why buy something today if it will be cheaper tomorrow?). Secondly, to the extent that bitcoins are used to buy means of production (land, labor and capital) that are used to produce goods and services, and assuming that there is some time lag between the purchase of these means and the delivery of the final product to the Bitcoin market, a steady fall in average prices will translate into a constantly shrinking price-cost margin for firms dealing in bitcoins.
Secondly, two major fault lines are developing, quite inevitably, within the Bitcoin economy. The first fault line has already been mentioned. It is the one that divides the ‘Bitcoin aristocracy’ from the ‘Bitcoin poor’, i.e. from the latecomers who must buy into Bitcoin at increasing dollar and euro prices. The second fault line separates the speculators from the users; i.e. those who see Bitcoin as a means of exchange from those who see in it as a stock of value. The combination of these two fault lines, whose width and depth is increasing, is to inject a massive instability potential into the Bitcoin universe. While it is true for all currencies that there is always some speculative demand for them, as opposed to transactions demand, in the case of Bitcoin speculative demand outstrips transactions demand by a long mile. And as long as this is so, volatility will remain huge and will deter those who might have wanted to enter the Bitcoin economy as users (as opposed to speculators). Thus, just as bad money drives out good money (Gresham’s famous ‘law’), speculative demand for bitcoins drives out transactions demand for it.
Can these two flaws be corrected? Would it be possible to calibrate the long-term supply of bitcoins in such a way as to ameliorate for the deflationary effects described above while tilting the balance from speculative to transactions demand for bitcoins? To do so we would need a Bitcoin Central Bank, which would of course defeat the very purpose of having a fully de-centralised digital currency.
4. Conclusion: The Fantasy of ‘De-Politicised’, ‘Honest’ Money
The Crash of 2008 has infused our societies with enormous skepticism about the role of the authorities, both governments and Central Banks. It is quite natural that many dream of a currency that politicians, bankers and central bankers cannot manipulate; a currency of the people, by the people, for the people. Bitcoin has emerged as the great white hope for something of the sort. Alas, the hope it brings to many people’s hearts and minds is false. And the reason is simple: While it is true that local communities have, in the past, generated successful communitarian currencies, which enabled them to improve welfare in their midst, especially at times of acute economic crises, there can be no de-politicised currency capable of ‘powering’ an advanced, industrial society.
Since the second industrial revolution made the emergence of large, networked oligopolistic companies possible (the Edisons and Fords of the 1900s, and the Googles or Apples of today), capitalism became dependent on large credit spurts for the purposes of financing these corporations’ needs. Such credit spurts required large boosts in the money supply, both in order to finance the creation of new capital goods and also to support the new consumption patterns that were necessary to maintain the economy’s new productive capacity. Even when capitalist economies operated under the Gold Standard, banks found ways of creating money by lending increasing quantities against the existing, stable, stock of gold.
The 1920s demonstrates the impossibility of an apolitical money supply. Even though the monetary authorities were insisting on a stable correspondence between the quantity of paper money and gold, the financial sector was boosting the money supply inexorably. Should the authorities stop them from doing so? If they had, the Edisons and the Fords would have never flourished, and capitalism would have failed to produce all the goodies it did. Indeed, it would have stagnated and spawned social tensions that would have put its institutions under a cloud well before 1929. So the authorities stood by, allowing the bubbles of the 1920s to inflate, leading to 1929 and to the disaster of the Great Depression.
To the extent that Bitcoin attempts to emulate the Gold Standard, if a large portion of economic activity is denominated in bitcoin, the dilemmas of the 1920s will return to plague the Bitcoin economy. Finance would either have to find ways of introducing Bitcoin denominated securities, 1920s-style, which would cause asset bubbles to form, or the Bitcoin political economy would nosedive into a deflationary spiral that either causes untold hardship amongst its users or leads them, as is more likely, to abandon the currency altogether.
The reason money is and can only be political is that the only way of steering a course between the Scylla and Charybdis of dangerous ponzi growth and stagnation is to exercise a degree of rational, collective control over the supply of money. And since this control is bound to be political, in the sense that different monetary policies will affect disparate groups of people differently, the only decent manner in which such control can be exercised is through a democratic, collective agency. In brief, while apolitical money is a dangerous illusion, a Central Bank that is democratically controlled (as opposed to the indefensible notion of an ‘independent’ Central Bank) remains our best hope for a form of money that is for the people and by the people. Bitcoin, despite its many interesting features, can never be that.
Yanis Varoufakis is an economics professor at the University of Texas and the University of Athens. He is the author of “The Global Minotaur: America, the True Causes of the Financial Crisis and the Future of the World Economy.” Follow him on Twitter here.
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