I’ve been following Bitcoin for a few years now. I was there when it first peaked (and crashed) in 2011, and then peaked and crashed again in April of this year. I read along as Laszlo trekked across the country on Bitcoin and bought the infamous $2.5 million pizza (just a $1,000,000 pizza now), and watched in amusement as Bruce Wagner bumbled his way through the first BitCon. I’ve read countless articles and forum posts alternately attacking and applauding Bitcoins, and countless more articles analyzing the whims that drive the Bitcoin market. All too often, the issue of Bitcoin’s viability as a currency is muddied by non sequiturs, strawmen, and ad hominem attacks from both sides of the debate. Despite all the confusion, misunderstandings, and poorly-guided rants though, when boiled down to the essential facts, things don’t look too good for Bitcoin.
To understand why Bitcoin will never become a driving force in the economy, you have to rewind the clock and look at where it started. Way back in 2008, someone clever posing under the pseudonym Satoshi Nakamoto proposed the idea for a decentralized, peer-to-peer, virtual currency. Theoretically, this currency could rely on cryptography to provide “proof of work” for each unit of currency, allowing the network to exist without the benefit of a central server. Then, in early 2009, Satoshi released the first Bitcoin client as a proof of concept for such a currency. It was a simple yet brilliant piece of work, and it demonstrated that the technical feasibility of the earlier thought experiment. But that’s all it was meant to be: a proof of concept, not a fully-fleshed basis for the New World Order.
That’s where Bitcoin essentially fails. Instead of taking what Satoshi provided for what it was – a proof of concept and a starting point for further innovation – the Bitcoin community went nuts and jumped in feet first. Satoshi had essentially released Beta v0.1 of an economic experiment, and a bunch of people with more enthusiasm than sense accepted it as Global Currency v2.0. It’s as if you came up with a new method for voting on where to order lunch at work, and someone took that as the basis for a new global system of government. That’s where the essential problem lies: Bitcoin supporters are evangelizing for a currency that doesn’t really exist yet. Would an anonymous, self-regulating, virtual, internationally-traded currency with no transaction fees be useful and worth investing in? Absolutely. But Bitcoin isn’t that currency.
Bitcoin’s most damning problem is its scalability and transaction confirmation speed. By design, it takes 10 minutes at a minimum to confirm a Bitcoin transaction, in order to prevent double-spending attacks. In practice, it often takes much longer. Furthermore, the Bitcoin network is currently restricted to a maximum of 7 transactions per second. To put this into perspective, the VISA network alone has experienced transaction volumes as high as 11,000 transactions per second. Although the Bitcoin protocol can conceivably be altered to allow a faster transaction volume, this would present significant challenges of its own in the form of a rapidly expanding blockchain. If the Bitcoin protocol were expanded to accept just 2000 transactions per second (less than the average transaction rate of the VISA network alone), at 0.5 kilobytes a transaction, that would mean that the blockchain would expand at a rate of a megabyte a second. Taking both transaction speed and confirmation speed into account, this means that in a hypothetical future with an economy based on even a heavily modified Bitcoin protocol, you would need to have a mobile device capable of constantly downloading at least a megabyte a second to make transactions and that those transactions would in turn take 10 minutes to an hour to process. You might also have to wait a while during periods of higher transaction volume just to begin your transaction.
To make sense of everything above, imagine the following: You are living in the future; one in which a significant volume of trade is processed through the Bitcoin network. One day you pull into a convenience store to buy a candy bar and a soda. As you prepare to make your purchase, you pull out your smartphone and connect it to one of the central hubs that provides storage for the blockchain (you aren’t able to personally download the blockchain any more since it grows several gigabytes an hour now). Thankfully, the wireless connection in the store is strong and your phone syncs with the network, allowing it to begin downloading the megabytes per second of transaction data flowing through the network. You walk up to the counter, hand your items to the cashier, and then swipe your smartphone over the payment terminal. Nothing happens the first few times you swipe it – the network is too busy – but after a couple minutes of frustration and frantic swiping, the network volume has dropped enough that you’re able to sneak your transaction in. The cashier smiles, bags your items, places them to the side, and then hands you a buzzer like the kind they use in restaurants to let you know your table is ready. You thank him and head to the waiting area… now it’ll just be another 10-30 minutes for your transaction to process. Welcome to the future.
“But,” I hear the Bitcoiners screaming, “that’s not fair, all those issues can be solved!” And they’re right. There are some pretty obvious solutions to those problems. For instance, you could use third party payment processors that download the blockchain themselves and handle transaction confirmations quickly within their internal network. You could store your funds with secure and respected handlers to prevent them from being stolen and to circumvent the need for multiple confirmations. But those third parties are sure to require transaction fees and you certainly won’t be anonymous when using them, and if that’s what you’re left with, then I have news for you: We already have all that. It’s called the banking industry. Essentially, the technical merits of Bitcoin are only worthwhile so long as the “currency” remains a geeky, novelty toy. In order to support the sort of large-scale economic activity that Bitcoin supporters claim it is destined for, it will require sacrificing its anonymity, peer-to-peer operation, and transaction-free processing (this claim has always been a lie anyway; nominal fees are an essential element of Bitcoin transaction processing).
Supporters of Bitcoin will claim that there are other advantages to Bitcoin beyond its basic technical merits though. Unlike those hated fiat currencies, they insist, Bitcoin is a deflationary currency. It’s like someone found a way to digitize gold. This argument has more than its share of problems though. The first among them is that Bitcoin is itself a fiat currency. As much as Bitcoiners clamor about how the US dollar, the GBP, and the Euro have no intrinsic value, they fail to achieve the same understanding about Bitcoin. It might take lots of electricity and processing power to “mine” a Bitcoin, but you can’t trade one back in for electricity and processor cycles. If anything, a Bitcoin has less intrinsic value than paper currency. Paper currency at least is a zero-sum game with no material value attached to the currency, whereas the production of Bitcoins amounts to negative-sum game. Spending processing power and vast amounts of electricity on mining Bitcoins is little better than shoveling money directly into a furnace and then trying to claim that the ash it spits out has an intrinsic value.
Sadly enough, the one “feature” of Bitcoin that its supporters are unequivocally right about is what really sinks it as a currency: Bitcoin is deflationary (kind of, the number of Bitcoins in circulation will continue to rise until 2140, when they cap out). This is where having a currency designed by engineers, and not economists, comes to bite back hardest. On the surface of it, the idea of having a deflationary currency seems like a good one; instead of your currency consistently losing value over time, it actually gains value. You don’t have to worry about run-away inflation, and the purchasing power of your savings isn’t slowly whittled away. But slow, predictable levels of inflation have a positive side; it encourages people to invest their money or buy things with it. If you expect your currency to gain value over time simply by sitting around doing nothing, why would you ever spend it? That’s exactly what’s happening with Bitcoin right now. Eleven million Bitcoins have already been mined – more than half of all the Bitcoins that will ever exist – but no more than half of those coins are actively traded. A full quarter of all the Bitcoins that will ever exist are simply sitting around, either long since abandoned or waiting in wallets for the Bitcoin market to skyrocket into another bubble.
This has all kinds of consequences. Firstly, it contributes to the wild fluctuations in the Bitcoin price. Right now, the market depth on Mt. Gox, the largest Bitcoin currency exchange, is so shallow that if the Winklevoss twins were to attempt to cash out their 100,000 Bitcoin stake, it would crash the market to less than half its current value. But the second issue with the sit-and-hold nature of a deflationary currency is the one that is most toxic to Bitcoin; there is no incentive to establish an active economy or marketplace. No one wants to spend their Bitcoins since they expect them to only increase in value, and with no one buying anything, there’s nothing to attract businesses to Bitcoin. The fact that there are no chargebacks with Bitcoin (a critical consumer protection, the absence of which is quite puzzlingly advertised as a feature) only further discourages spending. With over half of the value of the entire currency now held in the hands of a few thousand nobodies, you also have to wonder why the average person, government, or business would care to invest in Bitcoin. Even if you felt that the Bitcoin protocol was strong enough to change the world, why empower and enrich a few thousand hoarders when any reasonably large company or government could just found its own Bitcoin clone, seize the majority of available currency, and then encourage its adoption among the much wider user base available to them?
The truth is though, that’s all just the tip of the iceberg in terms of Bitcoin’s problems. You don’t need to poke around very long to find glaring new holes in the concept. But don’t worry; there is hope on the horizon. Some new innovator has just recently announced the creation of a currency which addresses all of these flaws: it’s primarily virtual, it can be exchanged freely and anonymously, businesses around the world are prepared to accept it, it’s secure, and its value will be closely monitored to ensure a slow, predictable rate of inflation. Word is they’re going to call it the “Dollar”.
Read Part 2 of this article here