Bitcoins: Can it challenge the mighty dollar?

Should currency issue be a state monopoly? Not necessarily as evidenced in ancient India and Lanka and new evidence emerging in USA and other Western countries in the form of a new digital coin labelled ‘bitcoins’ or BTC for short.

Currency issue need not be a state monopoly

In the ancient Indian economy some 2,400 years ago, as described by Kautilya in his textbook on economics, The Arthashastra, issuing coins for exchange was not an exclusive monopoly of the king. The private people were also in the business of issuing coins and what the king did was to ensure their quality and standards through a public official designated the Examiner of Coins.

This ancient Indian coinage practice would have been common in this part of the world since a large number of coins found in the Southern Kingdom of Ruhuna of Lanka belonging to the period from 3rd century BCE to 1st century CE carried the Brahmi inscriptions of private issuers, among many, like “Of Gutta”, “Of Pussa, Son of Householder Dutaka”, “Of Lady Sama”, “Of Municipal Officer Nakati” or “Of Lady Uttama, Householder” and so on.

Private issuers are disciplined by the market    

Thus, the evidence demonstrates that the issue of coins was not a monopoly of the king, had not been centralised as it is today and the value and the standards had been maintained through mutual acceptance supported by governmental supervision.

This would not have been a problem in ancient times because coins had an intrinsic metal value and any private party issuing coins had to meet the prescribed standards set by the market place. Any issuer who had failed to do so would have been driven out of the market.

Paper money based on trust    

But today, countries have paper currency, thanks to the Chinese who invented it, without an intrinsic value attached to the paper but everyone accepts it as a valuable property with no questioning. People do not ask questions about paper money because they intrinsically trust the strength of the governments that have issued them. The trust is that ‘that paper money’ can buy them a desired basket of goods and services as long as they hold on to them.

Thus, in the event they lose that trust – because its value is falling and the basket is shrinking eternally or because others are unwilling to accept it for exchange – they refuse to accept them again without questioning. So, it is the trust – nothing but the trust – that keeps money issued by a government circulating in an economy performing the functions of money.

Bad real money leads to money substitutes

When this trust is lost, money substitutes are developed within a country as was argued by the British economist Nicholas Kaldor some 50 years ago. In that case, people create their own money – maybe a little piece of paper acknowledging debt – and that money will soon thrive like the spread of a forest fire because it is better than the money issued by a sovereign government.

When these money substitutes challenge a reserve currency – a currency that is used by people in many nations to settle payments and keep their wealth – then, the money substitutes so created will soon spread beyond the borders of the country in which they have been issued.

This should happen when governments recklessly overproduce money and deliberately push down its value over the time. This has happened to the US dollar though the US authorities are unwilling to acknowledge it.

Money substitutes can be produced digitally

Today being a digital era people do not have to write a little piece of paper like in the Kaldorian time. Accordingly, the mighty US dollar has been challenged by a digitally created currency – a currency that is there only in the cyberspace and not in the real world – called “bitcoins” or BTC for short that came into existence only four years ago. The creation of BTC is considered a technological marvel by many because it was the first time a money substitute had been created by using digital apps.

Pseudonymous Satoshi Nakamoto: Father of Bitcoins

Bitcoins were created in 2009 by an anonymous developer who took the pseudonym “Satoshi Nakamoto” and has chosen to remain in that way up to date. Therefore, the real people behind bitcoins are still a mystery. Nakamoto expressed his desire to create the new digital currency in a paper he published in a website called listserv in 2008 under the title “Bitcoin: A Peer to Peer Electronic Cash System” without going through a financial institution and without relying on trust to make it acceptable.

Hence, all the problems involved in real money – the erosion of value due to inflation, frauds in the form of theft, multiple payments and dishonor of obligations and safe and costless delivery – are to be sorted through a foolproof computer programme that cannot be changed at will by those who participate in the system.

Digital coins: A chain of digital signatures

This appears to be a pipedream of some weird person but it became a reality within months of his publishing the paper, the first 50 bitcoins being produced – called being ‘mined’ in bitcoin terminology – by Nakamoto himself.

He has defined in his paper an electronic coin as a chain of digital signatures where each party digitally signs a computer message called an electronic coin and passes to the next owner so that there is a chain of signatures which can be verified again electronically. In this sense, it is like a cheque of which ownership is transferred from person to person by endorsement and delivery showing on the reverse a list of endorsements indicating the ownership that had passed on at every stage.

The difference between a bitcoin and a cheque is that in the case of a cheque, the transfer takes place on trust and there is a bank that guarantees its payment if it is a good cheque. Any dispute can be resolved by resorting to the judicial system which is guided by laws passed by legislatures and case laws established by the judicial systems themselves.

There is no such redress in bitcoins and one has to rely on “the work of proof,” as Nakamoto called it, established by the computer program governing its issue. But the computer program is virtual, anonymous and unreachable in the event of a dispute. This should surely worry the users of bitcoins.

Zero tolerance of errors

As Nakamoto has argued in his paper, several foolproof safety measures with zero tolerance of errors have been incorporated in to the computer program. Here, a zero tolerance is important because in the case of normal real currencies, there is always room for errors inflicting costs on some and the system’s goal is to maintain such errors at a minimum level.

Safety features of bitcoins

First, though it is an open source program which can be used by everyone freely, it is based on a difficult cryptographic protocol – a system where security based functions are performed through the use of advanced algorithmic calculations to generate results. Thus, not everyone with a computer can mine bitcoins but only those with sufficient computational capacity and knowledge.

Second, there is a built in mechanism in the program to make it harder for subsequent participants called miners to mine bitcoins by gradually reducing the number of coins that could be mined over time. Accordingly, in every four year period the number they could mine halves and by year 2140, the total number of bitcoins that could have been mined by all is set at its peak level of 21 million.

When plotted against time, this is similar to the total utility curve that increases at a decreasing rate or with diminishing marginal utility familiar to students of economics. So, coins cannot be produced at will by miners and there will not be an excess supply that leads to the erosion of its value through inflation like the real currencies of the world.

Third, double or multiple payments have been prevented by publicly announcing the chain of ownership change of each bitcoin so that it is recognised by the system as paid conclusively. So, once an owner has placed his digital signature to a coin, even if he tries to sell it for a second time, the system does not authorise it thereby putting an effective stop to such attempts.

Thus, bitcoins can pass on from hand to hand indefinitely settling payments in the process without the need for recalling and destroying if they have become unserviceable as in the case of real currencies. Thus, bitcoins have a virtually zero maintenance and replacement cost.

The details of how bitcoins are mined and used are found in a web portal at www.bitcoin.org and similar to Wikipedia which provides cyberspace information freely, there is a ‘Bitcoin Wiki’ too that provides information on coins to interested readers.

Mining of bitcoins

A producer of a bitcoin is called a miner and anyone with a sufficient computer capacity to crunch through the difficult algorithms set in the programme can be a miner by acquiring the open-source software. The system has been set to produce blocks of bitcoins at intervals of 10 minutes and miners like those prospecting gold can hit the bitcoins that are being thrown out by the system.

Since doing it alone gives only a very slim chance of success because the computer capacity may not be sufficient, many have developed mining pools combining the processing power and sharing the profits among them as previously agreed.  At the beginning, a block contained 50 bitcoins and as the system has been set, at the production of each set of 21,000 bitcoins, the production is halved; accordingly, today, a block contains only 25 bitcoins and has become more difficult to mine.

A new user has to acquire a bitcoin wallet which is simply a computer facility like the email account of a person. He has three choices to maintain his wallet containing bitcoins – his mobile phone, his desktop or with a centralised service provider in the cloud. Non-miners can acquire bitcoins by buying from the market at the prevailing market prices which are variable and subject to fluctuation.

For instance, when the first block of 50 bitcoins was mined in January 2009, a bitcoin was prices at 10 US cents. By June 2011, it went up to $ 32 but fell again to $ 7 in January 2012. It recovered to $ 15 again in August same year moving further to $ 49 in March 2013. In early April 2013, it boomed to $ 266 and then crashed to $ 140 by the middle of the month. Yet the current price is some 1,400 times the original price in 2009.

Thus, there are bitcoin miners who are decentralised and make profits if they are lucky enough to mine sufficient quantities that are available in the original software package. But, their job is becoming increasingly difficult with a fewer bitcoins are being thrown out by the system as time passes.

Then, there are others who acquire bitcoins by paying in real currencies on the exchanges that function again in the cyberspace. Both parties can use bitcoins for making payments to others who accept them in payment or sell them on the exchange and make capital gains or losses.

Paul Krugman: Mining of bitcoins is a waste of resources

There are several criticisms against bitcoins. On economic grounds, Nobel Laureate Paul Krugman has commented in his New York Times regular column that even the use of computer time and energy to mine bitcoins is a waste of resources because they do not serve any economic purpose like a real currency.

Krugman has a point here because real currencies facilitate trade and exchange in increasing volumes, provide international liquidity to conclude international transactions, serve as reserve currencies so that nations could maintain their excess wealth in those currencies and help develop financial and capital markets by creating new and smart financial instruments. Bitcoins are nothing of these.

Krugman has even gone to the extent that even Adam Smith about whom he has no particular liking would have scorned bitcoins because the celebrated economist had as far back as 1776 downgraded both silver and gold currencies on account of the wastage of real resources tied up with money when the same money could have been produced cheaply with paper money.

Bitcoins are not environmentally costless

Some have criticised bitcoins on the ground of the environmental costs they have inflicted. For instance, Mark Gimein writing to the Bloomberg.com has argued that mining bitcoins require huge computing power and the electricity consumed in mining in a single day has been around 982 megawatts hours sufficient to provide power to 31,000 homes a day.

Thus, though it is a virtual currency that does not use paper, ink, printing machines, energy, packing and transport materials and storage, it also involves a huge amount of power that has to be produced by emitting greenhouse gases that contribute to global warming.

Though this claim is a little exaggerated as argued by Tim Worstall, a Fellow of the Adam Smith Institute in London, what Mark has tried to present is that creating virtual coins is not totally environmentally friendly as some people have been claiming.

Bitcoins and Ponzi schemes

Then, there is the criticism that it resembles the features of a pyramid scheme, better known as Ponzi schemes. A Ponzi scheme is a financial scam where those who first join the scheme stand to gain at the expense of those who join it later.

Similarly, those who have first joined the bitcoin system have mined the coins easily and have acquired the coins relatively at a cheaper price. But since its supply is restricted, the late comers have to spend more resources to mine coins and have to acquire them at high prices.

Their ability to make cash out of their investments depends on whether there are willing buyers of bitcoins after them. If there are no such buyers, they have to lose the value of their investments whereas the early joiners have already made money and quitted the system.

Invitation to hackers

There is the possibility to lose bitcoins held by people due to hacking and deliberately infected viruses. It already happened on several occasions in 2011 and 2012 and on one occasion so far in 2013. The worst incident in this connection was the hacking of the largest exchange on bitcoins, namely, Mt Gox in June 2011 by a hacker and reducing the price of bitcoins to one US cent. If the possibility of security breach is high, then, there is a high risk which the participants have to take.

Financial bubbles in bitcoins

The most damaging criticism against the bitcoin system is the possibility of developing financial bubbles and their bursting eventually. Bitcoins have no intrinsic value and are not protected by national economies as in the case of real currencies. Since there is no regulatory authority, there is no one to protect the interests of innocent participants in the event of the bursting of the bubble. Right now, bitcoins priced at $ 140 level is a bubble because it has no intrinsic value to push the price to that high level.

Bitcoins cannot displace the mighty dollar

Bitcoins are an adventurer type experiment using modern high technology and computing powers. Yet, they have no way of taking over real currencies because they are not backed by the productive powers of national economies which issue real currencies. Hence, though the mighty dollar is faced with problems, it has no reason to fear that it will be displaced by bitcoins, the adventurous digital coin that has come to the market recently.

(W.A Wijewardena can be reached at [email protected] )