Unless you’ve been living under a rock in the middle of nowhere for the past few years, you’ve no doubt heard about this fancy new “cryptocurrency” called Bitcoin. You’ve probably asked “WTF is Bitcoin?” if you even cared enough to think about it. I’m not going to go into details about what Bitcoin is or how it works – there are plenty of places a short search away that do just fine with that, though you need to read them with a bit of a jaded eye – there is a lot of propaganda mixed in with the actual facts.
One real question is whether Bitcoin really is a currency. In my opinion, it is not. Bitcoin has a few problems that prevent it from really being a currency.
First, there is a permanent cap on the number of bitcoins that will ever exist. That, on its own, makes it largely unsuitable because if it did take off as a wildly popular currency, it would have deflation built in. In a growth economy, which we currently have, that deflation would be unavoidable and lead to hoarding which would further exacerbate the deflation problem. In a shrinking economy, we would have other problems to worry about than how well Bitcoin works. However, even in a steady state economy (which is required for sustainability), Bitcoin would be deflationary. That is because eventually, no further Bitcoins could ever be produced and there will always be at least some rate of loss of existing Bitcoins through various mechanisms.
Second, there is a problem of convenience. Bitcoins require a non-trivial amount of infrastructure to handle. Even more infrastructure than credit cards and other electronic transactions. Additinally, Bitcoins transactions are not instantaneous. It takes anywhere from a handful of minuts to an hour to have any reasonable confidence that a transaction is valid. That is simply not suitable for point of sale operations.
Third, the network that maintains the currency is not sustainable. Currently, the reward for running a node on the network is well below the cost of operation to any other than deep pocketed organizations that run specialized hardware. The fundamental flaw is that the difficulty of running such a node is determined not by the needs of the network itself but by how fast the network is crunching numbers. Additionally, all work done on a “block” on the network is completely lost if your organization is not the one to solve it. That is, there is no reward for the “also rans”. When it was feasible to run a node on commodity hardware and still earn a reward once in a while, it worked, but now, in the age of ginormous mining pools and so on, it’s just not reasonable.
Finally, a currency that can, by definition, never have a physical manifestation is not particularly reassuring. With a typical fiat currency like the Canadian Dollar, even if it went completely digital, this concern would not be present. If the entire electronic transaction infrastructure disappeared suddenly, it would still be possible to transact business in Canadian Dollars by the simple expedient of falling back on old style cheques and contracts until such time as the Bank of Canada was able to resume issuing physical currency, which it would no doubt be able to do with some rapidity. This is simply not possible with Bitcoins since they cannot exist without a massive electronic infrastructure.
So if not a currency, what exactly is Bitcoin? Bitcoin has much more in common with a fungible freely exchangeable commodity. That is, it has much more in common with gold, silver, aluminum, and other non-renewable resources. There is, for practical purposes, a fixed amount of any elemental metal or fossil fuel available on Earth. When we’ve mined all the existing deposits of any of them, we’re done. The best we can do is recycle. With metals, it is theoretically possible to recycle them infinitely. The same applies to Bitcoin. Of course, this gets increasingly expensive over time as it becomes harder and harder to accumulate enough small bits into a useable lump (and it turns out, this also happens with Bitcoin).
Indeed, there is another major parallel between Bitcoin and traditional metal mining. The age of the individual prospector striking it rich looking for gold are long past. Now, it takes a massive investment to find new deposits or exploit known ones. Bitcoin passed the “gold rush” stage some time past. Some people benefitted some from that stage by pure luck but by the time most prospectors heard about it, it was already too late. The same occurred with gold rushes – by the time most prospectors showed up, the producing deposits were already claimed.
Note that I would not consider gold or silver to be viable currencies either, even when they were used as such. Even then, they were often mixed with baser metals. To use any limited resource as a marker for economic activity is inviting the same disaster that Bitcoin would cause – deflation, or worse, illiquidity. Illiquidity is when there is economic potential but it cannot be reached because there is insufficient currency available to actually transact business. This is exactly what happened as a result of “austerity” measures to rein in soaring national debts. (It wasn’t the national debts that caused the problem – they are a symptom, but rather the way the world banking system works. That’s a topic for another time.)
So if Bitcoin is not a currency, what good is it? After all, it has no secondary uses like gold or silver do. Actually, just like any freely tradable commodity, it can still be used to transact business. However, it would be like giving your plumber actual gold in exchange for fixing your toilet. Or paying your doctor in cabbage rolls. There is nothing intrinsically wrong with barter!
Additionally, just like gold or other precious metals, Bitcoin could potentially serve as an inflation hedge. It can also serve as an intermediate step between two other commodities that are not freely exchangable, or currencies in a similar state. They can be used as an object of speculation. But anyone doing so must be aware that, just like investing in any other commodity, it is entirely possible that one can lose one’s entire investment. Bitcoin is even more of a risk than physical commodities, though, because it could simply disappear if everyone got bored with it and shut down the network.
In short, don’t treat Bitcoin as a currency even though it can be made to behave like one. Instead, treat it as a volatile commodity and act accordingly.