Why I’m Skeptical About the Prospects for Bitcoin

By Daniel Bier

Since its debut, bitcoin (BTC) has taken the libertarian and tech communities by storm. Hailed as everything from the money of tomorrow to the stake in the heart of the Federal Reserve, enthusiasts and early adopters have praised the decentralized, open source, peer-to-peer digital currency. Meanwhile, an increasing number of users and businesses have jumped on the bandwagon (or roller coaster) that is the bitcoin phenomenon.

While there is much to admire and appreciate about this intriguing new technology, some proponents may have overstated their cases and downplayed the challenges it faces. A realistic look reveals several reasons to be skeptical that bitcoin is really the answer to inflationary monetary policy, chaotic financial markets, or the overbearing State.

The most basic criticism of bitcoin is also the most severe: It isn’t money—yet. Money must serve at least three basic functions: as a medium of exchange, store of value, and unit of account. At the moment, bitcoin is good a medium of exchange and a lousy store of value.

The reason is erratic price fluctuations: During the last year, it has gone through several major crashes, often losing half of its value (or more) over the course of a day or two before clawing its way back. Its most recent correction, beginning earlier this month, has driven its price down by more than 20 percent.

This volatility poses serious liabilities for anyone using the cryptocurrency. Making long-term contracts, keeping your books in order, or simply trying to figure out whether you’ll have made a profit by the close of business become monumental challenges.

It also isn’t clear how often bitcoins are being used to purchase actual goods and services, rather than being traded for other currencies. While every bitcoin transaction is recorded and visible on the blockchain, no one knows what proportion of the 50,000 to 60,000 daily transactions signify purchases in the real economy.

Given that BTC is behaving more like a speculative investment than a standard currency, its current price could bear little relationship to its long-term value or fundamentals. This is probably inevitable, and no fair criticism could say it “ought” to be behaving like established currencies. Concerns about its volatility, velocity, and vulnerability are all potentially answerable. But they should still give us pause before we invest at $1,000 per bitcoin.

Fundamentally, the question isn’t so much whether bitcoin is money, but whether its fundamentals are such that it can become so in the future. This depends on a variety of factors, including the public’s willingness to give up the predictability of dollars and governments’ willingness to tolerate encroachment on areas they have traditionally controlled.

Many bitcoin enthusiasts seem sanguine about the issue of regulation, arguing that governments can’t easily shut it down, while also pointing out that, to the degree it is successful, it directly undermines the effectiveness of monetary policy, financial regulation, tax collection, and vice laws. If there’s one thing I know about governments, it is that they do not appreciate being undermined. If they perceive BTC to be a threat, a variety of policies could impede its use and destroy its value.

Beyond this, there’s good reason to think that the most valuable aspect of bitcoin is not the currency, but its core design as a payment system. The peer-to-peer network circumvents the need for third-party intermediaries, like Visa or PayPal, to transfer currency. For very low fees, paid out by the system to users who validate the transactions and add them to the blockchain, users can move as much money as they want, anywhere in the world.

While bitcoins are virtual assets that you can buy and exchange for things, bitcoin is not merely that. Its basic protocol has the potential to become “the Internet of money.” In much the same way that the decentralized Internet surpassed prior centralized communication networks, allowing innovative applications to be developed without requiring upgrades to the  whole system or permission from a central authority, the BTC protocol permits unrestricted innovation to thrive on top of its basic transfer system. It has many potential applications, including contract enforcement, notarization, micropayments, and much else.

But while the bitcoin system may be analogous to the Internet in 1998, you cannot buy shares of Internet protocols. You can only buy tech stocks, and the question is whether BTC currency is like Google—or like Pets.com. In order to buy into bitcoin as a currency, you need to buy into a lot of assumptions that are hard to prove. You need to assume that its current price reflects its long-term value; that governments won’t regulate it out of existence; that BTC’s price won’t decline due to competition from newer cryptocurrencies; that its arbitrary cap of 21 million total coins and built-in deflationary pressures are optimal monetary rules; and that deflation won’t lead to hoarding.

Prediction is hard, especially (as Yogi Berra said) when it’s about the future, and prophesying about markets or technology is a fool’s errand. I don’t know if BTC is a bubble, but I do know that most new technologies dont work on the first attempt. Innovation, like entrepreneurship, is the lifeblood of the market economy, but most new businesses do fail. We need people who are willing to take risks, try new ideas, and, yes, sometimes go broke in order to challenge the status quo. This process of trial and error is how the market discovers what works, and we should applaud those who, with eyes wide open, are willing to risk their investments on new ideas.

The ideas that transform our lives tend to be ones that are copied, adapted, and subjected to brutal competition. Success for bitcoin will occur if its innovative model helps transform how our familiar institutions, like payment processing and even national currencies, change and progress in the 21st century. In that respect, bitcoin is likely to be more evolutionary than revolutionary—but that’s precisely what we need.

Daniel Bier is the executive editor of The Skeptical Libertarian. He writes on issues relating to science, skepticism, and economic freedom, focusing on the role of evolution in social and economic development.