{"id":8041,"date":"2021-01-05T00:01:00","date_gmt":"2021-01-05T00:01:00","guid":{"rendered":"http:\/\/www.economicsobservatory.com\/question\/are-bitcoin-and-other-digital-currencies-future-money"},"modified":"2022-01-20T14:59:52","modified_gmt":"2022-01-20T14:59:52","slug":"are-bitcoin-and-other-digital-currencies-future-money","status":"publish","type":"question","link":"https:\/\/www.economicsobservatory.com\/test\/are-bitcoin-and-other-digital-currencies-future-money","title":{"rendered":"Are Bitcoin and other digital currencies the future of money?"},"content":{"rendered":"\n

Bitcoin is a decentralised virtual currency or \u2018cryptocurrency\u2019: in the words of its anonymous founder<\/a>, \u2018a purely peer-to-peer version of electronic cash [that allows] online payments to be sent directly from one party to another without going through a financial institution.\u2019 When you own Bitcoin, you own the \u2018key\u2019 (or password) to an \u2018address\u2019 (or account) that contains the virtual currency. Bitcoin can be sent from one address to another by generating a transaction, which is then recorded on an immutable public \u2018block\u2019. These blocks are then chained together, creating a \u2018blockchain\u2019 \u2013 a publicly available record<\/a> of all historical Bitcoin transactions.\u00a0<\/p>\n\n\n\n

These \u2018blocks\u2019 are generated around once every ten minutes by a user of the network, who receives a reward in the form of newly issued Bitcoin. Which user generates this block, and therefore receives the reward, is determined by \u2018proof of work\u2019: using computing power to guess repeatedly a very large random number, with the new Bitcoin awarded to the user who guesses closest to this number. This process is known as \u2018mining\u2019 Bitcoin. The size of the reward tends towards zero over time, ensuring an absolute limit of 21 million on the quantity of Bitcoin in existence.<\/p>\n\n\n\n

What are the advantages of Bitcoin over existing currencies?<\/h3>\n\n\n\n

According to its supporters, Bitcoin has two advantages over existing currencies. The first is that its supply is limited, making it impossible for a central authority to issue it in quantities that would devalue it. This means it is much less vulnerable to hyperinflation crises, such as those seen in Weimar Germany, Zimbabwe or Venezuela. But a limited supply can also be a weakness, as it makes it impossible to control deflation \u2013 a phenomenon that can also lead to very severe economic consequences (Bordo and Filardo, 2005<\/a>).<\/p>\n\n\n\n

The second claimed advantage of Bitcoin is that all transactions are permanent and immutable. When money is held in a bank account, that bank could theoretically expropriate the money from its user and claim that it never existed. With Bitcoin, this is impossible, because the database on which transactions are recorded cannot be edited by any central authority. Bitcoin is thus often described as \u2018trustless\u2019, because it does not require its holder to trust a financial institution not to expropriate it.<\/p>\n\n\n\n

These advantages are very much theoretical. Hyperinflation is not currently a major problem in advanced economies, and while financial institutions have been known to engage in fraudulent practices, they are typically more subtle than simply to seize their customers\u2019 funds and deny that they had ever existed.<\/p>\n\n\n\n

In practical terms, the main advantage for users of Bitcoin is its anonymity, which allows it to be used to break the law with a lower risk of prosecution. One 2019 study found that 46% of all Bitcoin transactions involved illegal activity, accounting for around $76 billion per year (Foley et al, 2019<\/a>). The most common forms of illegal activity using Bitcoin are the purchase of illegal drugs and money laundering. It is also frequently used to solicit anonymous payments during blackmail and extortion schemes.<\/p>\n\n\n\n

Banks dealing with cryptocurrency platforms have historically struggled to comply with \u2018know-your-customer\u2019 regulation<\/a> and several governments \u2013 most recently the French Minister of the Economy and Finance<\/a> \u2013 have sought to crack down on the anonymity afforded by Bitcoin.<\/p>\n\n\n\n

What are the disadvantages of Bitcoin compared with existing currencies?<\/h3>\n\n\n\n

In economic theory, money is said to have three primary functions: a medium of exchange; a store of value; and a unit of account. How well does Bitcoin fulfil these roles?<\/p>\n\n\n\n

As discussed, Bitcoin is an excellent medium of exchange for transactions that require anonymity. But using it for other transactions is often prohibitively expensive. The average Bitcoin transaction fee during 2020 has ranged from 28 cents on 2 January to $13.41 on 31 October<\/a>.\u00a0<\/p>\n\n\n\n

Furthermore, transferring Bitcoin without going through a third party, such as a crypto exchange, can be logistically challenging for those without a background in computer science. Most traders therefore use an exchange or a virtual wallet handled by a third party. But this means that the currency is no longer trustless, and Bitcoin holders have historically lost large sums of money to careless or fraudulent third parties. The most famous such episode was the theft of $460 million worth of Bitcoin<\/a> held in the Mt. Gox Bitcoin exchange in 2013.<\/p>\n\n\n\n

The usefulness of Bitcoin as a store of value is limited by its volatility. In the year to 9 December 2020, the US dollar value of Bitcoin \u2013 and therefore the quantity of goods that can be bought with Bitcoin \u2013 changed by an average of 2.22% per day<\/a>. The price of Bitcoin has risen considerably in that time and advocates often argue that the cryptocurrency is a good store of value because its price will continue to rise over time.<\/p>\n\n\n\n

The future price is inherently unpredictable, but even if optimists are correct that its price will rise, this is only an argument that Bitcoin is a good speculative investment \u2013 not that it is a useful form of money (Baur et al, 2018<\/a>). Countries typically aim to have a stable currency rather than an appreciating but highly volatile currency, because the former is much more conducive to a healthy economy. This volatility also limits the effectiveness of Bitcoin as a unit of account: denoting the value of an asset in Bitcoin makes little sense when the real value of Bitcoin changes by an average of 2.22% per day.\u00a0<\/p>\n\n\n\n

Figure 1: Closing price of Bitcoin (USD), 2016-2020<\/h4>\n\n\n
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