In Austrian Economics circles there is currently a debate whether Bitcoin – the most widespread of the new crypto-currencies – is a legitimate currency or just a complex scam. The debate has become some somewhat reminiscent of the inflation vs. deflation arguments of a couple of years ago with each side digging their heels in and ultimately debating semantics. Similarly, the debate over the legitimacy of Bitcoin is quickly boiling down to a debate over whether it qualifies as money.
Many taking the scam side of the debate argue the Rothbardian definition of money – that money has to originate from some sort of backing, it can’t be just created out of air from the get go. To which Bitcoin supporters note that it can’t be created arbitrarily. It must be “mined” mathematically by solving time consuming problems that require a nontrivial investment in computation hardware and electricity with no guarantee of return. Very similar to the risk taken when attempting to mine precious metals from the Earth’s crust.
But the debate over what is money serves little to expand the understanding of what Bitcoin really is and how it fits into the modern financial landscape. Rothbard stated in his book What Has Government Done to our Money that money can only be a commodity that is measured by weight. Clearly Bitcoin does not satisfy the Rothbardian definition of money. But Rothbard’s definition is largely based on historical precedent. It wasn’t too long ago that physicists believed electrons, protons and neutrons to be the smallest units of matter – the building blocks of the atom. Were later discoveries of even smaller particles such as quarks and leptons negated by such a prior definition? Of course not, it simply meant that the definitions had to be updated to account for new understandings enabled by technology. Our concept of money is not immune to such effects.
In a free market, characterized by voluntary individual choice, money is what any two parties involved in a transaction deem it to be. This is what Ron Paul’s Free Competition in Currencies Act was all about. It also means that many forms of money can exist side by side. Bitcoin is not a replacement for gold or even the dollar but rather a complementary currency that serves a relatively small niche in ways that no traditional money can.
So what exactly is Bitcoin? Think of a tally sheet with a list of names and associated credits. This is essentially what Bitcoin is except that the tally sheet is maintained simultaneously by thousands of computers – including yours if you like. And instead of names, there are just numerical addresses associated with each amount. In order to authorize a transaction involving any bitcoins at a particular address, the associated private key (similar to a long numerical password) is required. Once a transaction is requested by the owner of the private key, a somewhat complex mathematical process is used by the network of computers to update the tally sheet in such a way that fraud is prevented.
The result is that Bitcoin offers several advantages over traditional money. It’s digital, it’s anonymous (sort of) and most importantly, it has no central point of authorization or control. It is this latter point which has so far made it immune to government attack. Governments do not allow competition to their fiat issued currency as to do so would threaten their ability to fund themselves via inflation. There have been multiple attempts in the past to create gold backed digital currencies but the weak point in those designs has always been the necessity of a central company to issue the currency and honor the backing. All a government has to do it shut down the company and the currency disappears.
Bitcoin is an experiment that has been remarkably successful to this point but it is not without enormous risk. If at any point in the future a flaw is exploited in its protocol or encryption, its value could vanish instantly – the fastest hyperinflation in history. And its biggest test is still ahead of it. If the growth and popularity of Bitcoin continue unabated, at some point it will come under the full attack of the US government’s formidable resources. It would not surprise me at all if at some point the Bitcoin protocol fails. But it would simply mean that a wave of new and improved crypto-currencies would emerge from its ashes. Yes, crypto-currencies are here to stay but gold will remain the preeminent vehicle for wealth preservation in times of economic crisis.