Bitcoin Solves the Wrong Problem

Bitcoin has been in the news lately for its amazing run-up over the past year and recent crash. For those who have been living under a rock (or anyone reading this years in the future when Bitcoin has disappeared), Bitcoin is a "virtual currency" created through some clever cryptoanalytic techniques to ensure a limited supply of currency and unique ownership of the bitcoins.

I'm not an expert in these things, but by all accounts Bitcoin does what it claims to do. The total supply of bitcoins is limited and predictable, and ownership of bitcoins is provable and transferrable. Some people are promoting Bitcoin as a replacement for money, and claiming that it can be treated like virtual gold.

But it isn't, and I predict Bitcoin will never achieve anything close to mainstream success as actual money. The fundamental weakness with Bitcoin is that the underlying Bitcoin technology solves the wrong problem. The system uses the model of a physical commodity (like gold) as money, and therefore is engineered to guarantee a very specific and predictable supply of bitcoins.

In the real world, though, one of the most important characteristics of money is that it has a stable and predictable value. It's vitally important that a dollar today is worth very close to what a dollar was worth yesterday, and that we are confident it will be worth pretty much the same tomorrow. But the demand for money can vary widely, depending on whether people want to hold on to their money (like in 2007-2008 when the banks were collapsing) or spend and invest like crazy (like in the dot-com bubble). So the supply of money has to change to match the demand and keep the value stable.

Our financial system has a system for creating and destroying money: through fractional reserve banking, banks create money by making loans, and can destroy money by calling loans in (or simply not making new loans as the old ones are paid off). The system isn't perfect, which is why we have the Federal Reserve and why different currencies change value relative to each other. But on the whole, it's pretty good most of the time.

Bitcoin, though, has no such mechanism built in. With a predetermined bitcoin supply, the value of a bitcoin is guaranteed to fluctuate like crazy as demand changes (and this is, in fact, what has been happening), and that's useless for money. In order to give some flexibility to the bitcoin supply, you have re-introduce fractional reserve banking. That requires an oversight body like the Fed to make sure the banks do the right thing in both boom and bust. In the end, you've basically just re-created the banking system of 1928, which failed in part because the gold standard was not flexible enough to deal with the challenges of the Great Depression.

I do like the idea of having a peer-to-peer currency, where the system creates the right incentives to have a frictionless money with no requirement for central oversight. But the core problem to solve isn't fixing the supply of money, it's democratizing the process of matching money supply to money demand so that the value is stable. I don't have any idea how to do that, but I do know that Bitcoin is entirely the wrong approach.