BitCoin is Fatally Flawed

BitCoin is a peer-to-peer virtual currency based on strong cryptography that is starting to gain some traction for use in transactions for real-world goods and services. It recalls plot devices from Neal Stephenson’s Cryptonomicon  or Daniel Suarez’s Freedom™ where major characters are involved in a nascent new economy based on some form of cryptographic cyberbucks. To a certain extent virtual currencies are not new. Edward Castronova has shown that virtual currencies in massively muliplayer online games (MMO) have virtual currencies that exchange into hard currencies and therefore the MMO worlds have GDPs that rival large nations. People will exchange hard currency for virtual goods. Consider that Zynga (Farmville, Mafia Wars) earned half a billion US Dollars selling virtual goods in 2010.

The thing that is different about BitCoin is that it is a peer-to-peer system and as such there is no central bank to control the money supply and no middle-man to mediate transactions. Transactions are anonymous, and secured through a public key cryptogrpahy system.The record of every transaction is stored on every BitCoin node. Ownership of BitCoins is established by possessing the private key used in transactions to acquire coinage.

Instead of a central bank, BitCoin uses a complex, brute-force mathematical function to generate currency. As nodes come online, the peers scale the difficulty of solving the problem such that over time the rate of currency creation will decline as it approaches a maximum of 21 million BitCoins in circulation.

My critique of BitCoin doesn’t depend on the cryptography. I’m willing to stipulate that the system is adequately secure for the purposes of this discussion.

The problem lies in the cap of 21 million BitCoins being created as well as inevitable loss of private keys which will cause coinage to permanently fall out of circulation. This is a deflationary system.

BitCoin is a Deflationary Currency System and That’s Bad

Let’s do a thought experiment. Suppose that the world lost confidence in US Dollars, UK Pounds and Euros and instead BitCoin became the standard transactional currency. Currently, a BitCoin trades can be exchanged for roughly one US Dollar, but if it were used widely by billions of people the exchange rate would have to change such that a single BitCoin is worth millions of Dollars. This is because the supply of BitCoins is capped at 21 million. Anyone who acquired BitCoins now at one-to-one exchange rate and held on to them would be a huge winner.

BitCoins can be traded in fractions up to 8 decimal places. If BitCoin were to ever to become a general currency used by billions, this precision would not be enough for minimum transactions to be small enough to buy consumable goods.

But wait, there’s more.

Suppose you are an appliance dealer. You buy appliances in BitCoin and sell them at a later time in BitCoin. But because the value of BitCoin is always increasing, you may well be forced to sell your appliances for fewer BitCoins than you paid for them. Loans have to be paid back with money that is more valuable than the money that was loaned. Even a 0% loan is unattractive if it must be paid back with currency that is worth 10% or 20% more than what was loaded. It becomes unprofitable to be in business. It becomes too risky to take a loan to start a new business. Money becomes more valuable but it goes out of circulation because everyone is terrified to spend it.

This scenario is call a deflationary spiral. BitCoin is designed to work like the Gold Standard in that it is a fixed pool of currency. But the fact is that having a fixed pool of currency is incredibly dangerous. The Gold Standard caused the Great Depression in the 20th Century and the Panic of 1837 in the 19th century. If you’re not convinced, I recommend listening to “Gold Standard, R.I.P” from NPR’s Planet Money podcast.

I don’t think BitCoin will ever come to this. Long before there is a Great BitCoin Depression, the world will have realized that it is a flawed monetary system. I think we’re much more likely to end up with in a future that conducts business in Facebook Credits than BitCoin.

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34 Responses to BitCoin is Fatally Flawed

  1. Pingback: BitCoin is Fatally Flawed | Mafia Wars Resources

  2. youfucktard says:

    Suppose you are an appliance dealer. You buy appliances in BitCoin and sell them at a later time in BitCoin. But because the value of BitCoin is always increasing, you may well be forced to sell your appliances for fewer BitCoins than you paid for them.

    So fucking what? Absolute ‘number of bitcoins’ is meaningless.

    If you bought appliances (divested yourself of bitcoins), and the value of bitcoins increased, it doesn’t fucking matter that you are selling them for ‘less bitcoins’, you are selling them for the same value. Bitcoins at a later date have more purchasing power; the fact that people with no understanding of currency may feel ripped off is not of importance.

    • Brian Reiter says:

      Why would the appliance dealer restock if he ends up with fewer BitCoin than he started with? The purpose of commerce is to increase your wealth. In this case, he lost money relative to doing nothing.

      Also, in business, our hypothetical merchant will have entered into long-term fixed expenses that do not deflate such as rent and payroll. He has top pay the same rent every month in currency that is worth more while his ability to generate currency through sales is decreasing. His employees must also be paid the same quantity of currency on a bi-weekly basis.

      Think about the consequences of this for a moment.

      The rational thing to do when money is deflating is close up shop and hoard the currency you have.

      • Andreas says:

        > [..] long-term fixed expenses

        It would be a bad idea to use fixed amounts with Bitcoin as currency. Rather, one could use USD, EUR etc so determine the amount and then decide to use the equivalent in Bitcoins at the given date.

      • Ian says:

        You are confusing ‘wealth’ with ‘number of coins’. Youfucktard is 100% correct.

        Say an appliance is worth exactly 100 bitcoins, and you have 100 bitcoins in your wallet. That means you have the power to purchase exactly 1 appliance.

        Then, you buy one for 100, and later the value of bitcoins increase, so when you want to sell it, you can only get 95 bitcoins.

        But now because of the increase in value of the coins, an appliance only costs 95 bitcoins, and you have now 95 bitcoins in your wallet. That means STILL you have the power to purchase exactly 1 appliance.

        i.e. Absolutely no difference in wealth (purchasing power).

      • Brian Reiter says:

        And if I instead sat on my money and engaged in no risky commerce, I would stillhave 100 bitcoins. Why should I take the risk and effort to buy inventory if the return is less than doing nothing at all?

      • There is a flip side to your argument. Why would the appliance dealer want to sell his goods today for a currency that is going to be worth less tomorrow? In an inflationary system it’s better to own and hold assets because the value of the currency is always going down. The logical thing to do in this case would be to never produce or sell anything for “cash” because the cash will buy you less tomorrow. The seller of assets in an inflationary system always loses.

      • Why should I take the risk and effort to buy inventory if the return is less than doing nothing at all?

        “Then, you buy one for 100, and later the value of bitcoins increase, so when you want to sell it, you can only get 95 bitcoins.

        But now because of the increase in value of the coins, an appliance only costs 95 bitcoins, and you have now 95 bitcoins in your wallet. That means STILL you have the power to purchase exactly 1 appliance.”

        This argument isn’t how the real world works

        In the real world dealer buys $100 for say 100 bit coins, at current bitcoin rate could sell appliance for 120 bitcoins,

        Then lets say bit coins go up in value 20%, now 100 bitcoins are worth $120, so consumer comes along and buys appliance for 100 bitcoins or the equivalent of $120.

        So dealer has same number of bitcoins, but convertable to $120, so he buys another appliance for $100, or 80 Bitcoins.

        Either way he is in business to buy low sell high, not buy and sell at the same price.

    • Bit Blit says:

      The author is correct that Bitcoin has some design flaws, including the need to deflate in order to expand the money supply, but I’m not sure they are fatal, and the fact that it may constantly increase in value is certainly making it an attractive investment and causing it to grow. But not being able to price products in Bitcoins is very inconvenient… otherwise you need a second currency, like the dollar, to provide a stable price reference.

      If you were selling a product in Bitcoins you wouldn’t want to be reducing the prices of your goods every day, and as some have wisely pointed out, you could sell a product and end up with less than if you had not bought and sold it in the first place.

      It would make it very hard to do any price based shopping with prices always dropping. Is a dozen eggs for @.1 Bitcoins a reasonable price. It might be on one day, but a terrible price a week later.

      The lack of stability makes it useless as a price reference and selling of goods very inconvenient.. Nevertheless, Bitcoin fills an important need, and until a significantly better system comes along, Bitcoin will continue to grow.

  3. Mr. Wizbang says:

    “Youfucktard” took the words right out of my mouth. You are completely correct.

  4. Sebby says:

    I think BitCoin has bigger problems just at the moment: there’s no social security, and it’s exchanged for more BitCoins or real currency only. Until the coins are shared around, BitCoin is a good laugh, but I’m not betting with them.

    Cheers,
    Sabahattin

    • Sebby and all, I know this post is 5 years old but just thought I’d come over here to chat any how.

      it appears that bitcoin is running at $615 today and actually got close to $700 in the past few weeks. In addition, I can go to an ATM machine and cash out bitcoins for FIAT paper to go grocery shopping! WAIT! WAIT! I can actually go shopping with Bitcoins or play casino games with bitcoins. Ahhhh…. lovely and even more lovely when the coins were purchased for under $100. And yes! The paper dollar is actually of no REAL value being that our “guvment” … wait not the “guvment” … but the unregulated Fed Reserves just keep printing the almighty dollar, backed by absolutely nothing and decreases in relative value every day. I’ll take bitcoins any day which helps me to increase the value of paper money that I hold. Have a wonderful day. I’m going to pay some bills with my FIAT paper junk and keep most of my bitcoins as a speculative albeit lucrative investment instrument

  5. Futurologist says:

    “BitCoins can be traded in fractions up to 8 decimal places. If BitCoin were to ever to become a general currency used by billions, this precision would not be enough for minimum transactions to be small enough to buy consumable goods.”

    I think you’re underestimating the will of the financial services market to find new ways to extract transaction fees. Just create a new cryptocurrency backed with bitcoin where each single BTC guarantees 10^9 further cryptocoins. Repeat as necessary. Enjoy your financial stability.

  6. Michael says:

    But such logic will affect any currency outside bitcoins too. Imagine you have 10 dollars, you can spend them right now, or you can convert them to bitcoins, wait a year and get 20 dollars back. What will you choose?

    And we already have gold with the same deflationary property, but we don’t see a deflationary spiral. People spend USD on goods, though they can spend them on gold and get more goods year later. Why? 🙂

    • Brian Reiter says:

      > But such logic will affect any currency outside bitcoins too.

      That’s not correct because the supply of other currencies is not capped. The US Treasury or European Central Bank can always produce more currency. Bitcoin has a fixed maximum number of units that can be created which will never be reached.

      > And we already have gold with the same deflationary property, but we don’t see a deflationary spiral.

      Incorrect. The Great Depression deflationary spiral is linked to the currencies being tied to the gold standard. The Planet Money podcast, I linked to provides an excellent summary.

  7. anonymous says:

    lol, if you really think facebook credits would/could/should be used over bitcoins then you my friend are an idiot. why would anyone use something that is so tied to one specific social networking site? bitcoin is global and facebook credits are for lamerz who want to play farmville. c’mon, r u serious? your comparing apples and oranges here. if you are serious then go start investing in facebook credits, might as well flush that money down the toilet. do your research about currency and this topic since it has been debated at infinite.

    and thank you “youfucktard”

    • Brian Reiter says:

      @anonymous: I’m afraid that you have a reading comprehension problem. I did not endorse a Facebook credit future. I’m not a fan. I said it was more likely that Facebook credits would be more likely to be used for transactions than BitCoin. I was also being facetious.

  8. Jeremiah says:

    Nobody mentioned that when you buy that fridge for 100 you can sell it for 300, people do not trade refrigerators, they mark them u.

  9. Mart says:

    Guys,

    Brian is right here.

    In the example given, the merchant could spend 100 bitcoins, do all the work of running his business, sell the application later for 95 bitcoins – albeit those 95 bitcoins now have better purchasing power than the original 100 he invested – i don’t have an argument with that..

    But why do that? He can just sit on the original 100 bitcoins. They will have more purchasing power than the 95 bitcoins he ends up with if he buys and sells appliances. He’ll have 5 more bitcoins, all of which have more purchasing power.

    So a deflationary system encourages people to just sit on their money, rather than do anything with it.

    Of course an inflationary system (like the Fed furiously printing money) is also bad. What we need is a system that grows money supply inline with the growty of the economy.

    This said, I’m tempted to buy some bitcoins, I’m sure in the shorter term I could make a lot of money doing that.

    • Paul Walton says:

      To answer your question “why would he do that?”

      Because he needs an appliance! He needs to wash his clothes right now. He can wait months for the price to drop to 95btc, but by your logic he would still sit on the cash and not buy the appliance he needs. How’s he gonna wash his clothes? Is he an investor or is he someone that needs to buy something and use it?

      By your logic, there’s no reason for anyone to buy any goods and services ever, even with USD or EUR. Why not just stick it in a savings account, a secured loan, or a mutual fund. There’s no reason to buy a $500 appliance now when you can turn that $500 into $600 by investing it!!! Right?

      People need and want goods and services and their needs and wants are time-dependent.

  10. Derrick Aleman says:

    Mr. Reiter

    Can the deflationary spiral be fixed if a bitcoin must be spent by a pre-specified time, say, 21 months? If the bitcoin isn’t spent, it is added back into the central bitcoin bank.

    I think it can be solved.

  11. Derrick Aleman says:

    There is a solution for everything.

  12. lasereyes says:

    If billions of people are using bit-coins, than the exchange rate to dollars would become irrelevant. The usage of fiat currencies would become deprecated, and the value of bitcoins would be based entirely on commodities i.e., a Satoshi would end up being used for the least valuable item that is still worth trading. But that will never happen.

  13. Tonio Barmadosa says:

    It seems that Bitcoin is a scam. It is not meant to succeed as a currency. It is meant to enrich early adopters.

    Most likely the reason the inventor of bitcoin remains anonymous is because he has started a bitcoin exchange business and also has a server farm that has generated thousands of bitcoins since the beginning when it was very easy to generate. He’s waiting until bitcoin reaches a critical mass, and just before the bubble pops he sells all of his bitcoins making millions of dollars on all the suckers.

    My 2 cents.

  14. Rune K. Svendsen says:

    A deflationary currency is “bad” for debitors, you are right there. But it’s good for creditors.
    An inflationary currency is the other way around; good for debitors, bad for creditors.
    Saying that either is inherently “bad” is less accurate than that.

    I think the main reason we see a deflationary currency as just “bad” is because most people are in debt (especially governments).

    To me it seems obvious that a deflationary economy would compensate for the fact that the base currency is deflationary. For example, if I lend you money in Bitcoins, knowing that they increase in value (deflate) by 10%, I can thus give you a 5% (effective interest rate) loan by having a negative interest rate of 5% (loan problem solved). I mean, how hard can it be? It’s just math… we are quite good at that after all.

  15. Exotissima says:

    Are you a misinformation agent? Something appears to be seriously off about your claim that “The Gold Standard caused the Great Depression in the 20th Century and the Panic of 1837 in the 19th century”.

    I am no expert (but neither are you?) so would refer you to the book “Currency Wars” (82 four & five star reviews on Amazon.com versus 9 three, two and one star reviews). “Currency Wars” has perhaps the best explanation of the Great Depression that I have come across and one of the few drawing distinctions between two very different types of so-called “Gold Standard” currencies that are often confused as they are too frequently (deliberately?) conflated:

    – gold-based (currencies fixed to gold: prosperity with neither deflation NOR inflation during such periods) and

    – gold-linked (currencies linked to gold: nations can debase these and they are capable of causing depressions and panics such as those you refer to).

    Whereas you appear to be recommending debt-based (fiat currencies: aka suckers’ game)?

  16. Gee says:

    Mr. Reiter,
    Please read “America’s Great Depression” by Murray Rothbard. Your understanding of money and banking is lacking, to put it likely.

  17. anonymous says:

    Gold Standard doesn’t allow other parallel currency.

    Bitcoin will coexist with tons of other cryptocurrencies. Each cryptocurrency system will service a portion a world trade that it can handle. The market will gradually figure out how many separate and distinct cryotocurrencies to have in parallel.

  18. Paul Walton says:

    You are missing a big key characteristic when comparing Bitcoins to the Dollar, Euro, or other currencies controlled by central banks. Loans made by banks with those currencies are ‘fractional reserve loans’.

    Here’s a simplified example. You deposit $1 in Bank A. When Bank A makes a $10 loan, they loan out your $1 plus $9 created out of thin air. The borrower eventually pays back $12 and that $9 is destroyed by the bank. These numbers are simplified but this concept is standard and has been for hundreds of years. This is fractional reserve banking.

    As a result, the money supply expands or contracts depending on the ratio of *loans being made* (inflation, money created) to *loans being paid back* (deflation, money destroyed) in a given time period. If every loan was paid back and/or defaulted all at once, the vast majority of the currency would disappear instantly. The big banks would own the majority of mortgaged properties and the majority of the ‘real’ currency left over (ie., fully deflated).

    This is why the economy is in a constant flux of boom and bust. Inflation followed by deflation. The banks must create money (by giving loans) to earn interest, then they must destroy money (by not giving as many loans) to raise the value of their money and collect assets from mathematically-inevitable defaults. It’s a constant cycle. All of this is controlled by the central bank, eg. the Federal Reserve. THIS is what caused the Great Depression. The money supply was heavily deflated *purposely* by the Fed. Money became scarce and there simply wasn’t enough in circulation for everyone to pay back their loans to the banks.

    Bitcoins create, as far as I can tell, a ‘full reserve lending’ economy. This is an entirely different beast. There are no special banking entities that get to create money by giving loans. When a Bitcoin is lent, no money is created; it is simply transferred. This should result in a more stable, sane economy that rewards wise decisions and outright purchases instead of encouraging massive debt (car, house, credit cards, etc).

    I’m no expert though. Whoever created Bitcoin is a genius.

  19. Adam Scarborough says:

    i know i’m late but Paul Walton. Read what fractional reserve banking is…

    that $9 isn’t created out of thin air. if you deposit $10 then the bank can only loan out $10 (usually they will loan out $5-7 – based on the idea that they only need x% of deposits to satisfy day to day transactions). The only misconception created is that you both have $10 as it appears as “your money” on your statement. if you were to look at a banks balance sheet you would see the $10 you have in your account (a liability) balanced against $5-7 (plus say $1 in interest) loaned to someone else (an asset) and a $3-5 cash pool the sum of all that is the $1 interest payment. In the circumstances where there is a run on the banks and banks default you then have to go through the system of trying to pay the cash pool back to the banks creditors (those holding deposits with the bank). Either way, no money is created or destroyed in the process

    • Bit Blit says:

      Adam S, you are not really understanding fractional reserve banking. For one thing, the “reserve” is very close to zero for most loans, it’s not really limited by the official “reserve requirement”.

      Second of all, they absolutely do create money out of thin air when they make a loan. If I have $10 in my account and they loan that $10 to someone else, then there is now $20 in circulation (since we both have $10 to spend as we like.) In fact, 95% of the money in circulation is created in this way.

      This is the reason that we owe $40 trillion to private banks which dwarfs the national debt of a mere $15 trillion.

      There’s a great book called “Money” by Thomas Greco if you want to understand how the system works, in a non-biased manner.

      Of course the banking system doesn’t really want you to know that they are conjuring the money from your home loan out of thin air, because they want to charge you lots of interest (which magically turns the *conjured* money into *their* money) and they want to take your house if you don’t pay them back.

  20. Paul Lucero says:

    I read this and laughed my ass off! Today Bitcoin closed at $115.00 and because it keeps going up I will have to start trading in Fractions of a Bitcoin. Thank god for those 8 digits!

    Ha Ha HA!

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