What Is Bitcoin Good For?

This may be a question you’ve asked yourself, looking at the recent run-up in prices. Why, exactly, would you want to pay $18,000 and change to get your hands on one?

I myself have been asking that question. Is bitcoin in a bubble? Or do all those folks who are eagerly snapping it up know something that I don’t?

Maybe they do. That’s the magic of markets, isn’t it? As individuals, we’re often wrong, but markets aggregate the opinions of individuals, and over time, the errors ought to cancel each other out. So the market’s guess at the value of bitcoin is probably better than mine.

Except: Markets do go into speculative bubbles (just ask anyone who bought a house in 2006). Also, the bitcoin market is a little strange. At the moment, it consists of a relatively small band of heavy enthusiasts. A bunch of those enthusiasts work in media or Silicon Valley, so their fixation gets more attention than, say, the market for Hummel figurines. But essentially, the market is similar to a market for collectibles, in that it is disproportionately composed of people who are obsessed with bitcoin. 1

Now, in and of itself that doesn’t mean the price reflects a bubble. But it does mean that we have to go back to the original question: What is a bitcoin good for?

There are basically two answers to this: Either a bitcoin is money, or it is a payment system. This is a problem that very smart economists grapple with all the time; the question “What is money?” is perhaps the most delightfully dizzying metaphysical mystery to be found in modern economics. 2

The best way to think about it is that if bitcoin is a payments system, it will compete with Visa, or PayPal, or bank settlement, or some other system of moving money hither and yon. If it is money, it will compete with the dollar and the euro and the yen.

Bitcoin’s future as a payment system is more plausible, because it would not need to dethrone other currencies, something that the governments that run those currencies are apt to get rather testy about.

But if you think bitcoin is a payments system, you quickly run into a few problems.

The first is that bitcoin has severe scaling problems. It is designed for transactions to take 10 minutes to clear (a modern miracle, but those of us used to the modern miracle of debit cards are probably not willing to stand at the grocery checkout queue for 10 minutes after our groceries are bagged). And its overall architecture means it simply can’t clear very many transactions -- a tiny fraction of what Visa and Mastercard handle every day. Already people are complaining about rising fees and longer wait times for payments to clear.

For bitcoin to compete as a payment system, it has to offer the same benefits that Visa does: rapid transfers of funds, immense scale, protection against theft (in the U.S., at least), and the ability to dispute charges, all at a reasonably low transaction fee. Otherwise, it has to be better at something than Visa is. The only area where it can really be said to better than a credit card lies in the privacy.

But I’ve yet to see evidence that people other than current bitcoin enthusiasts actually value privacy all that highly. I doubt they value it enough to support current bitcoin valuations. So bitcoin is going to have to deliver on some of Visa’s other advantages. There’s no sign it can. Which makes it hard to see how bitcoin-as-payment-system can justify current valuations.

There are ways to fix these problems. For example, you can increase the size of the transaction ledger that posts every 10 minutes (in fact, bitcoin's digital architecture just had a “fork” that did this). But then the total ledger of every transaction that was ever done will also get bigger -- and bitcoin’s peer-to-peer architecture means that this bloated ledger would have to be stored on every computer in the network. That’s unlikely to be practical.

Alternatively, third-party systems can develop on top of bitcoin, so that most of the transactions are posted inside the third-party systems, and netted out, so that only some of the transactions have to be posted to the mass ledger. But then those third parties are really the ones competing with Visa, and bitcoin starts to look more like money.

In a column next week I’ll assess bitcoin’s plausibility as money. (Check out the new TV series “Ozark” if you want some homework before then.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
And what of it, you may ask? People have been buying Hummel figurines for decades, haven’t they? But the situations are not quite parallel. For one thing, people who buy Hummel figurines like to look at them, something you can’t really do with a bitcoin. I mean, maybe there are people who just love staring at their hard drive and contemplating the elegant solution to the Byzantine Generals problem contained therein, but I kind of doubt that very many of those people would pay $18,000 for the privilege.
Moreover, collectibles collectors have some sense of the limitations of their market. People who own Hummel figurines may believe that they are in possession of great works of art. They may think that the world should pay more attention to the charms of fat-faced, round-eyed little children than it currently does. But few people who buy Hummel figurines believe that someday, all of the decorations in the world will be based around Hummel figures, and they will be able to exchange their twee little goose girl statuette for a villa in Tuscany. On the other hand, I have heard many such claims from the owners of bitcoins.
The best popular exploration of these issues is probably Milton Friedman’s "Money Mischief." Don’t worry, liberals, you can safely read this book, which is just a fun meditation on the strange social construct that is money, not libertarian politics that will make your eyes turn red and your ears steam.