Bitcoin on the rise, but may not get too far

Shahid Mehmood

In 2009, a person (or persons) using the name ‘Satoshi Nakamoto’ set off an event that continues to ripple through the space-time of global monetary mechanisms with the creation of what is now one of the world’s most sought-after investments. So much so that the Federal Board of Revenue, Pakistan, recently started taking measures against its use in the country. Nakamoto created an electronic currency called Bitcoin, which is gradually gaining traction in its use and implications.

There are currently about a dozen electronic currencies, or cryptocurrencies, competing with each other, collectively worth $80 billion. As the most well known, this article focuses on Bitcoin. Wall Street is the latest to latch on to the Bitcoin frenzy, its central clearing house reorienting its software to include Bitcoin transactions. In 2016, the Australian Stock Exchange surprised many by announcing that it would join the same ‘blockchain’, thus signalling its intention to accept Bitcoin transactions. Others have already accepted it, or have gradually followed suit.

Unlike conventional currency, Bitcoin is ‘mined’ on computer networks using complex algorithms. It is a single-person creation, not backed by any government. The record of transactions is kept in an electronic ledger. The combination of these ledgers forms a blockchain. Unlike modern currencies that can be printed without limit, Bitcoin’s creator set the limit at 21 million units. Now trading at more than a $1,000 per Bitcoin, this has revived predictions that cryptocurrencies will become mainstream currencies in the coming years.

The rise of electronic currencies is relative to the decline of trust in conventional investments.

But cryptocurrencies have many drawbacks that may prevent this. First, as already stated, Bitcoins are ‘mined’ through algorithms, not printed. So for most of the world’s population, this currency is out of their reach since few have the skills to run algorithms. If Bitcoin or similar cryptocurrencies were to ever become part of a payment system (like a dollar or a rupee) they would be concentrated in the hands of the very few individuals who have the skills to ‘mine’ it — potentially disastrous in a world already vexed with record wealth inequalities.

Second, currencies like Bitcoin are in limited supply — i.e., the money supply is fixed — which could be problematic, especially in times of economic turmoil, when increasing money supply is a time-tested tool to rein in recessions. The most monumental event of economic history, the Great Depression of the 1930s, was precipitated in part by contraction of the money supply. One of the main reasons for its severity was the failure to expand money supply in the early phases, leading to a prolonged crisis. Since then, central banks have acted crisply by providing immediate liquidity to the financial sector – i.e., they expanded the money supply quickly to offset the danger of a depression-like situation. But with cryptocurrencies, such remedies will become redundant and the severity of economic crises may be prolonged — the socioeconomic fallout of which could be catastrophic.

Another problem is that cryptocurrencies lack stability in value. Put another way, it fails the sound money test — one of the qualities of which is the absence of drastic changes in value (relative to other monies). While relative valuations do change (as in rupee vs dollar), the percentage change is typically minor. Bitcoin, in contrast, has gone through wild swings in valuation.

In 2012, its value was zero per dollar. By mid-2013, its value shot to more than $1,100 per Bitcoin; by mid-2015 it collapsed to $300; now it’s up again at $1,000. Such swings render it as a poor store of value — a risky bet for increasing one’s wealth.

Next, the resource cost exerted on a society and the economy could be formidable, with little advantages in return. A few years ago, as Bitcoin’s value surged, so much pressure was exerted on the electricity grid in California (‘mining’ requires substantial computing power) that it tripped. Compare this to the probability that only a tiny fraction of those who ‘mine’ these currencies actually get them; only a few get to realise its advantages.

Last, but not least, the internet and computers are probably some of the most unsafe places on earth. It takes just one person to create malicious software that can destroy data and wreak havoc on the web. There will never be guarantees against such breaches; the internet’s history is awash with such episodes. In 2016, $81 million were ‘stolen’ from the account of the Bangladesh government through a cyberattack. The thief’s physical presence was not required — just a computer and a virus. So, on a system running on cryptocurrencies, what if people were to wake one morning to find that they’re penniless, all their wealth erased in a cyberattack?

Advantages

Cryptocurrencies do offer some notable advantages. Till now, the biggest advantage is in the form of Bitcoin’s blockchain technology, which holds tremendous promise for ensuring property rights. Transactions like property transfers and ownerships cannot be manipulated or changed easily since these are backed by complex coding. For countries where records can be easily manipulated (making enforcement of property rights difficult), this has tremendous value. Honduras, in fact, requested a technology firm to help implement blockchain to arrest this very problem, and the US state of Georgia is already using it to digitise its records. The transaction costs of operating crypto-currencies are also lower than regular payment systems.

Bitcoin and other virtual currencies have a long way to go before formally becoming a part of payment systems. For that, they do not necessarily require a government’s nod. Acceptance of a method of payment is as much a social phenomenon as economic. No government recognises Bitcoin, but many places still accept it for payments. Its acceptance owes more to the relative decline of trust in investments like dollar and dollar-denominated wealth instruments. Events like the 2008 economic crisis only accentuate its demand, which suggests that the future use of such currencies will largely depend upon the level of trust citizens have in their respective governments and its systems.

The writer is an economist.
The article was first published in Dawn, Pakistan, on June 26.