Bitcoin: The Future of Global Currency or A Gold Mine for Criminals?
by Nadav Morag, Ph.D.
Bitcoin is a new global currency created in 2009 by an unknown person using the alias Satoshi Nakamoto. It represents an interesting experiment in creating a global currency that is not tied to national currencies and which exists only electronically (though, in theory, physical currency could be created from it if there were a “Bitcoin central bank”).
Our current global monetary system, known as the “Washington Consensus” dates back to August 1971. Prior to that, the post-World War II “Bretton Woods” system pegged the value of global currencies to the U.S. Dollar, which itself was convertible to gold. This meant that the dollars were issued based on US gold reserves at Fort Knox and that US currency could be exchanged for the whatever the equivalent amount was at the time in gold bullion. The U.S. finally abandoned the gold standard because the rise in spending on social programs and the Vietnam War meant that America’s currency was overvalued and this led to other major economies, following America’s lead, shifting to the current market-based system in which the U.S. Dollar and other currencies have value because they are bought and sold at a particular exchange rate - in other words, currency has value because people believe it has value. Thus, to use a more dramatic example, if a country is facing serious economic problems or in danger of defaulting on its debts, its currency will be viewed as worth less and consequently investors who purchased that country’s currency will be looking to offload it on other currency markets thus making that currency even cheaper to purchase, and thus less valuable, much as in the manner in which stocks and bonds are bought and sold based on their perceived values.
Inflation and deflation also affect the value of currency as governments print more money, making currency have less purchase power, or decrease the money supply through printing less and increasing the interest rate. This makes money more expensive to “rent” or borrow, by making the cost of loans higher.
Before Bitcoin, the only entities authorized to print currency and create monetary policy were sovereign countries. Prior to that, individual banks and some other businesses sometimes printed their own currency - something more akin to a check - with the value of that currency (banknotes) based on the reputation of the bank. Of course, a system in which currency production was in the hands of virtually any bank meant a lot of different currencies were in circulation (which was confusing and inefficient), no one ever really had a good sense of what those currencies were actually worth, and the whole system was very open to fraud through the widespread counterfeiting of banknotes.
Counterfeiting, of course, continued to be an issue, after the creation of national currencies. Most people associate the US Secret Service with protection of the President, but the agency actually got its start dealing with counterfeiting and this is still one of its central mission areas. Nevertheless, national governments have the financial resources to make life more difficult for counterfeiters, through various way of safeguarding financial transactions and making paper currency difficult to reproduce illegally. Over the years, some countries have come to the conclusion that, chiefly for reasons of facilitating trade, it makes sense to create supra-national currencies, or currencies that exist across a number of countries. The Euro, for example, has superseded the national currencies in 18 European Union member states so that venerable currencies like the French Franc and the German Mark no longer exist. There are also similar supra-national currencies in parts of West Africa, Polynesia, and the Caribbean.
Unlike national currencies, or even old-fashioned banknotes, Bitcoin is decentralized and is not issued by any sort of monetary authority. Instead, Bitcoins are created by a computer network in which machines connected to the network execute sophisticated mathematical computations (a procedure known as “Bitcoin mining”) that become more sophisticated and time-consuming as time goes on, thus making it progressively more difficult to “mine” new currency and so that the total number of Bitcoins that can be “mined” is limited to around 21 million Bitcoins. As new Bitcoins are created, the network records the creation of new Bitcoins (around 25 can be created at a time by users). Bitcoins can be exchanged for traditional currency on a number of exchange sites and can also be used, in some cases to purchase web services and even to buy pizza! They can also be sent from one person to another via mobile apps or via computers, much the way electronic bank transfers occur. Bitcoins are stored in “digital wallets” which exist either in the cloud or on a user’s computer.
One of the problems with Bitcoin, aside from the fact that a currency of this type, should it become successful and widespread, has the potential to undermine national currencies, is that giving any user the ability to produce currency opens the process up to wide-scale fraud. Because the process of Bitcoin mining is so complicated and time consuming, some Bitcoin users have employed powerful computers to speed up computations or hijacked other computers, so that they can produce more of the online currency for themselves more rapidly. In addition, while every Bitcoin transaction is recorded by the Bitcoin network, the names of buyers and sellers are never revealed, only the ID number for their respective digital wallets. This allows users to keep their identities, though not the actual transactions private, but it also means that virtually anything can be bought or sold (provided the two parties to the transaction accept Bitcoins) with a high degree of anonymity.
By contrast, most major banking transactions (those above $10,000) require a paper trail which investigators can use to ascertain if someone is engaged in money laundering, the purchase of drugs or other contraband through the wiring of funds, etc. In addition to money laundering, it is also feared that Bitcoin may prove a useful medium for drug trafficking organizations, human traffickers, terrorists, child pornographers, illegal gambling operators, and others. To provide just one example, the now closed down but previously highly-popular online illegal-drug website “Silk Road” used Bitcoins as its primary medium of exchange. On top of all this, Bitcoin users are highly vulnerable to “bank robbery” wherein certain users steal the contents of digital wallets through hacking into victims’ personal computers or cloud sites. Finally, it is unclear whether the method in which Bitcoin currency is created and the trust people put in this new digital currency created by a computer network will make it sustainable in the long term. Nevertheless, as with many other areas, technology is challenging the way we think and behave and it increasingly empowering individuals and small groups to do the sorts of things that only nation-states could do in the past.
What do you think about Bitcoin mining? Do you anticipate Bitcoin value to increase or decrease?