Bitcoin Looks More Like Gold Than a Currency

Bitcoin Looks More Like Gold Than a Currency

The cryptocurrency is volatile,
costly to store, hard to use
and deflationary.

By Noah Smith

July 11, 2018, 5:00 AM MDT

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

Follow @Noahpinion on Twitter

In the seven months since Bitcoin’s price peaked, it has fallen by about two-thirds. But it’s still almost three times more valuable than it was a year ago.

But Bitcoin is only superficially similar to gold. There are powerful arguments for the Bitcoin Bust scenario, in which the cryptocurrency is abandoned. One such argument is made by University of Chicago Booth School of Business economist Eric Budish in a new working paper entitled “The Economic Limits of Bitcoin and the Blockchain.”

All money works via trust — you have to trust that the person paying you in a transaction won’t send you fake money, or somehow take the money back after you give them the goods. Banks, which certify fiat money transactions, have built up a large stock of trust over time, so each new transaction is very cheap to perform — to pay someone a dollar, you just have a widely trusted bank mark your account down by $1, and the other person’s up by $1, and you trust that there will be no funny business involved. But Bitcoin runs on a decentralized network, so there’s no trusted bank — in other words, trust has to be reestablished each time there’s a transaction. The innovation of the blockchain represents a way of doing this via a distributed network of competing players, who get a reward for certifying the transaction faithfully.

But Budish notes that reestablishing trust every time there’s a transaction can get very expensive. If you devote a huge amount of computing power to dominating the blockchain, you can create fake Bitcoin transactions, thus stealing things from people without paying them. Budish shows that in order to prevent this from happening, the payoff for the blockchain players has to be high relative to the value of the attack. In other words, the more there is to gain from an attack, the more each Bitcoin transaction costs.

The value of using a Bitcoin attack to steal things is related to the size of the largest Bitcoin transaction you can make, so this means that in order to keep Bitcoin usage costs low, transactions have to be kept small — which makes paying for things cumbersome and slow.

Even worse, you can attack Bitcoin in order to sabotage and destroy it — perhaps so that your own cryptocurrency or fiat currency can gain popularity in its stead. Budish conjectures that the value of this kind of sabotage could potentially be enormous — comparable, in fact, to the total value of Bitcoins in existence.

And if he’s right, it means that Bitcoin as a whole can never get very valuable. If it does, it either becomes way too expensive to maintain (because it consumes electricity), or it becomes vulnerable to sabotage by a rival. If Budish is right, it means that Bitcoin’s total value has an upper limit. And once people realize that, they’ll abandon the cryptocurrency, leading to the Bitcoin Bust scenario.

So far, Budish’s apocalyptic scenario hasn’t come to pass, even though Bitcoin’s market capitalization briefly surged above $300 billion in late 2017. So, the danger seems remote for now. But if Bitcoin is going to replace fiat money, its market value will have to reach into the tens of trillions of dollars — more than 100 times higher than anything it has attained so far. The weakness Budish has identified — the inherent cost of repeatedly reestablishing trust under constant thread of sabotage — may make Bitcoin economically unviable. If so, either another cryptocurrency will take its place, or fiat money may continue its reign as the world’s dominant monetary system.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.


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