A look at what will happen next in the world economies
Friday, April 5, 2013
This 1998 Paul Krugman Column Perfectly Explains The Design Flaw At The Heart Of Bitcoin
Lots of talk about bit coin it has caused quite a controversy. Aivars Lode
Bitcoin is garnering a lot of hype, to the point where some people are wondering whether Bitcoin can be not just an interesting experiment, but a real, functioning currency.
The verdict is in, and you don’t have to look at Bitcoin today to know the answer. You just have to read a simple column written in 1998, more than a decade before Bitcoin was created. And the answer is no.
Before looking at the column, we have to understand a key point about the design of Bitcoin. Most commentary has focused on the fact that it’s an entirely decentralized and cryptographic currency, which is certainly interesting. But here’s the key thing: Bitcoin’s algorithm states that at some point the total supply of Bitcoin will be capped at around 21 million. Bitcoin users create more bitcoin by “mining” it (running software on their computer), but Bitcoin’s algorithm states that the rate at which Bitcoin can grow will slow down asymptotically to close to zero, such that the supply of Bitcoin will essentially be fixed.
Total Bitcoin supply over time. Starting in 2009, the Bitcoin supply is created at a rate of approximately 50 bitcoins every 10 minutes. Every 210,000 generations (about every four years), the creation rate is cut in half (i.e. 50, 25, 12.5, 6.25, etc.) and tends to zero, such that there will never be more than 21 million total coins created. (Photo credit: Wikipedia)
Why is that a problem?
To understand that, you just have to read what may be the most famous column by Nobel-prize winning economist Paul Krugman: the baby-sitting co-op.
The story of the baby-sitting co-op is that a bunch of people agree to baby-sit for one another, so that they don’t have to pay cash for adolescents. To make sure everyone does their fair share, the co-op uses coupons equivalent to an hour of baby-sitting time–sort of like an alternative currency.
A problem arose when people tried to hoard coupons to build a reserve and then run it down. The more people tried to hoard coupons, the less people were willing to go out and get their babies sat. And since there were less coupons in circulation, there were less babies sat. The baby co-op, in other words, had entered a recession. It was in a classic liquidity trap.
The co-op decided to issue more coupons, and all was well again.
As Krugman writes:
If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.
Krugman is right: if you really understand the baby-sitting co-op, you really understand monetary policy. And if you understand the baby-sitting co-op, you understand why Bitcoin’s design is fatally flawed. (The column is also worth reading because, even though Krugman is now mostly known as a left-wing firebrand, arch-libertarian Milton Friedman almost certainly would have signed up to every word of Krugman’s column.)
Once the supply of Bitcoin is fixed, at some point the Bitcoinomy will run into the same problem as the baby-sitting co-op: there won’t be enough currency, and there will be a recession, and there will be a liquidity trap.
There are some objections to this: for example, that since each bitcoin can be infinitely divided into components, the money supply can keep growing. But that’s not related. If you have a $10 bill and I replace it with ten $1 bills, do you feel richer?
I’ve also been told that this is only valid if the entire world is on Bitcoin, but if you think about the world today, that’s not true. There are plenty of currencies out there, and the supply of some of them is too low, and that hurts the people who use that currency. The fact that the dollar exists doesn’t prevent the yen from being too strong.
All the talk about the science fiction-like aspects of Bitcoin–the design, the cryptography, the sophisticated algorithms–obscures what a column from 15 years ago about a humble baby-sitting co-op tells you and allows you to understand why Bitcoin isn’t viable.
If Bitcoin keeps growing, at some point the money supply will be too low, and “Bitcoinomy” will experience a recession, which will turn into a deflationary depression as the money supply never expands. Just like the baby-sitting co-op (or the world under the gold standard in the 1930s).
Now, it’s worth noting that this fatal flaw of Bitcoin is not a fatal flaw for all cryptocurrencies or algorithmic currencies. One can imagine a Bitcoin-like currency with a smart algorithmic central bank (indeed, Bitcoin does have an algorithmic central bank–just an economically illiterate one).
In fact–and this is where things get really interesting–you don’t have to imagine just one. As Quartz’s Christopher Mims said on Twitter, “Imagine a future in which a handful of cryptocurrencies, each headed by a different monetary philosophy, compete.” We would, if nothing else, certainly learn a lot about human nature, technology and economics.
In this world of multiple, competing cryptocurrencies, Bitcoin would be a pioneer–and, ultimately, a loser.