Bitcoin will bite the dust.

Abstract

Bitcoin is most radical innovation in monetary space for a very long time. It is an entirely private monetary system that runs itself and does not depend on trust in any central authority to honor its promises. Instead, it relies on trust in Bitcoin community or network that verifies transactions and maintains integrity of system. This system of distributed trust creates bitcoins and produces an automatic, tamper-proof bitcoin money supply process. (1) As such, it avoids dangers of discretionary monetary policy--namely, quantitative easing, manipulated interest rates, and need to rely on wise men or women to withstand political pressure or successfully forecast future. Indeed, under Bitcoin there is no monetary policy at all. There is just an automatic monetary rule dictated by Bitcoin protocol designed in 2009 by an anonymous programmer using alias Satoshi Nakamoto. Bitcoin has been widely hailed as a success and has won a substantial following. Unfortunately, underlying economics of Bitcoin mean that it is unsustainable and in all likelihood will be remembered as a failed experiment--at best a pointer to some superior successor. A first-pass intuition into Bitcoin can be obtained from a comparison with stone money in Milton Friedman's (1992) case study, Island of Stone Money. In this story, people of island of Yap in Micronesia used as money large round limestone disks transported from nearby island of Palau. These were too heavy to conveniently move around, so they were placed in prominent places. When ownership was to be transferred (e.g., as part of a dowry, inheritance, or ransom payment), current owner would publicly announce change in ownership but stone would typically remain where it was and islanders would maintain a collective memory of ownership history of stones. This collective memory ensured that there was no dispute over who owned which stones. Similarly, in Bitcoin, record of all transactions, blockchain, is also public knowledge and is regarded as die definitive record of who owns which bitcoins. Both stone money and Bitcoin share a critical feature that is highly unusual for a monetary system: both systems operate via a decentralized collective memory. On February 11, 2009, Nakamoto gave an explanation of thinking behind Bitcoin in an e-mail announcing its launch: root problem with conventional currency is all trust that is required to make it work. The central bank must be trusted not to debase currency, but history of fiat currencies is full of breaches of that trust.... With e-currency based on cryptographic proof, without die need to trust a third-party middleman, money can be secure and transactions complete. Cryptocurrencies, however, face problem of As Nakamoto notes, owner could try to re-spend an already spent coin by [digitally] signing it again to another owner. The usual solution is for a trusted company with a central database to check for double-spending, but that just gets back to trust model.... Bitcoin's solution is to use a peer-to-peer network to check for double-spending. Consequently, the result is a distributed system with no single point of failure. (2) Kevin Dowd is Professor of Finance and Economics at Durham University in United Kingdom and a partner at Cobden Partners. Martin Hutchinson is a journalist and author of Bear's Lair column (www.tbwns.com/category/the-bears-lair). The authors thank Ferdinando Ametrano, Gavin Andresen, Raadhiyah Anees, Steve Baker MP, Roger Brown, Dave Campbell, Akin Fernandez, Dominic Frisby, Jim Harper, Doug Jackson, Gordon Kerr, Jim Rapp, Eric Samieski, Lawrence H. White and Basil Zafiriou for much helpful feedback. We note that several of our readers have expressed serious reservations about our analysis and conclusions. Any remaining mistakes are authors' own. …