Bitcoin – part 2


You may be used to the card in your wallet or the coins in your pocket but there is a new form of currency making headlines. Bitcoin is described as a crypto-currency, existing outside of national frameworks and banks and acting as a tender for all sorts of exchange – legal and illegal.

In the first part of this two part series on Bitcoin we looked at how Bitcoin works. In this second part,  Alex Burd is back at the Oxford Internet Institute to talk again to Vili Lehdonvirta, a research fellow there and an expert on Bitcoin, about the political and philosophical implications of private currencies and what they can teach existing systems. They started by discussing the immediate future of the Bitcoin.

Alex Burd:  So where do you see Bitcoin going from here? At present it’s a niche technology for a minority of society who use it for various things.

Vili Lehdonvirta:  It’s interesting first to talk about the intentions of various people and communities who use Bitcoin. There is no central authority. There are some cyber-libertarians who want to make Bitcoin independent of authority, so their stated objective is to provide an alternative to national currencies, so that relates to the anonymity also, they wanted it to be anonymous so that authorities can’t track that. And you know my own opinion is that, so far as some people that believe that for example taxation is theft and I don’t agree with that so I think we need to have institutions, we need to have society that has some kind of ability to tax its members. Because of the ‘free-rider problem’ in economics taxes need to be collected coercively  for us to be able to collect taxes at all.

AB : Could you just explain the ‘free-rider’ idea?

VL: Well, the problem is that if you ask people collectively to contribute to a cause that they all benefit from, lets say healthcare, roads or national defense then obviously everyone believes that these are important causes but the individual can ‘freeride’ on the others by saying that ‘look my contribution, my individual share is so small that even if I don’t pay it will not impact the overall very much. But if everyone thinks this way the we’re going to have less of those services than we really need. So any, what are called ‘public goods’, any good where everyone gains the benefit and those who do not pay cannot be excluded from obtaining the benefit is going to be underproduced, it’s going to be produced less than we need it produced according to micro economic theory. And this is basically a justification for collecting taxes and having taxes be mandatory , not something you can opt into or opt out of.

But at the same time, what I’ve just said is only valid in a democracy where tax money is used in an accountable manner and where tax money is really used on public goods and not for the private benefit of some interest groups for example. There are well documented abuses of tax money but also of governments power over national currencies. So just to give you one example, we all know the organisation Wikileaks, information leaks that were highly embarrassing to the US government and US authorities, however it appeared they had not done anything illegal so could not be charged, I’m not actually sure now if they have been charged. But, certain US senators publicly boasted that they had used their connections, their  political power, their leverage to force payment processors like Visa, Mastercard and Paypal, to force these payment processors to stop serving Wikileaks, so that Wikileaks could no longer conduct its business, it could no longer receive donations, it could no longer receive payments, it could no longer transact with people. Obviously if you’re going to exclude someone from the economy like this that should only be a decision that can be done by a court, it should be the consequence of some kind of legal wrongdoing. So this was one very clear example of state power over national currency had been abused   and so the argument is that if we had these private crypto-currencies which are controlled by no one, they’re only controlled by the algorthmn then we wouldn’t have any abuses of power either.

AB: Wikileaks now takes a lot of donations through Bitcoin.

VL: Exactly, what Wikileaks did is move onto Bitcoin. And this seems a very legitimate use for Bitcoin in my opininion. My concern then is that by removing, by stripping, governments of their power – and governments are meant to be institutions that we people have put together to facilitate cooperation and overcome problems like free-riding and coordinate our economy to the benefit of everyone –  if we strip governments of their power  over the money system then yes, we get rid of the abuse but we also get rid of all the benefits right, we lose the baby with the bath water. That’s my view. So in my opinion we should try to fix our governments and keep national currency, but I don’t know if that is possible. For me this kind of crypto currency would the last resort.

AB: Do you ever see Bitcoin going more mainstream I guess in terms of being a commonly used currency or is it going to be something like Bitcoin that isn’t Bitcoin?

VL:  Two things limit Bitcoin’s ability to become very mainstream. One is that,- despite the serious abuses of a national currency system and national monetary system, the national monetary systems still provide a level of convenience for the ordinary who is not so concerned about more philosophical ideals which are important but the ordinary consumer prioritise their convenience. And still it is, despite Bitcoin clients becoming easier to use and so on it’s still just more convenient really. There are people who disagree with me but in my subjective assessment of the usability of this different payment systems it’s just more convenient to use Euros, or Pounds or Dollars. If you receive your salary in that currency it goes in your bank account, we have all this infrastructure built for those currencies. They’re quite safe, if your bank account is hacked it’s the bank who will compensate you so the risk is diffused; if your Bitcoin account is hacked, your key stolen, you lose everything.  There is no recourse and there is probably very little that law enforcement can do because authorities have been excluded from the system by design. So there are these very practical reasons why ordinary consumers will find it hard, well let’s say they won’t find many reasons to start using Bitcoin instead of their national currency.

Ordinary merchants also have reasons – incentives –  to use Bitcoin. The transaction costs, the money that you have to pay for payment processors, are very high in our national monetary system, but in Bitcoin that’s not necessarily so. Although if you’re going to exchange your Bitcoins back into pounds to pay your rent for example then you’re going to incur transaction costs in that process. So BItcoin’s not free to use either in that sense. And then for our merchants there’s the problem of currency risk. The value of Bitcoin fluctuates and changes quite a lot in one day, so it’s the same as if you’re trading between currencies, every time you accept a foreign currency you’re accepting a degree of currency risk and that’s not really a risk that merchants want to bear so there are some disincentives to stop adopting this more widely. There are some incentives as well, unfortunately I tend to think that tax evasion tends to be the biggest incentive, that it is quite easy not to report taxes if you take payments in Bitcoin. That said I do not want to say that merchants who accept payments in Bitcoin are tax evaders  because I think that the great majority use these kind of systems which allow them to accept Bitcoin but then exchange them into the national currency immediately so actually the only thing the merchant sees in their books is ordinary pounds or dollars.

AB: Given that this is the first widespread iteration of private crypto-currencies I guess it follows that there would be some logistical problems and issues breaking through. However, say that we all suddenly decided we wanted to abandon our notes and coins, could Bitcoin feasibly replace it?

VL: because the money supply is uncontrollable by design in order to prevent evil governments printing more money and causing hyper inflation. If you can’t control money supply then the value of money depends only on demand and so then there is this quite basic theory in macro-economics, the quantity theory, which basically says that if you have increasing use for money, increasing demand for money but the amount of money doesn’t grow then your prices are going to start falling and you’re going to have deflation. And deflation is seen as very bad for economic growth because it encourages hoarding instead of spending, because it means that if you have one Bitcoin in your wallet today and you know that it’s going to be worth more tomorrow and even more next week because its constantly deflating then you have an incentive to hold onto for a little and not spend it immediately. But because by doing that you’re actually preventing usage from going it’s a self defeating proposition. That deflation prevents economic growth from happening and you never really get very big or significant rise in the value of the currency. So if you think about what kind of deflation would be necessary for Bitcoin to be used in place of our national currency it’s just astronomical. So let’s say there are about five thousand billion Euros in circulation, this is M1, so this is cash and overnight deposits, so lets say if wanted to replace just 10% of that with Bitcoin – so five hundred billion Euros would be replaced by eleven million, lets say ten million to make it easier to calculate. There’s ten million Bitcoins, which is what we currently have, it means that each Bitcoin would have to stand in for €50,000, currently each Bitcoin is worth €50 to €100, if we say you know €100 then the value of each Bitocin would have to appreciate by 49,000%. It means that the value of Bitcoin would have to double ten times I think, in order to reach that kind of value. And you can see that kind of expectations is self defeating, it’s not going to be adopted very widely if people think it has a potential to be, the value is going to grow 49,000%, ‘I’m just better off holding onto my money.’

AB: Why spend it today when I can buy twice as much tomorrow?

VL: Right, Bitcoin use is growing. I just don’t see it ever growing to kind of level that I’m talking about it. The economic forces are stacked against it.

AB: So with this in mind, how do you see Bitcoin being used or implemented in the future?

VL: The type of use in which it might become more mainstream is that it could be used as a sort of intermediary to facilitate international money transfers. It could be used so that say I’m in the UK and I want to buy something in America in Dollars. Instead of buying dollars, which can be expensive because of lack of competition in commercial banking and so on, what I could do is buy Bitcoin and then sell those Bitcoin for Dollars and then buy whatever good I wanted. Basically this whole process would be packaged into a service so the consumer doesn’t even see the Bitcoin, they don’t have to know that there’s Bitcoin mediating this transaction. UK and US is maybe not a very good example because its very easy to do a currency exchange and move money between these countries; but lets say Africa. Africa’s economy is growing fast and also Africa’s digital economy is growing, but yet the financial services sector there is not very developed. Most people are, don’t have a bank account, or are under banked. So moving money to some random person in Africa is very difficult for me, so Bitcoin could help me overcome this kind of problems. Partly by cutting through regulatory red tape, so it is a little unclear whether this kind of money transfer service where you move money from country to country, which is not regulated, whether then that would cause new problems like we discussed earlier, it might facilitate money laundering and so on. But it might also offer a way to rapidly offer financial services to people. But the point here is that people wouldn’t really be using Bitcoin, they would be using their local currency, they wouldn’t even see Bitcoin, it would act as an intermediary and in this use no one really holds Bitcoin so its nothing we would do our daily transactions in. Then if I trade locally, you know if I trade with you I use Pounds and I’m not going to use Bitcoin, but when I trade internatonally I could use that as a sort of intermediary. So I think this kind of use may grow.

AB: As a platform, it becomes a way of conducting business?

VL:  Yes, for specialised purposes. For facilitating difficult transactions, rather than as something we use in our day to day transactions perhaps.

AB: Bitcoin marks an interesting development in currency, and as you’ve said it does contain some impressive ideas and aspects. Will this impact existing systems?

VL: There’s obviously a lot now that we can learn from Bitcoin, that national currency systems and also, and I should say monetary systems because it’s a little bit wider concept  that just currency and other digital currencies can learn from Bitcoin. So even if Bitcoin itself doesn’t become a huge mainstream hit I’m sure it’s going to continue to enjoy a level of popularity, unfortunately especially in the shadier corners of the internet – but not only there, I don’t want to say that everyone using Bitcoin is somehow shady – but even if Bitcoin is destined to remain limited in use then it has still shown to us several things. One is the viability of a distributed crypto-currency like this, no currency has done it to this extent before. So instead of having this central ledger you have this distributed ledger. And so now another crypto-currency to fix, or at least address, some of the shortcomings in Bitcoin and become even more popular and in fact there are already many other crypto-currency projects in motion as a result so Bitcoin will not be the last. There are also some projects that aim to implement the kind of money transfer that I was just talking about, where they use Bitcoin or something like Bitcoin to facilitate cross border transfer then have these local communities use their local currencies so there are projects in motion already. Now what we could also do is learn how to improve national currency, and I think that’s not happening at least to a sufficient degree. I mean there’s a lot of financial technology innovation going on, there’s even a sort of community in London because the UK is a finance hub. So there are technologists in London and around the UK who are coming up with innovations in financial technology; but they’re not being adapted and adopted in mainstream financial industry, at least not at the pace we’re used to seeing in internet innovation. There’s all kinds of reasons for that because these are huge systems and legacy systems and they also have lots of regulations to follow and there’s good reasons for that. There’s also bad reasons  like lack of competition but some concrete learnings that we can take from Bitcoin is that Bitcoin provides a very easy for software innovators to integrate money related features into their software, so it provides a very easy API, a very easy programming interface for anyone to create software that deals with money, does things like sends money, receives money, manages account balances. So it’s a platform in the same way as you know iPhone has, Apple has created a platform with iPhone and IOS that makes it very easy for developers to reach millions of people and reach their pockets, in the sense of the phone being there but also in the sense of the wallet being in there; so iPhone ecosystem has been a huge success. In the same way Bitcoin creates a kind of platform which is very easy for programmers to use to develop software. Now if you contrast this with national monetary systems, integrating money related features into software, it’s a huge pain because you have to deal with these payment processors, companies like PayPal, we’re usually talking about American companies who take a very big cut, transaction fees are high and technology is outdated and its very bureauocratic and slow; and many features are not even available – there’s no way to query an account balance from software for example – there’s good privacy reasons for that but there’s also with today’s technology should be doable. So improving money as a platform for software innovation is something that we should learn from Bitcoin.

If you missed the first part of this series on bitcoin , find it here