First, let's review what Bitcoin is. The open-source software for Bitcoin was introduced in 2009, and it represents a decentralized means for transferring ownership of digital objects, along with a decentralized system for augmenting the supply of such objects. Central to how Bitcoin works is the blockchain, which consists of a record of the entire history of ownership of the digitial objects - the "coins." The ingenious part of the system (and the hardest part to understand) is how the blockchain is updated. David Andolfatto gives a nice explanation of how the thing works. Also see this paper by Berentsen and Schar. No one owns the blockchain, but it is distributed among the community of users - it's a "distributed ledger." "Miners" (which is really not an apt description of what these people do) compete to form the next block in the chain - basically their job is the counterpart of what happens in the clearing and settlement process in a centralized monetary system, such as interbank payments. For the system to work, it has to be more costly to cheat than for the correct information to be added in the new block. Thus, the system adjusts the costs of mining over time to keep up with technology. If the costs are too low, then cheating might occur - it's important to slow the clearing and settlement process down sufficiently, and the designers of the system shoot for a time lag of 10 minutes from when a transaction is posted to when it goes into the blockchain. The mining process is costly. Being a miner requires a lot of computing capacity, and one needs to burn much electricity in order to have a chance of winning the payment you receive for successfully verifying a transaction. Harnessing more computing power, finding cheap sources of electricity, and inventing faster chips (tailor-made for this purpose) implies a higher probability of a payoff, if you want to mine.
What role could Bitcoin - and other competitors such as Ethereum - play in the economy? What good could these systems do for society as a whole? The idea seems to be that such systems could provide us with an efficient means for carrying out transactions. In principle, centralized transactions - routed through the banking system and central banks - seem costly. There are large numbers of people working in these financial institutions, they occupy a lot of real estate, they require a lot of equipment and software, and they burn electricity. But, these systems work. They handle huge volumes of transactions every day, provide protection against fraud, and provide recourse when things go bad - like when the object you bought with your Visa card turns out to be something you weren't expecting. Further, we already have a decentralized means for executing transactions - paper currency. While currency doesn't permit some of the kinds of transactions we might like to make in modern societies - you can't buy stuff from Amazon with it - it is remarkably cost-effective. Proof of ownership is just a matter of physical possession, and transfer of ownership is essentially costless. I show the Starbucks cashier my cash, and hand it over. Of course, there's a centralized system in place that maintains the currency stock, assures that counterfeiting is a high-cost activity, and stabilizes the value of currency in terms of goods and services. That's called a central bank.
The monetary system we have, consisting of central banks which issue currency and run interbank payments systems, coupled with a private banking system that clears and settles transactions using debit cards, credit cards, and old-fashioned checks, evolved from earlier commodity money systems and commodity-backed paper currency systems. As a result of that transition, substantial resources were saved. Actual commodities - gold, for example - are costly to move around in large quantities, and making both small and large commodity money transactions can be awkward. Commodity-backed paper currency systems save on those costs, but the problem then - as for example under the gold standard - is that price stability can go out the window. That is, under a gold standard, the price of goods and services in term of money will be determined in part by the costs of digging gold out of the ground, the discovery of low-cost sources of gold, and the consumption value of gold. As a reminder of what that's about, consider the following chart:
It has been well-understood for a long time that, in order for money to have a predictable value in terms of goods and services, its supply has to be "elastic." The demand for means of payment fluctuates from day to day, week to week, and month to month. Why? (i) Aggregate economic activity fluctuates (even within the week - there are more people in the shopping mall on Saturday than on Monday); (ii) Wholesale payment activity can fluctuate considerably due to variation in financial market activity, and large one-time interbank transactions, for example. So, if demand is fluctuating, and we want price stability, supply needs to fluctuate in tandem with demand. Elasticity also makes the whole financial system work more efficiently. For example, the framers of the Federal Reserve Act understood that inelastic money in the post-civil war era in the US helped to create banking panics and financial instability.
Here's what's been happening to the price of Bitcoin, in dollars, lately: this one, coauthored with George Akerlof. An irrational bubble is supported by irrational behavior on the part of at least some market participants. For example, suppose there is an asset that will, with certainty, be valueless at some future date. But, people bid up the price of the asset, in the belief that there are some stupid people in the market who they can sell to before the price crashes. Sure enough, some stupid people enter the market, and they end up holding the bag when the price goes to zero, according to the irrational bubble folks. Shiller doesn't quite know what to make of Bitcoin. As far as he's concerned it could be gone tomorrow, or in a hundred years. But he seems to think it's a bubble, which isn't saying much, as Shiller sees irrational bubbles in essentially all asset markets.
Rational bubbles are all too familiar to any monetary theorist. A rational bubble occurs when an asset's value exceeds the present value of the expected future payoffs on the asset, appropriately discounted. To evaluate whether a rational bubble exists requires a model - in part to tell us what "appropriately discounted" means. Fiat money is a bubble, as it has no explicit future payoffs, yet people value it in exchange. There are other types of rational bubbles, for example the currently-observed low real interest rate on government debt can be considered a bubble phenomenon. Government debt is used in exchange, and as collateral in financial markets, so that its price exceeds the present value of its future payoffs - high prices imply low interest rates.
Is Bitcoin an irrational bubble? How would we tell? In some sense, going the irrational bubble route is a copout - we're abandoning any attempt to put structure on what is going on so we can understand it. Clearly the irrational bubble approach isn't helping Shiller - he can't tell us when the collapse will come. Could be tomorrow. Could be in 100 years.
Is Bitcoin a rational bubble phenomenon? One explanation for the appreciation in the Bitcoin price is that people are betting on Bitcoin's future as a means of payment. In the event that Bitcoin becomes widely acceptable as a means of payment, its value will be enormous - there is an upper limit on the supply of Bitcoin after all. Even if I think the probability of that happening is small, the expected value can be high, and if I buy a small quantity I'm bearing a small amount of risk for a huge expected payoff. But, the probability that Bitcoin becomes a serious means of payment looks like zero to me, as the system is fundamentally flawed. Transactions costs are too high, the price is far too volatile, and the system does not permit a large enough volume of transactions.
But, in spite of Bitcoin's price volatility, maybe people will ultimately treat it as a safe asset, like gold. Gold is an asset that people can flee to when the returns on financial assets are highly uncertain, and maybe it bears a premium above its "fundamental" value, because people coordinate on it for that purpose. I'm not sure if anyone has studied that. So, maybe Bitcoin can serve the same function? But precious metals have the virtue of having no competitors - there is only so much of the stuff. Though Bitcoin is ultimately limited in supply, the supply of potential competitors is unlimited, and we're currently seeing a flood of close substitutes for it.
So, I've run out of options for Bitcoin's future. It represents a poor payments system, and the ability to replicate it means that it can't survive as a safe store of value like gold. Advice: Don't buy that stuff, its value is going to zero - far short of a hundred years from now, I think. But does that mean this is an irrational bubble? Let's think harder. Not everyone is as certain about Bitcoin's demise as I am, and people are working with incomplete information and limited knowledge of how the world works. As with the Dot-Com "bubble" it takes a while for people to understand the market and to sort out which ventures are going to pay off. That doesn't look like the simple asset valuation models we have, but there it is.
But, we should give Bitcoin advocates a chance to defend themselves. What do they have to say? Well, Marc Bevand, who is apparently a miner, wrote a piece a couple of years ago, arguing that "Bitcoin Mining is Not Wasteful." He has five arguements, which I'll go through one-by-one:
Argument 1: Miners currently use approximately only 0.0012% of the energy consumed by the world. Most are forced to use hydroelectric power (zero carbon footprint!) because using cheap renewable energy is a necessity to win in the ultra-competitive mining industry.It's true that .0012% seems like a small number. But this is for a would-be monetary system that hasn't even got off the ground yet. Some people claim that a Bitcoin transaction currently requires 80,000 times more electricity than a Visa transaction. If that high cost is a "necessity" in this system, maybe we can do without it.
Argument 2: Even in the future, economic modeling predicts that if Bitcoin's market capitalization reaches $1 trillion, then miners will still not account for more than 0.74% of the energy consumed by the world. If Bitcoin becomes this successful, it would have probably directly or indirectly increased the world's GDP by at least 0.74%, therefore it will be worthwhile to spend 0.74% of the energy on it.Bitcoin's current market capitalization is about $180 billion. My estimate of its current contribution to world GDP: negative. There are plenty of economic activities that burn resources and contribute negatively to GDP - theft, for example.
Argument 3: Mining would be a waste if there was another more efficient way to implement a Bitcoin-like currency without proof-of-work. But current research has so far been unable to demonstrate a viable alternative.But we don't have to implement a "Bitcoin-like currency." The relevant alternative is the monetary system we have.
Argument 4: Bitcoin is already a net benefit to the economy. Venture capitalists invested more than $1 billion into at least 729 Bitcoin companies which created thousands of jobs. You may disregard the first three arguments, but the bottom line is that spending an estimated 150 megawatt in a system that so far created thousands of jobs is a valuable economic move, not a waste.Bevand either hasn't had economics, or he went to the class where they talked about Keynes, and missed the class on opportunity cost. The fact that people are spending time in activities associated with Bitcoin - designing it, trading it, mining, designing new chips, maintaining dedicated hardware, etc., is in fact a waste of resources. All those people could be doing something more productive with their time, assuming the opportunity cost of their time is not zero. To the extent we can learn something, the time spent is useful. But I think we are done with that. Time to stop.
Argument 5: The energy cost per transaction is currently declining thanks to the transaction rate increasing faster than the network's energy consumption.I'm not sure this is true, but even if it were, this isn't the right metric. If the transactions aren't accomplishing anything socially useful, all we're worried about is the total economic cost of this project - electricity, time, hardware, software, buildings - which looks to be a significant waste.
Digital currencies could indeed be useful, but current technological constraints do not seem to permit a decentralized currency system using blockchain. It's certainly likely that central banks will get into the business of offering digital means of payment, but my best guess is that those systems will be centralized.