November 26, 2018
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Bitcoin, the cryptocurrency invented in 2009 as a way to facilitate global commerce without a centralized repository or administrator, has recently been in the news due to its skyrocketing price. One bitcoin is now valued at over $16,000, up from just $1,000 at the beginning of 2017. We asked Assistant Professor of Economics William Luther, an expert in monetary economics, to explain bitcoin mania.
What does the general public need to know about bitcoin? Is it useful to the average person?
Bitcoin enables one to send large sums of money anywhere around the world at a relatively small cost. For many of us in the U.S., that might not seem too important. Most of our transactions are local and existing payment mechanisms do pretty well. However, there were roughly $135 billion in remittances sent from the U.S. last year. Many of those sending money to friends and family abroad at the moment rely on costly wire services like Western Union. Bitcoin offers a much cheaper alternative for these transactions.
It also offers some hope for some of the least well off. We are fortunate to have pretty good institutions in the U.S. But, all over the world, those much less fortunate than us risk having their wealth inflated away or confiscated by their government. With bitcoin, they can transfer what little wealth they’ve been able to accumulate to the U.S. or elsewhere, beyond the reach of an oppressive regime. In this way, bitcoin makes the world a little bit freer.
What is driving the current astronomical rise in the value of bitcoin, and is it sustainable?
Bitcoin is what economists call a network good. Its value depends, in large part, on how many people are in the network. For example, owning a telephone would not be very valuable if no one else owned one. At the moment, many people seem to believe bitcoin’s network will be a lot bigger than was expected just a year ago — indeed, even just a month ago. Those expectations put upward pressure on the price.
What does it mean to “mine” bitcoin?
“Mining” is a bit of a misnomer. It is better to think of it as processing a batch of transactions. As with any ledger, bitcoin’s blockchain must be updated when transactions are made. Some accounts are debited. Others are credited. Traditionally, we’ve employed a centralized clearinghouse model to update ledgers. When you swipe your debit card, your bank debits your account and credits the person you are paying.
The bitcoin ledger is updated using a distributed network. In brief, everyone running the bitcoin protocol uses cryptography to solve a complicated problem that confirms a batch of transactions as legitimate, hence the term “cryptocurrency.” Since the problem is complicated, the odds that anyone confirms any given transaction is a random probability equal to the share of computing power they are contributing to the network. That prevents one from reliably confirming their own transactions, which is sufficient to eliminate illegitimate updates to the ledger.
Of course, it is also costly to run the protocol. To induce individuals to do so, the system awards the first person to successfully add a block of transactions to the blockchain — that is, update the ledger — a new balance of bitcoin. That’s mining. You run the protocol and, with some luck, receive bitcoin that was not in circulation previously.
Should the casual investor try to get a piece of the bitcoin frenzy, or stay away?
The casual investor should have a diversified portfolio and a long-term strategy. Plan to buy and hold, rebalancing your portfolio quarterly. If bitcoin fits into your long-term strategy, buy and hold some bitcoin. If not, stay away. But don’t expect to get rich quick. Underpriced assets are much easier to identify in hindsight. Just because the price of bitcoin has shot up in the past does not mean it will do so in the future.
This interview has been edited for length and clarity.