March 1, 2021

I, Science

The science magazine of Imperial College

As the financial crisis in Europe continues, could Bitcoin be the solution to our economic woes? ...

As the financial crisis in Europe continues, could Bitcoin be the solution to our economic woes?

Before pounds and dollars, you could use solid gold in exchange for goods. There was a limited supply of gold, so its value was inflexible. When we started using the currencies we know today, their value was compared to that of gold; this was the Gold Standard.

But measuring currencies against the value of gold meant countries could not alter their own exchange rates – to make exports cheaper, for example. So, using political means, money became flexible. Fiat currencies now relied on a country’s creditworthiness, meaning centralised banks could control national economies and fund the state, by yielding power over money, exports and people. And it’s been that way ever since the start of the 20th century.

So for a currency that is still a speck on the global monetary landscape, it is amazing how Bitcoin shook things up in April 2013. The value of an individual bitcoin, which was at just over $20 in February, rose to record highs of about $250, before plummeting to below $100 on 11 April. With all this excitement, what exactly is a bitcoin?

Bitcoin is an experimental digital currency that is only available on the internet. Like gold, it is finite (supply is capped at 21 million bitcoins) and decentralised meaning that, in theory, it should be free from meddling governments.

You can generate them yourself using a piece of software called a Bitcoin Miner (building on the gold metaphor), which works to solve an algorithm; if you’re successful, it pays you 25 bitcoins. But as more algorithms are solved, and more bitcoins are mined, how is this supply ever going to stay capped? As the number of mined bitcoins increases, the algorithm becomes more difficult to solve, thus levelling out the supply. You can also get some using regular currency: exchanges such as Mt.Gox allow you to buy bitcoins from people who already have some.

What can we use them for? Well, like any regular currency, you use them to buy things. For example, Bitmit is the eBay of the Bitcoin world, while Silk Road is popular for more illicit trades. There are even some brick and mortar places that accept them, such as the Kreuzberg area of Berlin.

So why use Bitcoin instead of traditional currencies? One of the advantages is that there is no middle man handling the transactions, ultimately making them cheaper. If you want to send someone bitcoins, you just send them. Transactions should also be more secure, since when you make a transfer, an electronic signature is added. After a few minutes, the transaction is verified by a miner, and permanently stored in a public network.

But for the governments, none of this is good news; they will start losing control of money, transactions, and people. As politicians are entirely removed from the Bitcoin monetary loop, it makes the currency all the more attractive.

But Bitcoin, unlike the fiat currencies, is not legal tender for paring debts. So why do we need it? It will have been difficult to miss that we’re in a financial crisis; the banks in Cyprus froze all accounts; no one is allowed to access their cash, and if the banks in Cyprus go bust, only €100,000 is guaranteed. With the current economic climate, this could potentially happen elsewhere in Europe. So what could become the norm is for people to convert their pounds or euros into Bitcoins, and then sell them for dollars, therefore escaping a financial crisis.

So could Bitcoin be the new gold? Without banks, middlemen and fees, it looks pretty good. If Bitcoin were to take off, could it potentially re-stabilise the international financial markets?

Right now, the only people using bitcoins are the hardcore miners, those who are fascinated by the technology, and those that detest the banking systems. Will more people become involved, or is it just gold for geeks?

If the demand does go up beyond its supply, it will force up the value of each bitcoin too. This will force the price of goods down over time. Could this inevitable destructive deflation cause economic disaster? Economic disasters have been known to be associated with deflation, but so have benefits. Falling prices could encourage people to save instead of spend, and lend instead of borrow. And all the benefits listed above make it all rather attractive.

But there are still problems with this “virtual gold”. Your transactions are entirely irreversible, and uninsured. So if your bitcoins get lost in the digital ether, that’s it.

When playing the stock market, there is a technique called selling short, which enables someone to turn a stable market into a volatile one by selling a commodity before you own it. Bitcoin value can also be influenced using distributed denial-of-service (DDOS) attacks during a Bitcoin exchange. This is when a server that is receiving bitcoins is flooded with more junk-data than it can handle. The server is then not able to distinguish between the good data (your bitcoins) and the bad, junk data. Someone else can then come in, hack the system, and steal your bitcoins right from under your nose.

The changing value of any fiat currency, including digital ones, is speculative, and subjective. Even the price of gold, which (in theory) is in finite supply, could change overnight if a giant comet, made entirely of gold, came floating by.

But how much value would you put on a bunch of numbers that only exist where you can’t really see them? The only thing giving these bitcoins any value is people believing that they have value, which is exactly the same for fiat currencies. So in reality, all currencies have value because people have faith in them. In other words, people have faith in the government that they won’t keep printing dollars so that they become worthless. And sure, the same is true for gold, but with gold, you can make jewellery, which has its uses.

So should we all start mining and buying bitcoins? As it’s still an experiment for those who understand the Bitcoin system, I would only put in what you can afford to lose. If only the investors would follow this advice with fiat currencies!


IMAGE: Zach Copley