Like many, I see great value in the de-centralized blockchain protocol that enables the trusted transfer of a digital token. (Briefly: since the token can represent the ownership rights to just about anything in the digital world, or for that matter, in the physical world, the blockchain technology can make transactions much lighter weight and much cheaper, creating potentially enormous economic value.)

However, I do not share that optimism about the fate of Bitcoin as a global currency; in fact, I argue in this post that Bitcoin represents the Achilles heel of blockchain technology.

Of course, the reason why Bitcoins and blockchains are so tightly coupled together is that the blockchain protocol needs incentives for all those decentralized computers busily engaged in the reliable transfer of trust. And the current solution is to get this task done as a side-effect of the distributed systems trying to “mine” Bitcoins. In other words, the mining of Bitcoins incentivizes the distributed computing needed to implement any blockchain’s trusted ledger of transactions.

But unlike the obvious value in decentralized blockchain transactions, I think there are fundamental economic problems with the very notion of a currency that is not supported by a central bank of some kind.

To see why, consider the following analogy to build up some intuition.

Circulating blood is the medium of exchange of energy in our bodies, just like circulating currency (whether digital or physical) is the medium of exchange of goods and services in an economy. As the body grows larger, the amount of total blood needed to fulfill its exchange-of-energy role is proportional to the body size. If there is too little blood, the energy exchange will be deficient; we need to transfuse blood in extreme cases of blood loss. By analogy, as the global GDP level grows, as it does every year, the amount of currency in circulation must also rise, roughly in proportion!

The Bitcoin algorithm, however, has no relation to the level or growth of the global GDP. This may well prove to be a significant fatal flaw in its design.

To further deepen intuition, I recommend the brilliant essay Paul Krugman wrote for Slate magazine way back when he was a professor at MIT. In it, he explains the irreplaceable role played by the central bank in maintaining a stable currency — one that is neither inflationary not deflationary —  using an insightful baby-sitting analogy based on a real world case study. I suggest pausing here to read that brief (one-page) essay, mentally replacing Bitcoins for the baby-sitting scrips in his example: “Baby-Sitting the Economy.”

A strong implication of thecurrency experiment described in that essay is that any form of currency —  including Bitcoin  — just cannot become a stable, mainstream currency without a central bank function that acts to stabilizes their value from time to time, and keeps the circulating base of currency proportional to the size of the economy. One could, perhaps, imagine an algorthmic replacement for a human central banker —  say a Taylor-type rule —  implemented in a decentralized manner, although it would still be a central policy decision, in essence, since it needs to control the aggregate amount of the currency in circulation. However, all that is besides the point since the current algorithm behind Bitcoins is completely decoupled from the size of the economy, since there are going to be exactly 21 millions Bitcoins, a fixed parameter in its very design. This is a major problem that I think will prevent Bitcoins from becoming a global currency of any major standing (as envisioned by its enthusiasts).

Perhaps, however, it can survive as a limited sort of transient exchange medium, its value always secured at both ends by currencies that are stably backed by central banking. Indeed, this is exactly how it seems to be working these days. But I am dubious of the long term fate of this as well, since the point about the need to be proportional to the size of the economic “body” still stands, even for transient exchanges; after all, the number of simultaneous exchanges will surely rise in line with the growth of the global economy, thus raising the need for more Bitcoins in circulation.

More importantly, if all Bitcoins do is transmit money, then their role as a store of value becomes problematical. Every succesful currency must perform both functions (store of value and medium of exchange) simultaneously. If all Bitcoins do is transmit money, then Warren Buffett has this to say about its ability to hold any intrinsic value:

“It’s a method of transmitting money. It’s a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money, too. Are checks worth a whole lot of money just because they can transmit money? Are money orders? You can transmit money by money orders. People do it. I hope bitcoin becomes a better way of doing it, but you can replicate it a bunch of different ways and it will be. The idea that it has some huge intrinsic value is just a joke in my view.” — Buffett quoted by CNBC.

In response to this, Marc Andreessen, the venture capitalist behind many Bitcoin related investments has tweeted:

“Warren has gone out of his way for decades to avoid understanding new technology. Not a surprising result.”

Much as I admire Andreessen, I think this completely misses Buffett’s point, which is not about technology at all. Buffett understands moats, and he is saying that there is no moat in any technology in the role of a transmitter of money. As he says, there have been many technologies to transmit money in the past but that this carrier function has never managed to have much value, primarily due to competition. (Incidentally, Buffett is a student of business moats and has written in the past about the lack of moats in many innovative technological breakthroughs — airplanes, and cars being two examples that immediately jump to mind.)

Buffett’s point about money transmitters not being moated implies that the motivation of miners will be surely affected if the value of what they are mining is subject to competitive erosion over time. Note that Buffett is carefully not saying anything about the value of the blockchain protocol itself. Most articles on Bitcoin end up laying out the future possibilities of blockchains, rather than Bitcoins. I actually agree that the blockchain protocol has great potential; but I find the conceptual foundation behind Bitcoin not quite up to the task.

At least for now the two are tightly joined at the hip, and that is a bug, not a feature, in my opinion!

My argument so far is about the long-term issues with Bitcoins. But even over the short term, the recent plunge in Bitcoin prices is troublesome — in fact, it is now worse than the notable crash of both the ruble and oil prices:

This matters, since it will affect the motivation of Bitcoin miners. As explained in NYT’s DealBook blog:

Bitcoin miners are computers that run Bitcoin’s open-source program and perform complex algorithms. If they find the solution before other miners, they are rewarded with a block of 25 Bitcoins — essentially “unearthing” new Bitcoins from the digital currency’s decentralized network. Such mining operations, though potentially lucrative, are also expensive, requiring huge amounts of equipment and electricity.

It is vital for the integrity of blockchain protocol that Bitcoin miners continue to mine, since blockchain maintenance is a side-effect of Bitcoin mining! Any plunge in the motivation level, and hence the capital investment level, of Bitcoin miners clearly slows things down. If I am right about this (I am not a professional economist), the conceptual deficiency behind Bitcoin could really undermine the long-term prospects of blockchains.

The key question: Can the blockchain protocol be decoupled from Bitcoins in some way?

If only there was some other way to incentivize all those miners performing the distributed computations needed to maintain the integrity of blockchains …

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Disclosure: I have no Bitcoin related investments at the time this post was written.