What's wrong with Bitcoin?

In the past several weeks, the world watched as what looked like a bubble in Bitcoin inflated past $50, $100 and even $200 before plunging back down. In the wake of it all, lots of questions have arisen surrounding the virtual currency, and disagreement is widespread among economists and traders alike.

Paul Krugman, a Nobel Prize-winning economist and an editorialist for The New York Times, has been critical of Bitcoin for at least the past several years. “My first reaction to Bitcoin was to say, what’s new,” Krugman joked on his blog in September of 2011. “We have lots of ways of making payments electronically.” Aside from caricaturing the virtual currency, Krugman has also argued that it would suffer from the same problems as a traditional gold standard. “Bitcoin has created its own private gold standard world,” he wrote in the same post, “in which the money supply is fixed rather than subject to increase via the printing press.” More recently, however, Krugman leveled a new charge against Bitcoin. “One thing I haven’t seen emphasized,” he said on his blog last week, “is the extent to which the whole concept of having to ‘mine’ Bitcoins by expending real resources amounts to a drastic regression.”

Bitcoins are “mined” by a network of powerful computers that use complex algorithms to solve a series of complicated equations. “The idea,” writes Bloomberg’s Mark Gimein, “is to keep the supply of Bitcoins from multiplying too quickly. Bitcoin mining, like mining of precious metals, is supposed to be arduous. By design, the more miners there are, the more processing power is required to mint new coins.” In one 24-hour period last week, Bitcoin miners used $147,000 of energy, enough to power half a Large Hadron Collider, just to run their computers.

Krugman and Gimein feel not only that this process is wasteful, but also that it recapitulates the follies of the gold standard. Gold mining is a blunder in which “basically useless ore is mined and refined at great cost, then sent to sit idle in the basements of central banks,” Krugman wrote in August 2011. “One of the strangest aspects of the Bitcoin frenzy is that the Bitcoin economy replicates some of the most archaic features of the gold standard,” agrees Gimein. “Real-world mining of precious metals for currency was a resource-hungry and value-destroying process. Bitcoin mining is too.”

At first, this resource-based case against Bitcoin (and precious metals) seems convincing. It is true, after all, that both require us to use resources that could have been directed to other wants, needs and goods. Upon further inspection, however, the Krugman-Gimein case against Bitcoin begins to fall apart.

First of all, costs of production are not unique to Bitcoin. A paper money system—like a virtual currency system, a precious metals system, or any other thing that we as human beings create—requires an input of time, labor and raw materials before it can come into existence. In fact, our paper money system costs us $848 million in 2008 alone, or $2,323,288 a day. That’s more than 10 times that of Bitcoin’s daily energy costs for mining, and that’s not even taking into account the environmental costs of the physical waste generated in producing paper money. (Indeed, an even more nuanced point, put forward by Tyler Watts and Lukas Snyder of Ball State University, uses historical evidence to point out that fiat money volatility has driven gold investment on par with the monetary gold production of the gold standard years, suggesting that a switch to a fiat money system does little to undermine the resource cost of gold mining anyway. I suspect that, in the future, the same may be true of Bitcoin.) It would still be valid, of course, to argue that the high cost of a paper money system is justified because it is somehow preferable to a hard or virtual currency, but that would be a different point. So for a supporter of paper money to criticize Bitcoin simply because it costs us something to produce has to be seen, then, as at least a little bit unfair.

(As a brief aside, Bitcoin is also criticized as an avenue for shady transactions. “The main use of Bitcoin so far,” Krugman testifies, “has been for online versions of those dark-alley exchanges, with Bitcoins traded for narcotics and other illegal items.” But unless drug dealers have started taking checks and credit cards, this, again, is equally true of paper money.)

“It’s very peculiar,” added Krugman in a recent editorial, poking fun at the fact that libertarians, who tend to oppose state manipulation of the paper money supply, also tend to support Bitcoin and other alternative currencies. “Bitcoins are in a sense the ultimate fiat currency,” the Nobel laureate in economics continued, “Bitcoins derive their value … from a self-fulfilling prophecy, the belief that other people will accept them as payment.” All currencies, of course, are mental constructs, abstract models that we use to facilitate exchange and overcome the incongruity of our immediate individual desires; that can be no criticism of Bitcoin or paper money. But what Krugman is overlooking is that Bitcoin and gold, abstract though their values might be, are not subject to the supply and interest rate manipulation that libertarians tend to oppose in the same ways that unbacked paper euros and dollar bills are. It is the artificial suppression of the interest rate, some free market economists and libertarians argue, that promotes economic recessions by leading entrepreneurs to embark on more long-term projects than we have resources to complete, and I suspect they would argue that this misallocation of resources is far more costly to society than the $147,000 it costs us to mine Bitcoins for a day.