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Hi, I'm Adam, I wrote this answer on Quora. Against my better judgement, I'm going to wade in here and make a couple of clarifying points.

1 - Scam. I regret using the word "scam" in my answer, because I think it overshadows the broader point I was making about Bitcoin's severe structural design flaws. After watching the community react to this debate, I'm pretty confident that the average bitcoin supporter is not intentionally defrauding people. Consider my inflammatory rhetoric redacted and apologized for.

2 - Volatility. Since April 1, the average change (up or down) of the bitcoin/dollar exchange rate has been just under 8%. That's unprecedented. It's a clean order of magnitude more volatile than the stock market, which is considered a "volatile", "risky" class of asset. It's two orders of magnitude more volatile than a legitimate currency pair like the Dollar/Euro. Now, it's all fun and games while the exchange rate is basically trending up, but if that trend reverses look out below.

3 - Liquidity. All of that volatility comes on an average bitcoin volume of something like 20,000 per day. If I put in an order for $15,000 worth of Bitcoin right now, I'm pretty sure I could move the market between 5% and 10% to the upside. It's probably even worse to the downside. Call me a skeptic, but with that kind of easy price manipulation, I'm not quite ready to denominate my paycheck in Bitcoins quite yet.

4 - What It Means. A number of people criticized me for not understanding that Bitcoin is designed to be complementary to traditional currencies, and that analyzing it as an alternative is invalid. A number of different people criticized me for not understanding that Bitcoin is a different kind of currency, which will inevitably replace traditional fiat money, and that analyzing it as a component of the fiat currency system is invalid.

The Bitcoin community is diverse, and no one really knows what this is supposed to be yet. That's totally fine with me. I can assure you I don't have any skin in this game. My money is in LinkedIn stock.* But I've studied world currencies extensively (and trust me, a normal currency debate is not this lively). So, I don't know what Bitcoin will end up as, but I know two things with certainty:

a) that it's unstable as a currency

b) that it's currently behaving as a speculative vehicle in an aggressive bubble

* That was a joke

If you follow the Bitcoin forums carefully, it's actually not at all clear they aren't trying to defraud people. The behavioral patterns are very similar to a pump-and-dump scheme: many people have a large number of coins (usually acquired at a low price through early mining) and are aggressively and inaccurately promoting Bitcoins to people whose money they will be taking. Bitcoin as a technology has the potential in concept to be more than a scam, but the way it is being used appears, for all practical purposes, to be indistinguishable from a scam. Like Groupon, it gives people the appearance of a vested interest and turns them into marketers.

Even if not a scam, your conclusion that it's currently entirely speculative is inescapable.

I'm not sure you can start a new currency from scratch, and succeed, without extreme volatility. If it increased in value by a steady five percent a year it'd still be worthless in twenty years. The low volume is a function of it being new, not of it being a bad idea.

Aside from that, I thought this was an excellent rebuttal: http://www.reddit.com/r/NonAustrianEconomics/comments/hputj/...

Hi Adam, I'm Carl Lumma. I usually upvote your posts on Quora but I didn't upvote this one because of "scam" and also because you gave more reasons than necessary. "Built-in deflation" is alone the reason bitcoin cannot work as a currency (at least, not without a prevailing currency to act as a 'heat sink'). This can be remedied of course by the practice of holding bitcoins on deposit in exchange for demand receipts, which can then be printed and sold without restricting the withdrawal of deposits. And I suspect that, with continued popularity, institutions will start doing this.

Why is built-in deflation necessarily a problem?

If the real economy continues to generate investment opportunities, wouldn't the deflation rate just supplement that? Sure, you could put money in your mattress for 5%, but if you can invest for a nominal 10% and thus yield a real 15%, why would you choose the mattress?

If this is an average loan, all 15% of its real return must be captured by deflation since the money supply cannot increase 10%.

But then the mattress rate is also 15%.

Of course some loans are better than average, and some are worse. The "deflationary spiral" takes out the worse ones first. That lowers the average and takes out the next tier, until the average is zero. Actually it goes below zero, to the average rate of real depreciation (e.g. termite damage to houses). Well, that's the bottom equilibrium anyway.

And also what is the difference between this scenario and a scenario where you can get a saving account that has a higher rate than inflation ?

Fair enough.

Thanks for posting here and on Quora. As someone with an economics background, it's nice to hear a sane explanation based on fundamental theory.

I'm just surprised people aren't considering Bitcoins from a supply-demand standpoint. Why purchase Bitcoins in the long run unless you're laundering money or hiding from the government?

Some people think wikileaks is a good idea. Paypal and other processors have blocked donations to wikileaks, even though it's legal to donate to them.

Some people like to play poker online. The same entities have been prohibited by the government from processing transfers to poker sites.

From a startup perspective, the "terms of service" for Paypal, Amazon payments, and others are full of applications you can't use them for, even though many of them are legal. On top of that, Paypal is notorious for locking accounts if they decide they don't like you.

Currency used to be neutral. Now it's not. So people have invented a new one that is.

It's extremely difficult and expensive to transfer money from one country to another.

I live in Europe and you can transfer EUR money from one country to another for free; that's progress. But from the UK (in the EU but doesn't use the EUR currency) my bank only allows me to transfer £5k (US$8k) per day to other European countries, and each time I do it they charge me £25 for the privilege (US$40). I had a tax bill recently in Austria (where I live) due to assets held in the UK, I owed £20k. (I have no problem with having to pay the tax.) That took 4 long phone calls over consecutive (business) days to transfer that money, and cost me £100 in total. Imagine if my assets in the UK, and thus my tax owed in Austria, had been 10x as large, or 100x as large.

I have no interest in dealing drugs or hiding income from the taxman. But using banks make things incredibly difficult, and charge huge fees for their trouble. It's time banks got "disrupted".

I would think that those limits would be mandated by government and only implemented by the banks. There are various limits about trasnferring in excess of $10,000 of cash across national boundaries, and also to/from cash.

AFAIK the limits are imposed by government, but the fees are totally up to banks.

> Why purchase Bitcoins in the long run unless you're laundering money or hiding from the government?

That's kind of odd to say-- couldn't you say the same thing about doing cash-only transactions?

There's also the hope that you can "hide" from corporations/bad-people and make transactions that don't require you to provide information that can be used for identity theft, marketing, etc. Just typing in a unique 1-time deposit number has a lot of appeal for stream-lining transactions and making people feel more comfortable performing electronic purchases. I'd love people to get addicted to that kind of high-privacy transaction and push more innovation for traditional currencies/startups to help with that.

In the modern world, every purchase of anything not bought at a yard sale is a privacy and identity concern-- I'm eager to see alternatives that find new ways to avoid that.

That's kind of odd to say-- couldn't you say the same thing about doing cash-only transactions?

Yeah, I added that modifier after thinking some more. People are really interested in bitcoins as a "private" currency, and cash would accomplish the same thing. Large cash transactions raise flags, though.

Still, bitcoins are a bad alternative to popular currency for a number of reasons Adam mentions. An e-currency without a finite supply would be an interesting exercise.

Money supply need not be infinite. Prices will adjust as demand for the unit arises. Essentially, you are doing the same as "creating" more units, without eroding peoples real savings.

The entire system could thrive on one bitcoin.

Money supply needs to be a flow, instead of a stock, so that it can adapt efficiently to supply and demand and change with population and economic output.

The entire system could thrive on one bitcoin.

No, it couldn't. One bitcoin could not sustain a currency market, and a one-bitcoin market would value that bitcoin at highly variable prices.

But you can have half of a bitcoin. In fact, they're divisible to 8 decimal places—so, in reality, when you have "1 bitcoin", you actually have ~10 million atomic units of tradable currency. It just comes "pre-redenominated," because it currently lacks value, and may be redenominated downward (making the unit "bitcents" or somesuch) as the exchange rate increases.

1 Bitcoin can be divided into .00000001-sized pieces and traded separately. You couldn't run out if you wanted.

To answer your question, it would be nice to be able to buy and sell things online without a central authority like PayPal.

Tyler Cowen argued this quite lucidly at http://marginalrevolution.com/marginalrevolution/2011/04/jer... .

I second the comment about the explanation. It was the best explanation of Bitcoins I've seen (even if it's trying to show that's it's flawed.)

Frankly, because other currencies are devaluing so Bitcoin is acting as a store of wealth. Over the next 50 years, USD isn't going up unless there is a short-term panic.

I bought $30 of Bitcoin just a month or so ago. Obviously they've done very well so far and I'll just leave them indefinitely to see where it goes. Yup, that increases deflation. Nice, for a change!

I don't necessarily disagree with your points nor think that Bitcoin will ever be much of a monetary force but most of your arguments simply have to do with Bitcoin being new. If everything was required to surmount your hurdles from the outset we'd never get anywhere.

I don't know why, but I'm suddenly remembering 1637, the Netherlands and some exotic tulip. Don't get me wrong, I think this is a wonderful technological breakthrough! But unless the flaws pointed out by the author are remedied, this will end in tears. Of course with bitcoins being the phenomenon they are right now, I don't expect many to agree with me :D

I think everyone is missing the biggest factors here - faith and integration. The way something becomes currency, is that people believe it will still have value in the future, and it becomes widely accepted for goods and services. These are, by far, the two largest factors that could drive even a digital currency into use, by themselves. This is why Bitcoin is so risky - nobody knows if the general public (albeit the entire public) will eventually accept Bitcoins for their product. I'm pretty sure that if certain companies had not started accepting them as valid currency, the Bitcoin would already be worthless. But because companies, which are large groups of people, believed enough that the Bitcoin would be worth something between the time that it was received for a product and then spent again, Bitcoins survived and even increased in value. Since there is no way to know if people will want to use these other than to throw currency to the wall and see what sticks, it is extremely risky. I would NOT recommend anyone pay for Bitcoins with an already-tested currency such as cash or credit. If you are, however, interested in acquiring a few of these Bitcoins, try getting free ones for online services, such as "mining", completing surveys, answering captcha's, etc.

Regarding your third point, the order book for the most popular Bitcoin exchange (Mt. Gox) is available [1]. Looking at the data, it seems there's actually quite a bit of liquidity bidding 7-10 USD and asking 10-13 USD per Bitcoin. It's only about 10,000 or 20,000 Bitcoin of depth on each side, so you can estimate the impact of buying or selling 15,000 USD worth of Bitcoin on the market. Of course, it might move less if you 1) consider using a dark pool of liquidity for a "large" trade, 2) add one or more limit orders to the order book (instead of using market orders), and 3) consider the fact that the order book gets "replenished" as trades come in.

[1] http://mtgox.com/code/data/getDepth.php

Unfortunately, Mt. Gox faces no regulation, so their data should be treated like the data from an offshore online poker company (many of which scammed users in underhanded ways even when they stood to gain significantly from their legitimate transaction fees). There would be almost no indication to the public until it were too late if Mt. Gox were actually directly a Ponzi scheme, even if the rest of the Bitcoin system were honest (which it is not).

I'd also be afraid of having my assets frozen if I transferred money to and from Mt. Gox or the other exchanges. To use Britcoin, for example, you need to send and receive money from an individual developer -- that is, from his individual account. There's not necessarily protection for his transferees if it turns out that he, willingly or not, was engaging in money laundering.

One additional thing that bothers me about the Bitcoin "community" at present is that they are engaged in an active and deceptive attempt to sanitize their public image. For example, in a Gawker story about drugs, Jeff Garzik, a core developer, inaccurately commented that Bitcoin could not be used to purchase anything anonymously. He surely knows that it wouldn't be difficult to do so; he appears simply to have been underplaying a regulatory risk that the currency faces in order to get part of the public on his side.

Bitcoin == marketing. It has very good marketing on its side, even if the marketing is in some sense "open source" and communal. In that sense, it's very interesting sociologically. But it's, at core, a deception in practice.

Thanks so very much for the clarification and the tempering of your response-- that "scam" wording was the only thing that gave me hesitation on whether you were objectively reviewing it from an economic standpoint. I'm pretty sure there are a lot of idealists behind it, but I haven't (yet) seen anyone excited about the currency that wanted to defraud anyone.

Bitcoins are quite likely a mistaken long-term investment, but it doesn't seem like its proponents are trying to trick anyone about the core ideas.

I'm just hopeful that it encourages more creativity in the space of private online transactions, digital currency advances, etc.

There is a currency that has been created in an attempt to have a vehicle currency that is not tied to any one currency. With the US dollar being the vehicle currency of today it ties the US economy with the global economies must to tightly. It's finding a floating exchange rate that isn't closely tired to any one currency. As seen after Bretton-Woods global economies ties to one currency is not optimal. Creating this new currency is the hard part.

What's the difference between the Bitcoin Concept if you leave out the computer algorithm solution to inflation and the unregulated exchanges that buy and sell their own created stock in privately held company's like Twitter and Facebook that has boomed in the last year or so? This will help me understand some of the concepts with this whole e-fiat money. Thanks.

I think that all we should do is wait and see. This is all very interesting and unpredictable. It is at least a good experiment. If you are going put money into the system, well it is at your own risk. Nobody who does not sign up is at any risk.

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