The Economic and Political Weekly has published my article on Bitcoin (free access for a limited time). This is an introductory piece about the technology and economics of Bitcoin. Read it first if you are new the phenomenon.
I feel a little bit of personal vindication from the continued existence of Bitcoin. My Ph.D. thesis was on the foundations of monetary economicts. I had tried to argue that there is nothing illogical in a medium of exchange that did not enter into consumption or production but which still did have a value in exchange due to the inertia of expectations.
A major criticism I received was for leaving out the role of the State in my analysis. After all all intrinsically valueless currencies we know of are backed by the some State. So how are we to know that the value of these currencies is not ultimately due to this backing by the State? At that time I could do no better than give the Laplacian reply of “I had no need of that hypothesis”. Since then Bitcoin and other cryptocurrencies have demonstrated that it is not impossible for an useless asset which is not backed by a State or any other entity to continue to have a positive value.
Of course, cryptocurrencies are still very far from being good substitutes for traditional currencies so the question of the fundamental nature of money remains open. But now we know that the State need not necessarily be part of the answer.
Stepping back I think that many people—including many professional economists—are very averse to accepting that macroeconomic phenomena such as the value of money or the rate of economic growth are a result of self-fulfilling prophecies. Money has a value because people expect it to have a value. Growth is high when people expect the economy to do well. Growth is low when people expect the economy to do badly. The opposition to such explanations comes in part from a justified sense of scientific prudence: since expectations are not directly observable explanations of phenomena in terms of expectations seem to be unfalsifiable. But this need not necessarily be the case. While there may be many states of the world consistent with self-fulfilling expectations, it may not necessarily be the case that the economic system can flip arbitrarily from one to another. To the extent that change in expectations is a definite psychological and social phenomena, it should be possible to give a falsifiable account of the dynamics of expectations (to the extent that any explanation is falsifiable). Bitcoin, by showing the futility of trying to pin down money to material aspects of the state of the world, forces us to take the task of understanding expectational dynamics seriously.
Bitcoin also appeals to the cypherpunk in me. One of my favourite novels is Neal Stephenson’s Cryptonomicon. There are two timelines in the novel. The historical one is about the birth of modern computing and cryptography during the Second World War. The contemporary one is about a group of digital entrepreneurs trying to set up a data haven whose ostensible use is to support digital currencies and electronic banking but whose hidden goal is to disseminate a resistance manual for people facing genocide. The horrors of WW-II in one storyline give meaning to the hackers’ quest in the other.
At the time when Cryptonomicon was written the problem of a purely digital currency was still not completely solved since all proposals known then required a central authority which had to be trusted by all participants. Bitcoin has finally solved that problem and given us an form of electronic cash that is truly decentralized. And like Stephenson’s characters we can hope that a technology for easier commerce will also create the means for citizens to carve out new private spaces away from the surveillance and tyranny of states.