In the past decade, it has been hard to avoid talk of Bitcoin online, particularly in libertarian circles. But for many, it is still a somewhat confusing and esoteric topic. So, what is this piece of software, and why have advocates of liberty been so enthusiastic about it?

Bitcoin is a peer‐​to‐​peer electronic payments system and the first cryptocurrency—that is, a digital medium of exchange that relies on cryptography. Invented in 2008 and launched in early 2009, Bitcoin uses complex mathematics and decentralized verification to enable digital transactions without an intermediary. While hundreds of cryptocurrencies have followed in its wake, Bitcoin remains the most valuable, with a market capitalization of $294 billion (64.9 percent of the market capitalization of all cryptocurrencies) as of mid‐​November 2020.

Bitcoin, a privately issued medium of exchange, is a libertarian answer to a problem many libertarians care deeply about: the abuse and seizure of private property by the state. History is replete with examples of governments that exploited their monopoly privileges to debase the currency at the public’s expense. There have also been many, albeit less systematic, instances of private schemes to deceive people into handing over control of their funds. These public and private abuses cause a great deal of damage, both to their direct victims and to the general public, whose trust in financial institutions is undermined.

In a bid to tie the hands of these institutions, societies have over time evolved many arrangements, from the competitive provision of banknotes to their redeemability in gold and, more recently, the creation of explicit rules for central bank operations. But Satoshi Nakamoto, the pseudonymous inventor of Bitcoin, attempted something altogether more radical. Worried that reliance on third parties increased transactions costs and impeded “non‐​reversible payments for non‐​reversible services” on the Internet, Nakamoto proposed “a peer‐​to‐​peer electronic cash system … allowing any willing parties to transact directly with each other,” without intermediaries.

Before Bitcoin, attempts to bring peer‐​to‐​peer payments to Internet commerce had foundered on the “double spending problem.” This is the challenge of preventing users from spending the same funds more than once. Solutions had inevitably involved an intermediary payments processor, such as PayPal, charged with ensuring that buyers had the money to pay sellers and that sellers delivered as agreed, all in exchange for a fee. By combining cryptography and blockchain technology—whereby all past transactions are listed in a public ledger and consensus is required to add new ones—Bitcoin overcame the double spending problem for the first time, allowing users to protect their funds from theft while encouraging other users to verify transactions in exchange for a fee.

As if to affirm Bitcoin’s libertarian bona fides, in 1999 Milton Friedman—the free‐​market economist and Nobel Laureate—predicted something very much like it. “I think that the Internet is going to be one of the major forces for reducing the role of government,” Friedman said. He went on:

The one thing that’s missing, but that will soon be developed, is a reliable e‐​cash: a method whereby, on the Internet, you can transfer funds from A to B without A knowing B or B knowing A, the way in which I can take a $20 bill and hand it over to you and there’s no record of where it came from.

Bitcoin was the first such viable “e‐​cash.” But despite its promoters’ best hopes, Bitcoin has not yet achieved the status of money, as it is not a “generally accepted medium of exchange.” Because the willingness of any person to use something as money depends on other people’s inclination to accept it, Bitcoin—a startup challenger to established exchange media like the U.S. dollar—faces long odds in that quest. To date, only fringe jurisdictions such as Venezuela, where the domestic currency has become worthless thanks to relentless government‐​induced inflation, have seen limited adoption of Bitcoin as a shield against the erosion of savings and a means to circumvent capital controls.

But while Bitcoin has so far had little impact as a direct competitor to major fiat monies like the dollar and the euro, its influence on payments innovation is hard to overstate. Bitcoin has spawned thousands of other cryptocurrencies that rely on similar software to make transactions possible without a middleman. Perhaps the most famous—and the second-most-valuable—such derivative cryptocurrency is Ethereum, which its creator Vitalik Buterin has described as “a world computer” where “anyone can upload and run programs that are guaranteed to be executed exactly as written on a highly robust and decentralized consensus network consisting of thousands of computers around the world.”

Further afield, Bitcoin has awakened private companies and governments to new opportunities for innovation in electronic payments. Multinational firms ranging from Facebook (and its Libra Association partners) to JP Morgan have developed their own proprietary private currencies, while several leading central banks are exploring digital versions of the paper notes they have issued for decades. Unlike Bitcoin, these private and central bank digital currencies would not be peer‐​to‐​peer but issued by an intermediary. Yet they would be unlikely to exist even as prototypes without the intellectual and entrepreneurial impetus that Bitcoin provided.

Removing the previously indispensable trusted third party is Bitcoin’s main innovation, but also the chief barrier to its growth. Running a payments network without an intermediary is expensive: in Bitcoin’s case, users spend copious amounts of electricity solving hard math problems as a way to verify transactions, which they add to a long chain of transaction blocks on the public Bitcoin ledger (or blockchain). This system increases the cost of attempting to defraud the network, but it also makes Bitcoin transactions slower and costlier to process compared with intermediated networks such as Visa and PayPal. Even as a replacement to highly imperfect central bank money, Bitcoin has shortcomings, as the pre‐​programmed and fixed supply of bitcoins—intended to protect against their future depreciation—would make it ill‐​suited to deliver macroeconomic stability were it ever to gain general acceptance.

The high cost and limited discretion of running all transactions on the Bitcoin ledger means that, even in a world where Bitcoin‐​denominated contracts became the norm and Bitcoin the most popular medium of exchange, intermediaries such as commercial banks and private payment networks would continue to play a role. They might, for example, process thousands of transactions daily but only settle the day’s final balance on the Bitcoin blockchain. This would take advantage of the blockchain’s permanent, immutable nature, while also reducing the cost of using it. And while many fans of Bitcoin dislike the idea of relying on intermediaries, even they have attempted to come up with ways to reduce congestion on the Bitcoin network so it can come closer in processing speed to established networks such as Visa. Currently, Bitcoin puts through just seven transactions per second, compared with Visa’s 24,000.

Intermediaries could also make Bitcoin a more macro‐​economically desirable money by issuing bitcoin‐​denominated units and automatically altering their quantity in response to demand and speed of circulation (which monetary economists call velocity). This is how commercial banks in countries such as Canada and Scotland maintained monetary and financial stability at the time of the gold standard. Their gold reserves were fixed, but the banknotes they issued—while still ultimately redeemable in gold—varied with demand and velocity. Neither Canada nor Scotland had a central bank at that time, yet they achieved better macroeconomic outcomes than England and the United States, which did have central banks. By helping Bitcoin to gain general acceptance while also dispensing with the need for government monopoly in the form of a central bank, this intermediated solution should please libertarian fans of Bitcoin.

Whether Bitcoin will ever come to replace fiat monies remains uncertain, if not highly unlikely. Yet, even if its sole effect is to discourage governments from wreaking havoc on their countries’ monetary and financial systems for short‐​term political gain, Bitcoin’s invention will have been worthwhile. The most deleterious abuses have happened when governments (or dominant private firms) found themselves in unassailable monopoly positions. Keeping them on their toes by creating viable competitors such as Bitcoin is therefore essential.

Diego Zuluaga
Originally published