The Economist: The Bitcoin phenomenon

 When I wrote my Ph.D. dissertation back in 1979, my research topic was the money demand function and the effect financial innovations had as a result. I unearthed my copy this morning — all 391 pages — to remind myself what I’d learned.

Money, in case you’ve forgotten your macroeconomics, serves three functions:

         •  A medium of exchange

         •  A store of value

         •  A unit of account

In the late 1970s, people were using a lot less “money” – cash and checks – than the traditional demand function predicted. My thesis was that this was thanks to innovations like credit cards, sweep accounts, overdraft protection, debit cards and corporate cash management practices. Now it’s hard to imagine life without all of these conveniences. I don’t even carry a checkbook anymore and seldom pay for anything with cash. I want those airline miles! But in the mid-’70s there were only a few thousand ATMs in the U.S. and “charge cards” were used primarily to put gas in your car.

In the last few years, another advance has exploded on the financial scene. Bitcoin, which allows people to make anonymous electronic payments without having to reveal their identities, account information or pay fees, was introduced in 2008 and has since spread rapidly. Created by an anonymous programmer called Satoshi Nakamoto, the coins, or digital tokens, are “mined” – generated by cryptographic algorithms at an unalterable rate – and maintained by a decentralized peer-to-peer network of computers that records every transaction in the history of the currency. The owners of these computers are rewarded with an occasional payment of new Bitcoins. There are 12 million Bitcoins today, and the total number can never exceed 21 million.

This is merely the most prominent of new virtual currencies moving toward mainstream adoption. There is Litecoin, Namecoin, Ripple and Liberty Reserve and hundreds more crypto-currencies out there. The Channel island of Alderney, a British crown dependency, is considering becoming the first jurisdiction to mint a physical Bitcoin, hoping to expand its international appeal beyond online gaming. JP Morgan Chase has filed a patent application for a proprietary computerized payment system that is remarkably similar. 

There is, however, rising concern that Bitcoin supports illicit activities. Last July, Thailand became the first country to ban Bitcoin. The Chinese market, which accounts for about one-third of Bitcoin transactions, has banned its financial institutions from handling the virtual currency, although it still allows individuals to buy and sell it. Our Federal Reserve has been a bit more positive, arguing that it may be useful, if illegal usage can be prevented.

Bitcoin is also used more for speculative purposes. If you had good timing in 2013, it was an outstanding investment. The price soared more than 100-fold, from $12 to more than $1,200 per unit last year. But it also fell 11 percent the day China announced its ban. Because there is such a small amount in circulation, the price can be easily manipulated by speculators. Critics warn of the danger of a risky bubble and note that if it bursts, Bitcoins aren’t backed by anything.

Still, every day it becomes more evident that the Bitcoin boom is here to stay. Me, I’m going to keep my retirement funds in nice, safe annuities.