If you believe Bitcoin has the potential to replace traditional global financial systems, a new economic analysis is here to rain on your parade. The discussion of digital money thus far has been dominated by libertarians and computer geeks, but the massive popularity of crypto-tokens has gotten the attention of academics such as the University of Chicago’s Eric Budish. In a new paper, Budish examines Bitcoin’s incentive system and concludes that there are “intrinsic economic limits to how economically important it can become.”
Some “Bitcoin maximalists” — those who hope the digital currency will squeeze out all competitors — say that it’s a lot like gold — it works as a store of value, even if it’s not very efficient as a true currency. But if Bitcoin got anywhere close to gold’s value, Burdish argues, people would attack its network for profit.
Before we dive into the argument, a little context: Bitcoin’s market capitalization over the last year or so has oscillated between $100 billion and $200 billion. Gold stock is worth about $7.5 trilllion. So, yeah, in those terms, Bitcoin is nowhere close to being “economically important.”
And according to Budish, it never will be. That’s because, if it ever gets too large, the genius of Bitcoin’s design would be its undoing.
Bitcoin’s security arises from a competition between members of the blockchain network called “miners.” Each miner is in pursuit of chances to add new transactions to the blockchain and earn bitcoins in return. Miners use large amounts of computing power in a race to solve a complicated math problem. An attacker couldn’t defeat this system unless it coordinated enough computing power to overwhelm the network and manipulate the record of transactions in such a way that it could spend the same bitcoins repeatedly. A strike of that sort, called a “majority attack,” is Bitcoin’s biggest threat, but for now, mining coins is more profitable than trying to overthrow the network, so the network stays safe. (See “How secure is a blockchain really?”)
However, writes Budish, this protection is very expensive (the Bitcoin network uses about as much power as Ireland to run). And although Bitcoin’s value could theoretically increase almost without end, the blockchain’s security can increase only linearly, as more mining power is added to the network. That’s unlike other forms of security, such as the cryptography used in the traditional financial system, which, like adding a lock to a door, adds protection for a relatively low cost.
The cost of running the Bitcoin blockchain today is on the order of $100,000 per 10 minutes, whereas the cost of attacking the system is in the neighborhood of $1.5 billion to $2 billion, according to Budish’s calculations. A big reason an attack is so expensive is that Bitcoin mining is currently dominated by chips that are purpose-built for mining and can’t be redeployed to perform other tasks. An attack could also drastically lower the value of Bitcoin — and in turn, the attacker’s own holdings — but that wouldn’t deter someone who was simply looking to sabotage or destroy Bitcoin.
Although Budish’s paper has gotten a fair amount of praise from other economists, some cryptocurrency enthusiasts have been dismissive. Ari Paul, cofounder of BlockTower Capital, says it “may be true” that Bitcoin’s viability is limited because deterring sabotage might become too expensive, but that conclusion has long been a topic of debate in popular online forums. The paper “adds no new data or logic to the debate,” he says.
Joshua Gans, an economist at the University of Toronto, argues that those online discussions lacked scientific rigor. Economists are just beginning to discuss the issues, he says, and the research community will benefit from Budish’s “rigorous work of putting this all together.” Gans adds, “It is that kind of approach that leads to better science.”