Bitcoin -- or Something Like It -- is Here to Stay

For months, I have been intrigued by the Bitcoin phenomenon. I am not alone, obviously, since the decentralized digital currency has been the red hot subject of policy conversations and investment flurries for the past year.

Fueling that interest is the fact that Mercatus is the home of three of the best Bitcoin experts—Andrea Castillo, Jerry Brito and Eli Dourado—in town. So Wednesday, after talking with Dourado and Brito about their research, I decided to buy my first bitcoin—or half of one really—and see for myself what the buzz was all about.

However, as I was doing it, I couldn't ignore the growing panic coming from my Twitter feed about the imminent demise of the currency. Following weeks of impressive growth in value and presence, a recent round of unexpected regulations from the People's Bank of China doused cold water on Bitcoin's undisputed hottest market. Bitcoin prices tumbled, halving in value across exchanges the world over. Short-term speculators of this currency craze lost much or all of their investments. Online forums even posted suicide hotline numbers to help members cope. Political commentators again agree that this could be the beginning of the end for Bitcoin.

Are they right? Castillo thinks they might be too quick to declare failure. For one thing, it is unclear what this recent event really means for Bitcoin. Considerable price volatility -- the price was $260 in April, spiked to $1,200 in November and dropped to $530 on Wednesday -- a finite money supply, and no central banker may lead some to conclude that the digital currency is interesting, but ultimately doomed. Others, however, see those same qualities as features rather than bugs.

But more importantly, she explains, most of the recent doomsaying concerns Bitcoin's use as a traditional currency and is missing the best part of this new tool: Bitcoin as a technology. In fact, Brito, Castillo and Dourado have repeatedly pointed this out in their work.

I'll leave the complex technical details to them, but the general idea is not so hard to explain. The best way to understand why Bitcoin is such a technological advancement is to compare it to the existing payment system. Let's say you want to purchase an item online. Normally, the transaction would go through a third-party processor, like Mastercard or Paypal, to verify the exchange and send the money to the seller. These companies earn profits by charging fees and maintaining a current ledger of all transactions to prevent fraud and overspending.

Now comes Bitcoin, and with it, the ability to exchange directly without the need for a middleman. It replaces these third parties with its own programming by applying cryptography to verify and maintain its ledger of transactions.

Bitcoin is not controlled by any one government or company or person: It is maintained by thousands of individuals who choose to run the Bitcoin program on their computers. This program harnesses the computer's processing power to verify and maintain the ledger of transactions. Every so often, some computers are rewarded with new bitcoins. This is how the supply of bitcoins increases; hence, these computers are commonly called “miners.” Altogether, Bitcoin as a technology allows individuals to transfer payments directly, quickly and cheaply.

While dramatic currency fluctuations capture the popular imagination, Bitcoin's service as adecentralized payment system is what is truly exciting about it. For instance, small businesses that cannot afford credit card fees view Bitcoin as an affordable payment alternative that they can offer their customers. The potential applications for Bitcoin are almost endless.

Bitcoin as a “currency” may never be as popular as the dollar but no matter what happens, the technology it created isn't going anywhere. Think about it as the Napster of the payment industry. The original Napster program isn't around anymore but its innovations fundamentally changed the music industry. As the Washington Post's Tim Lee rightly notes, Bitcoin is both a decentralized payment system and an alternative currency, combining into a ground-breaking “platform for financial innovation.” So no matter what happens to the trading value of my purchase after this crash, as long as Bitcoin -- or a competing technology -- provides an affordable payment system to those who need it, there is a lot to celebrate.