THE POLITICAL ECONOMY OF BITCOIN

I. INTRODUCTION On October 14, 2013, Baidu, a web services company that runs the largest search engine in China, began accepting bitcoin. This single action opened the bitcoin network to roughly 570 million internet users in China and prompted other internet companies to consider the cryptocurrency more seriously. The closing price of bitcoin, which averaged just $124 over the 2-week period prior to the announcement, increased to $170 over the 2-week period following the announcement. (1) As the demand for bitcoin increased, the authorities took notice. The People's Bank of China issued a statement on December 5, 2013 prohibiting financial institutions and payment companies from buying, selling, quoting prices in, or insuring products linked to bitcoin. Baidu stopped accepting bitcoin the very next day. China is not the only user; although the network of bitcoin users is relatively small at present and economists are, for the most part, skeptical that bitcoin will ever gain widespread acceptance, the rapid growth of the bitcoin network has prompted some governments to ban or discourage the use of bitcoin. (2) Government officials seem to worry that bitcoin, which offers a secure and quasi-anonymous way to make digital payments, will be used for illicit transactions and will impede the administration of monetary policy or raising revenues. In some important respects, the legal issues surrounding bitcoin echo older debates. "The idea that governments issue 'money' and declare what qualifies as 'legal tender' is an ancient notion," Middlebrook and Hughes (2014, 848) explain. "The history of regulating money and legal tender suggests that it is not likely that governments will surrender their privileges to regulate cryptocurrency issuers, exchanges, administrators, or users." Can a government successfully prevent bitcoin transactions? In what follows, we consider whether government transactions policy would eliminate the use of bitcoin or simply relegate its use to areas effectively beyond the reach of government (e.g., black markets, small-value exchange, etc.). Using a monetary model with endogenous search and random consumption preferences developed by Hogan and Luther (2014), we articulate the conditions under which a government-issued currency and bitcoin might coexist, as well as the conditions under which one or neither of the different forms of money circulate. Then, we impose a government transactions policy whereby those agents controlled by the government refuse to accept bitcoin as payment and examine the effects of this policy on the circulation of bitcoin. The model employed herein combines insights from Kiyotaki and Wright (1993), in which agents are matched randomly for trade, and Corbae et al. (2003), in which agents deliberately choose with whom to trade. Agents in the model deliberately choose with whom to trade, but are then subject to random consumption preferences. One way to think of this assumption is that agents who wish to consume arrive at a place where they would like to make a purchase, but might decide not to buy anything. Although the decision to buy is random, the choice of where to shop is not. (3) Allowing agents to choose their trading partners means that some transactions might exist beyond the reach of government. The use of a government transactions policy follows from Aiyagari and Wallace (1997) and Li and Wright (1998). Others have used government transactions policies to consider the implications of competing money assets. However, our analysis differs from previous works in important ways. For example, Lotz and Rocheteau (2002) consider whether a government transactions policy can support the launch of a new currency. They use a random matching model and only consider a transactions policy that compels agents to hold government-issued money. Similarly, Waller and Curtis (2003) consider the use of government transactions policy in the context of competing international currencies. …