Bitcoin is indeed a rather surprising mix of frightfully clever ideas and frightfully simplistic mechanisms, as I argue in a recent paper . You can dismiss bitcoin as a doomed monetary experiment, but you must not pass over the opportunity to let your imagination run with it as it can shake some basic assumptions you have on how financial systems must work. Might there be some lessons in there for how to 'fix' what's broken in our financial system? Take it as an invitation to dream about the following three questions, which are based around the three basic design premises of bitcoin.
First: What if digital money was something that I could hold for myself and pass onto others, without necessarily having to go through a licensed financial institution? You can't do that now: you cannot hold digital money without becoming a customer of Citibank, PayPal or M-PESA. We've been delivered into their hands, and yet they do not necessarily see it their business to serve everyone. It didn't use to be that way: you can hold coins and bank notes by yourself, there is decentralized management of that. What if we held the option to serve ourselves financially with electronic payments, on a peer-to-peer basis, even if only as a countervailing power or last resort?
Second: What if we could build an entire digital money network which did not require any specialized infrastructure? Modern finance is burdened by ever more complex core banking platforms. Most other forms of digital content have gotten off specialized networks and converged onto the internet, simply by layering higher-level protocols on top of the basic internet protocol which take account of the unique technical needs of different applications. Bitcoin is just that: a set of higher-level protocols (not hardware!) which ensure that the digital value carried over the ubiquitous internet is uniquely and securely owned by someone and cannot be freely copied or double-spent by their owner.
Third: What if the digital money implemented through such mechanisms was actually an alternative or private currency? OK, to me this is the least interesting part of bitcoin, but unfortunately it's the one that has galvanized most attention. I think there will always be a need for some discretion in the management of money supply to accommodate economic shocks, and I don't see us trusting private entities with that power, much less foregoing it entirely and operating our money supply on a hard rule. Price volatility is inherent in such rudimentary treatment of money supply.
So take the first two ingredients only, and what we have is fiat (i.e. government-issued) money which can be held and passed on in a peer-to-peer fashion and operates over the open internet, resulting in a much more open, interconnected, contestable and lower-cost ecosystems for the delivery of payment and financial services. Centralized issuance but decentralized management of money once it's out there. That takes out the traditional banking gatekeepers (per the first point) and massively reduces the cost of moving money around (per the second point).
It also opens up the floodgates of innovation, because financial services could then be implemented at the customer wallet application level, without necessarily having to touch or even consult any central services or centralized providers. (A crude example: you could set up a time deposit by telling your wallet rather than your bank to not give you access to your money.) Some call it the rise of programmable money. And indeed the most powerful lesson of the internet has been the blossoming of innovation brought on by a great centripetal force which pushes intelligence to the edge of the network.
So what would be the benefits of such a system? The cost of achieving financial inclusion would be vastly reduced, as people could gain financial access simply by downloading a secure application on their smartphone (which are coming for all) without requiring any provider's consent. We could economically extend electronic transactions down to very small transaction sizes, as sending money need not cost much more than sending an email.
We would also go in the direction of giving us more options to prevent or deal with financial crises, by increasing market discipline on banks. There would be a much more credible flight-to-safety option for people if they smelled a weak bank or a bubble. And in the event of banking distress, there would be a more credible let-it-fail option for regulators since our economy need not be so dependent on them.
I'm not saying we should do away with banks, they will still have a huge role to play intermediating funds. They can seduce me with attractive deposit interest rates and on-demand loans which my wallet may not be able to negotiate on a peer-to-peer basis. All I am saying is that we should be able to opt for a self-service option whenever we like — or when banks are failing to include us. This is the same service-versus-application dichotomy which has played out between telecoms providers and Skype to such advantage to end-users.
We are a long ways from being able to implement this sort of solution, from a technical, regulatory and customer acceptance point of view. But shouldn't these issues be at the heart of the ongoing financial architecture debate? We need to think of financial systems much more as a seamless fabric and less as a restricted collection of connected institutions.