Broadly speaking, money operates on a bookkeeping system: that is, private parties can't just claim to have money, but instead must have it transferred from another account into your own account. With traditional money, these accounts can be verified by banks, financial institutions, and regulators, and the central bank reserves to itself the power to create money.
The remarkable innovation of Bitcoin is that it has created a currency that is automated and private, with no need for a central bank or regulatory system. A total of about 14 million Bitcoins have been created, with a US dollar value of about $3.5 billion. They have been used in about 62 million transactions. Anyone who signs up a Bitcoin account is given a "public" number, which is your account number to the system as a whole, and also a "private" number, which is your personal passcode for accessing the system.
The heart of Bitcoin is the "blockchain," which is a complete listing of every Bitcoin ever issued and all the transactions that have happened with each. Everyone with a Bitcoin account can look at the blockchain if they wish--but it's such an enormous file (and getting larger with each transaction) that most people could not download it to their personal computer even if they wanted to. So most people using Bitcoin hire a "wallet" company which holds your copy of the blockchain, and through which you can operate your account. Some wallet companies know your "private" number; some don't.
With traditional money, a transaction is verified by financial institutions operating in a regulatory framework. For Bitcoin, a transaction is verified when the blockchain is updated. But this is where the process gets a little messy and very creative. Someone needs to be paid for updating the blockchain, and of course, they can be paid in Bitcoins for doing so. To ensure trustworthiness, we actually want to have multiple actors all updating the blockchain at the same time, so that they can serve as a check on each other. And we need those actors updating the blockchain to pay some cost, because if there was no cost to participate, random players could claim to have received Bitcoins from others.
Every 10 minutes or so, the recent Bitcoin transactions are grouped into a "block." The Bitcoin automated system generates a mathematical puzzle based on the preexisting contents of the blockchain. The puzzle is not fundamentally hard to solve, but it includes a random component and takes a lot of computing power. In other words, those with faster computers will have a better chance of solving the puzzle, but because of the randomness, speed doesn't always win. The first to solve the puzzle posts a new blockchain, along with a proof-of-work that the puzzle was solved. Those who solve puzzles are called "miners," and again, they are rewarded with Bitcoin in a way that expands the quantity of currency at a smooth pace over time. Böhme, Christin, Edelman, and Moore estimate that in solving the Bitcoin puzzles, Bitcoin miners use about 173 megawatts of electricity at any given time, which is about 20% of the output of a nuclear power plant.
But remember that many miners are working simultaneously on blockchain puzzles. It may happen that as later miners complete their work, they confirm the blockchain addition made by the first miner. In other cases, later miners will provide a different form of the blockchain. In effect, the miners "vote" for the correct form of the blockchain, and the number of "votes" is determined by the quantity of computing power needed to solve the puzzles. A Bitcoin transaction is not truly final until it has been definitively added to the blockchain, which means that it needs to be confirmed by the process of multiple miners solving puzzles, which in practice can often take about a hour. The authors write:
But voting on the authenticity of a transaction requires first working to solve a mathematical puzzle that is computationally hard to solve (although easy to verify). Solving the puzzle provides “proof of work”; in lieu of “one person, one vote,” Bitcoin thus implements the principle of “one computational cycle, one vote.” Through this design, the proof-of-work mechanism simultaneously discourages creating numerous fake identities and also provides incentives to participate in verifying the block chain.
It is worth emphasizing the remarkable accomplishment of the Bitcoin system. It functions! However, as this brief description has hinted in various places, Bitcoin has limitations that have begun to emerge. Here are some of the main ones.
1) Bitcoin isn't anonymous: it's pseudonymous. For example, say that you use a Bitcoin account to mail-order something for delivery to your home. Now there is a connection between your Bitcoin account and your address, and any other transactions through your account can be traced to you. There are Bitcoin-based companies called "mixers" that try to make transactions more anonymous. They take a batch of Bitcoin transactions and scramble up who is receiving what from whom. But it turns out that their scrambling can often be unscrambled, if law enforcement wants to commit the resources to doing it.
2) The dollar-Bitcoin exchange rate can move abruptly, which makes Bitcoin less suitable as a transaction currency. The price of Bitcoin spiked enormously in late 1013, going from about $200 per Bitcoin to almost $1,200 per Bitcoin, before then falling back. A currency that fluctuates this wildly ends up looking less like a mechanism for buying and selling, and more like a financial investment with risky characteristics. Indeed, a study a couple of years ago found that more than half of existing Bitcoins either took more than a year to be spent or had not been spent.
3) It's not clear how the Bitcoin technology would function for widespread everyday uses. As noted above, finalizing a Bitcoin transaction--as miners solve mathematical puzzles and work toward a definitive update of the blockchain-- takes about a hour to be finalized. If Bitcoin had to deal with even a modest fraction of the number of transactions commonly handled by, say, Visa or American Express, the system would be overwhelmed by the number of transactions and unable to function.
4) Bitcoin itself operates remarkably well, but most people use Bitcoin through a number of platforms that are vulnerable to fraud and cyberattack. For example, there are currency exchange platforms that switch Bitcoin to conventional currencies. There are "digital wallet services" that host your Bitcoin account and your personal copy of the blockchain, and that many people use for making Bitcoin transactions. There are the "mixers" I mentioned above, which take a batch of Bitcoin transactions and scramble them together, to increase the anonymity of the transactions. These platforms are vulnerable to cyberattack and fraud, and when you pay these platforms, you are revealing that you are linked to the Bitcoin currency, thus compromising your anonymity to some degree.
In short, dealing with Bitcoin is full of risks and costs. It may be worthwhile for some large purchases under particular circumstances, but at least as Bitcoin is currently constituted, it seems unlikely to become a truly large-scale force in modern finance. So what's next?
One vision is that other forms of virtual money will follow where Bitcoin has already broken the trail and this is already happening in various ways. I'm sure that some of these will have niche success, but I would be surprised if they have more. As virtual currencies become larger, governments will insist on increased disclosure and degrees of regulation. As governments requirements rise, the advantages of virtual currencies will diminish.
Another vision is that the main use of Bitcoin-like technology may not be in the area of money, but in transferring other pieces of digital property. The JEP authors quote an earlier article by Mark Andreeson, a coauthor of the Mosaic browser:
Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. . . . All these are exchanged through a distributed network of trust that does not require or rely upon a central intermediary like a bank or broker. What kinds of digital property might be transferred in this way? Think about digital signatures, digital contracts, digital keys (to physical locks, or to online lockers), digital ownership of physical assets such as cars and houses, digital stocks and bonds . . . and digital money.
Those who would like some additional reading about the economics of Bitcoin might begin with the discussion and articles cited in my post "How Does Bitcoin Work?" (September 24, 2014).