Bitcoin: the new digital fools gold?

I will give Satoshi Nakamoto (or whatever his real name is) and crew credit for cleverness in developing the algorithms for bitcoin. By paying small amounts of currency for people who perform important verification tasks for the currency, the system funds its own administration.

The question is whether bitcoin will have enduring value. There have historically been two main types of money: commodity money (and related representative money) and fiat money. I’ll talk a little bit about each one and how it derives its value, then compare bitcoin.

Commodity money refers to the usage of some commodity (gold, beaver pelts, salt, wampum). Generally the currency had some underlying value: in the case of gold, as a material to make jewelry, or in the case of wampum (belts made from shell beads) as gifts for occasions like marriage. In the case of precious metals (eg, gold, silver), it was very tempting to “clip” or shave the coins. To prevent this possibility and increase the trust in money, governments issued currency, in the form of gold or silver certificates. In the United states one dollar was, until the Nixon administration, equal to one thirty-fifth of an ounce of gold.

Fiat money is money issued by a government that is not backed by a commodity. After 1971, the US dollar became fiat money. At that point the value of the dollar began to derive not from the ability to redeem a dollar for gold but from the US government’s declaration that it was legal tender. When a currency is “legal tender”, it can be used to settle a debt. (Side note: yes, it is legal for United Airlines not to accept cash on board for drinks; legal tender means the currency can be used to settle a debt already incurred, such as a restaurant check for a meal eaten, but parties are not required to accept legal tender in exchange for goods.) Because the government declares that money can be used to settle all debts, it has value.

Now, back to bitcoin. People talk about digitally “mining” bitcoins. This is a clever framing which tries to make bitcoin the new digital gold. Many of the traditional challenges of a currency are digitally solved: the supply is limited, and transactions are verifiable. But is that enough? In my opinion, no. There is still no underlying reason for bitcoin to have value, other than a bubble. In 1636 in Holland, there was a bubble in the price of tulip bulbs. Supply was limited. Trades were verifiable. But in February of 1637, the value of tulip bulbs crashed. Eventually their value settled at their commodity value.

The difference between tulip bulbs and bitcoin? Tulip bulbs can be planted to create tulips; thus they have some underlying value. Bitcoin are just a clever bit of cryptography, so when their bubble collapses, it seems like they ought to become worthless. So, do I think bitcoin will become worthless? Maybe not.

Why won’t bitcoin go to zero? There is value in an anonymous currency, particularly for black market transactions, and bitcoin has a strong first-mover advantage there. It would not surprise me to see bitcoin evolve into the standard currency for online black market (anonymous) transactions, for example on the silk road online marketplace. Because bitcoin will be easily converted into drugs, the currency will have some underlying value.

It will be interesting to see how that market evolves: what is the demand for an anonymous currency, and what competitors emerge. These two questions will eventually determine the value of bitcoin. My belief is that the demand for anonymous currency is high. The IMF estimated the shadow economy at 14-16% of GDP in OECD countries and much higher in the developing world. If bitcoin can become the currency of the shadow economy, it will be valuable. Will it? Your guess is as good as mine.

— Max

3 comments so far

  1. Sam Trenholme on

    When I first saw bitcoins three months ago, I was very skeptical: http://acw2.vk.tj

  2. George on

    “The question is whether bitcoin will have enduring value.”

    No. Bitcoin will be disrupted by the next virtual currency that rewards mining more often than bitcoin currently does. It’s the ability to “mine” coins that makes it most appealing; evidence the speed at which Radeon HD cards were bought up as soon as bitcoin started hitting the news.

  3. Mart on

    George,

    The difficulty is for that new currency to take root. Sure a new currency might appeal to miners (as first adopters they get the advantages of easy generation initially) but will it appeal to consumers? Bitcoins success seems to be that it is being accepted by a small but growing number of consumers. I think it will be difficult for a new virtual currency to come in and compete, unless some serious flaw with bitcoin becomes apparaent.


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