The surging price of bitcoin grabs a lot of attention. But it also raises questions about the nature of money and currency. What gives a currency its value?
The Elements of Money and Currency
Money is a medium of exchange. In a way, money is fiction; everything depends on people believing in its value. If enough people agree, anything can potentially be used as money—people have been known to use seashells, salt, grain, and even giant stone disks. Each of these options have drawbacks, of course. Seashells can weather and break. Grain can rot. Giant stone disks are hard to tote around in your pocket. Coins and paper money help solve these problems.
Currency is any widely-circulating form of money. The dollar, pound, and yen are state currencies. Gold is often considered a currency. Bitcoin, ripple, ethereum, and other alt-coins could also be considered currencies. You can exchange modern currencies in physical form, as you do with cash, or in electronic form, via credit cards, payment apps, or cryptocurrencies.
But what constitutes a useful currency? What attributes do we want for the currency we use every day? First and foremost, you need general acceptance. People must agree to accept the currency as payment. This agreement can come through legal means (when the government declares it legal tender), or through organic means (when people decide on their own, like with bitcoin).
Second, you want price stability. You need a reasonable sense of what your money will buy tomorrow, next month, and next year.
If you have hyperinflation, you have no faith in your currency’s purchasing power. Your incentive is to spend or exchange your currency as fast as possible. Many emerging countries (Yugoslavia, North Korea, Zimbabwe) have experienced currency hyperinflation.
If you have deflation, everyone’s incentive is to hoard the currency. If there is no incentive to spend or invest, economic growth stalls. Along with the Great Depression, the United States saw several deflationary periods in the 19th century such as the panics of 1837 and 1873.
A Real-World Experiment
I recall an interesting story that helps illustrate the difference between useful and ineffective currencies. The podcast Planet Money did an episode called Libertarian Summer Camp about a festival for government skeptics. For a few days, festival-goers were completely self-sufficient—they sold food and beer without licenses, traded goods, and discussed abolishing the IRS. They also engaged in a small-scale economic experiment, conducting daily business using silver and gold instead of the U.S. dollar.
It was clear that as everyday currencies, precious metals have some drawbacks. First, it’s hard to pay in small increments. If you want an omelet for breakfast, you need to measure out little shavings of silver. You need to carry around a scale, and unless you trust everyone you’re doing business with, you may have to test each bit of metal for purity. Paper money and electronic payments like credit cards and cryptocurrencies solve this physical problem.
But there’s another big drawback—the prices are volatile. This month, an omelet might cost 0.22oz of silver, but next month, it could be 30% more. Today it’s one price, but tomorrow, who knows? So how did the libertarians solve the volatility problem? They used their smartphones to look up the price of silver (in dollars, of course).
This is a silly anecdote, but the point is that price stability is extremely important for a useful currency. Because precious metals don’t have price stability, people need a stable reference currency (like USD) to decide what to pay. Not knowing what your money will buy tomorrow is not a good quality in a currency.
Mechanism for Price Stability
For decades, the U.S. dollar has exhibited strong price stability compared to other currencies. If you hold dollars, you aren’t worried about day-to-day volatility in your purchasing power. If you save money for a car, you have faith you’ll be able to afford it when it comes time to buy. You aren’t worried the car will cost $15,000 today, $20,000 tomorrow, and $5,000 a few weeks later.
The dollar’s price stability is aided by the central bank through monetary policy. To combat inflation, the Fed decreases the money supply. To combat deflation, the Fed increases it.
With gold, silver, and bitcoin, there is no central bank. If you distrust the government, the lack of a central bank may be a selling-point. But it doesn’t do much for price stability. If you own ten bitcoins or a pound of gold, what can you expect to buy with them next year? What about tomorrow? The lack of a mechanism for price stability is a major disadvantage. Without price stability, gold and Bitcoin are not effective as modern currencies.
Bitcoin and Source of Value
Bitcoin has no intrinsic value. You can’t eat it, use it to build things, or even look at it. It’s a virtual currency that exists in a virtual space—a decentralized ledger called blockchain. Its price is determined entirely by the market, and there is no government or central bank that can influence it. If people want to exchange bitcoin for $10 each, they can. If they exchange it for $1M each, so be it.
Blockchain, the distributed database bitcoin uses, is a useful payment system. It is anonymous, secure, and fast. To use blockchain for payments, you can convert dollars to bitcoin. The seller can instantly convert it back. Payment companies like Coinbase and Stripe already do this. There is no need to hold the bitcoin for more than a few seconds, so you can avoid the volatility risk.
Many people confuse bitcoin (the currency) with blockchain (the database). Because blockchain is a great payment system, people say, bitcoin must be valuable. But what imbues bitcoin with a specific value? Why should we assume $10, $100, or $1M is “correct”?
Some people claim it’s supply and demand—because bitcoin has a finite supply, the price of bitcoin will simply increase with demand. But if we can use bitcoin for payments without holding it for more than an instant, where is the stable source of demand? Demand comes from people wanting to hold bitcoin, not just use it for payments.
Another concern is the growing number of “altcoins.” Here is a list of the top 100 cryptocurrencies, by market cap. The higher the market price of bitcoin goes, the greater the incentive to create and trade alternatives.
Why Hold Bitcoin Long Term?
For months, I’ve been asking cryptocurrency fans for answers to this question. What are the benefits of holding bitcoin, besides speculation? I hear plenty of good reasons for the merits of blockchain, but never the merits of bitcoin as a currency. As far as I can tell, the only reason to hold bitcoin for any length of time is the belief that its price will rise.
This is absolutely fine, if you want to speculate. If you think bitcoin will trade for $1M in five years, it might make sense to own some. But I wouldn’t bet the farm. It’s an asset with no intrinsic value, no physical form, and no mechanism for price stability. Blockchain gets well-deserved hype, but this does not mean Bitcoin has any predictable value. Maybe bitcoin will trade for $1M someday, but not for any reason other than human behavior.
My inspiration for writing this piece was a concerning post last week from someone I’ve known a long time: