Bitcoins: New Gold or Fool’s Gold?

Categories: Economics
bitcoins

A craze is sweeping the nation. Indeed, it is sweeping the world. That craze is Bitcoins, the decentralized, encrypted digital currency, introduced in 2009. Bitcoins, which have a permanently fixed supply, are turning out to be a pretty big deal because of the stark contrast with our present (fiat) currency system — which thanks to central banker largesse is yielding a growing and seemingly endless supply of money (latest entrant to the game: Japan). Eventually, this rampant money printing risks triggering inflation, which destroys currency values.

So, to understand the recent Bitcoin binge, you need to understand inflation. Let’s consider what might happen if inflation applied to other facets of life . . . like sports.

Take basketball great Michael Jordan. On 20 April 1986, Jordan faced the Boston Celtics in a play-off game on national television. I’ll never forget that game. Watching Jordan school the great Larry Bird was something to behold. Specifically, I’ll never forget the number 63. That’s the number of points that Michael Jordan scored that night. It is indelibly etched in my mind as much as a symbol of his dazzling moves on the basketball court as for the achievement of scoring the most points in a single game by a Bulls player in history up to that point in time.

Now imagine that the NBA point system was regulated by a central bank — say, the US Federal Reserve. And let’s imagine that because of a loose “point” policy, the record books were rewritten each year and today show that Jordan scored only 28.4 points that day. What, you say?! How is that possible? (Especially the .4 part?) The answer: inflation. At a rate of just 3% per year, those points fell in value to just 28.4 over the ensuing 27 years. And 28.4 points no longer sounds like such a stellar performance, does it? This example is equivalent to sticking money in a mattress and letting inflation (created by the central bank) destroy its value.

Devaluing points in sports sounds downright absurd, of course. But the phenomenon is all too real when it comes to everyday money: The value of US$63.00 on 20 April 1986 is today worth only US$28.40.

Most governments throughout history have used gold (or some other tangible asset) to back their currencies. However, since the United States (and the world) departed from the gold standard in 1971, we have operated on a purely fiat system for money — meaning that money is not backed by anything tangible. Moreover, the record of many of these governments since then is grim. Loose monetary policy, dramatically weaker purchasing power, and an enormous buildup of debts today threaten substantial future inflation and financial instability.

Historically, there was not much anyone could do about this. But today, a bevy of independent currencies have sprung to life. Bitcoin is leading the pack and lives on the Internet, outside the domain or control of any one person or organization. Yes, some geek dreamed up a digital currency, wrote a program, and the darn thing is actually gaining traction. In fact, many commentators have been warning lately of a Bitcoin bubble, triggered at least in part by the actions of the European Union, the European Central Bank, and the International Monetary Fund, which laid down harsh terms in Cyprus that require owners of bank deposits to “bail in” the small nation’s troubled banks. Bitcoins have surged since that fateful day, increasing three-fold in value in just three weeks. Bitcoins now exceed $1 billion in total value.

How does it work? As with any foreign exchange transaction, a person holding local currency must first buy a foreign currency to transact in that currency. Bitcoin is foreign to everyone, so everyone must trade their local currency for Bitcoins through several Bitcoin exchanges that have cropped up around the world. These exchanges purchase Bitcoins, hold them in inventory, and sell them in exchange for the currencies of the world. In order to proliferate the system, new users download software onto their computers, enabling them to act as a node on the Bitcoin platform. In a process known as “hashing,” users’ computers compete to solve the mathematics of each transaction and thereby earn new Bitcoins.

The digital currency was created by an anonymous programmer, code name Satoshi Nakamoto. Bitcoins are remarkably sophisticated, both technically and financially. However, in order to assess Nakamoto’s creation, we must first consider what gives a currency its value. Currencies must be: a medium of exchange; durable and evenly divisible such that the quality of one unit is just as good as another; scarce such that they cannot be created at will; widely acceptable as payment to all participants for their goods or services; and used as a standard of market value, thereby enabling users of the currency to save money for later use.

In essence, currencies must be trusted by large numbers of people. However, in light of the recent history of fiat money (and the gross indebtedness of many nations), trust is rapidly eroding. So are Bitcoins a natural step in the evolution of money?

Let’s see how it stacks up point by point.

  • Medium of Exchange. Because Bitcoins are accessible as payment through computers and mobile devices connected to the Internet, it acts efficiently as both a currency and a payment system. People trade their dollars, yen, euros, etc. for Bitcoins and can exchange (or save) them anonymously. So, among people using Bitcoins, they perform well as a medium of exchange.
  • Durable and Divisible. As a digital currency, there is no risk of spoilage or breakage and, of course, each Bitcoin is of identical character and quality as the next. Moreover, because there is no central organization in charge of the currency (the system uses a distributed grid architecture) and because it uses highly sophisticated encryption, Bitcoins are reasonably durable over time. Consequently, the life of the system itself, as well as individually owned Bitcoins, should be extremely durable.
  • Scarcity. The quantity of Bitcoins is capped at 21 million, so the currency truly is scarce. Outside of potential fraud, no government or organization can “print” more Bitcoins. Furthermore, each Bitcoin is divisible by up to 100 million. As the value of a Bitcoin grows, people can increasingly trade fractional amounts. So far, so good. Being forever capped at 21 million means, however, that if Bitcoins were accepted as a global fiat currency, they would cause ongoing deflation. This is a problem. More about that later. But this drawback is also the currency’s primary virtue. Being decentralized and limited, Bitcoins offer an enormous advantage over other currencies. Nobody is empowered to create more. This feature differentiates it not only from other digital currencies, but also from existing government-backed currencies, thereby enhancing its attractiveness.
  • Widely Acceptable. Acceptance of the currency is contingent upon its adoption by many factions: consumers, businesses and other organizations, and employees. Unfortunately, Bitcoins are not (yet) currently widely acceptable, so it fails in this crucial area as well. Bitcoins do appear, however, to be gaining traction and are becoming more accepted each and every day.
  • Standard of Market Value. So long as Bitcoin usage grows, its intrinsic value to society will grow — although its price in dollar or euro terms might fluctuate wildly. Of course, the risk that Bitcoins will be abandoned is still very real at this stage. And if their usage declines, even a little bit, their intrinsic value would decline markedly and fear would replace the present optimism about Bitcoins. Look out below! And if you think this is just theoretical, consider the fact that Bitcoins were “trading” at $17 in June 2011 and then traded down to as low as $0.01 just a few days later when it was revealed that hackers had stolen 25,000 Bitcoins at Mt. Gox, a Bitcoin exchange. Subsequently, the open source community made a fix to the system that helped to rectify the problem and improve the trust. Making the platform open source was an ingenious step taken by Nakamoto, because the community can respond promptly to security breaches.

Because Bitcoin is an alternative to government-run fiat money, a comparsion to the gold standard is most appropriate. How do Bitcoins compare to gold? While gold is naturally scarce, Bitcoins were created to be scarce and ultimately fixed at 21 million. Like gold, this scarcity helps to create value, particularly as the popularity of the Bitcoin platform grows. Because volume is fixed, the intrinsic value of Bitcoins will grow markedly. However, unlike gold, whose stock increases by about 1–2% thanks to the gold mining industry, Bitcoins will be capped. It turns out that growth in gold volumes is quite helpful to stabilizing the value of a currency backed by gold.

In contrast, though, Bitcoins will rise in value relative to goods and services, creating a marginal incentive to save rather than spend. For example, if my 10 Bitcoins today can buy me one iPad, maybe in six months they will buy me two iPads, and six months later they will buy me four. So clearly, a currency increasing in value can set in motion continuous deflation in the economy as people defer purchases out into the future. This problem is solved by having a currency that neither appreciates nor depreciates materially over time. Of course, this isn’t just speculation. Looking back to the performance of the gold standard, we observe periods of both inflation and deflation that were induced by fluctuations in the volumes of gold produced by the mining industry. If Bitcoins remain capped at 21 million, then deflation will be an inevitable result.

What are the other implications of Bitcoins becoming widely adopted? First, what would the credit and banking system look like? Under the gold standard, bank customers deposit their gold in bank vaults in exchange for earning interest. Because banks only require a portion of total gold deposits to be accessible for withdrawal at any given time (fractional reserve banking), they then lend out money in greater proportion than they own it and keep only a fraction in reserves, thereby earning a spread on the interest earned (on loans) and interest paid (to gold depositors). As the economy performs well, loans are paid in full and some early thereby replenishing capital at the banks enabling them to lower interest rates. As the economy weakens, repayment of loans is slower and banks must raise interest rates to replenish reserves. In contrast, under a purely digital currency like Bitcoin, it remains to be seen whether or not owners of Bitcoins would maintain their affinity for Bitcoins during times of stress like war, famine, or economic or social collapse. Clearly, one could argue that the people of the European periphery are undergoing a great deal of stress and social disorder. On the heals of the Cyrpus fallout, demand for Bitcoins clearly grew. While positive, it is much too early to suggest Bitcoin has passed the tipping point. This is a question not to be taken lightly.

The whole concept ultimately comes down to trust. Quoting Alan Greenspan:

Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government’s promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited.

Likewise, if the people of the world moved to a “Bitcoin standard,” it would severely constrain the ability of governments to run large, persistent fiscal deficits. Consequently, governments the world over would be threatened by an independent currency. So if Bitcoin gains substantial traction, governments of the world will have a common enemy. Sun Tzu couldn’t have chosen a better rallying cry himself.

Is Bitcoin the new gold, or fool’s gold? Only time will tell.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: Shutterstock/LHF Graphics

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40 comments on “Bitcoins: New Gold or Fool’s Gold?

  1. Pingback: My Two-Penneth On Bitcoins | Objectivist Wealth
  2. ALBERTO said:

    The problem is that money can become something like another fashionable product. Why using Bitcoins when you can select another system or currency? Like we choose between Whatsapp or Line or any new product that appears on the market.

    Moreover, supply of Bitcoins is limited in time, ok, but when the limit is reached and the currency is not useful to buy low price products… What if people create another digital currency like bitcoins but no bitcoins, “Low-Bitcoins”? People could use this new currency (lower in value), and external to Bitcoin top-limit system, to buy these low cost products more easily than with Bitcoins. When this happens, the money supply will be increased.

    • Hi Alberto, thanks for your comments. Let me start by saying that Bitcoins are divisible by up to 8 decimal places, so they can ultimately be divided into smaller units for purchases of low-price point products. In terms of the bigger picture, money is what money does. Whatever people use as a medium of exchange is money. The world already has multiple forms of currency, and not just government sponsored. There are a variety of digital currencies in existence at present – though each of the competitors to Bitcoin have some sort of company, group or organization in central control. In addition, there are non-conventional currencies. For example, in prison, people use cigarettes. No doubt countless other people in locations all over the world can and do currently use unconventional forms of money. I think the real issue is whether or not a network effect is achieved. How common is the usage of bitcoin by retailers and businesses? How common is the usage of bitcoins for employers to pay salaries and compensation? How common is it for consumers to prefer Bitcoin to their local currencies? There is a tipping point where enough users adopt the system that it make it very, very difficult to eradicate. Just like the government sponsored currencies are now…

        • Vinamra Gharat said:

          According to me the real problem is with deflation. Consider this, the value of money is more in future. So we have to change our TVM concepts. The new Bitcom TVM will be FV = PV/(1+r)^n. Now people will defer their spending to future, apart from basic needs, just because they can buy their products cheap in future. Imagine the problems people will face because of this! People with highest number of Bitcoms will actually be the wealthiest people in the world. Better off with the good old fiat currency!

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    • longbeach said:

      Darra, you need to do a bit more research.. i just bought a few gold coins the other day with bitcoins. Merchants are springing up everywhere.

      Also, you should throw away your cash since an even larger percentage uses that for drugs and worse

  4. longbeach said:

    you didn’t point out the anti-usury nature of bitcoins. like gold, bitcoins are not created out of debt, but are mined. credit is a scam..bitcoins will bring prudent spending habits. it is time to trash the ‘growth’ model

    • Actually, like fiat money and gold, a credit system can be laid on top of Bitcoins. One just has to agree to lend them and another has to agree to borrow them and re-pay … with interest. As highlighted in the article, aggregate credit is then constrained by the performance of the economy/bank assets to the degree that credit is secured by real assets. To the degree they are unsecured (or secured poorly), there is risk in the credit system. Under a “bitcoin standard” aggregate credit would function much like a gold standard and inhibit governments from running fiscal deficits and improve trade balances materially.

      • longbeach said:

        Hopefully the only financial instruments with bitcoins will be bitcoins… if we can go to sound money and turn the page on the credit era we’ll all be better for it.. except for the coniving moneylenders who want the world to join in their speculatory gambling ‘financing’ racket

        bitcoins can do a very dangerous thing.. educate people on what money is

  5. Big O said:

    Ron,

    I disagree that deflation would be a problem for Bitcoins. Maybe it would be a problem for large manufacturers that create goods we want but not need? People will continue to purchase the things they need, but they will wait to purchase things they simply want. What is so bad about that? Sure economic activity might slow, but it will also teach people to save their money in a more natural way. If Bitcoins will become accepted it will also prevent the manipulation of the currency that is currently clearly going on with the price of Gold and Silver and our FIAT moneys. I believe the pros clearly outweigh the cons as long as the government does not intervene, which is really the question you should be worried about.

    • Big O, you raise excellent points. I sense we share the same concern for the fragility and problems created by the status quo. I tend to agree with your points about purchase of wants versus needs. Though I think the real issue is (or should be) freedom of choice – so that the average person choose to work and save money for the future or spend it now, can choose to borrow or save, and ultimately, can choose his or her own definition of wants and needs. Moreover, the average person should be able to make these choices without regard to the currency in question or systemic ramifications of that currency. Stability of the value of an individual unit of currency creates stability of freedom for the individual.

      Regarding deflation, there are two types of deflation: good deflation and bad deflation. Good deflation is characterized by advances in productivity and the simultaneous lowering of costs. As costs fall, prices fall and [product] markets remain healthy. In contrast, bad deflation is characterized by excess debt and the stifling of economic activity. Yes, it includes the unwinding of levered up activity as historical uses of credit had stolen transactions from the future. However, it also includes a downward spiral where prudent uses of debt and credit are likewise overwhelmed by falling prices. These discrete phenomena coexist. (For example, if you put 40% down on a house and the rest is mortgage, you are still underwater if the house falls by 50%.) If, and ONLY if, the world develops and maintains a commitment to Bitcoins, then the holders of Bitcoins will prosper enjoying real increases in wealth and the holders of fiat will suffer experiencing real declines wealth and in living standards. Debt deflation would likely be the norm and free market equilibria might never be achieved. As mentioned in the article, Bitcoin would be a common enemy of governments that wish to preserve the status quo. So, to the degree it gains traction, governments will get more and more interested in counteracting it. Already the ECB and the FBI have been looking at Bitcoin… and no doubt many more government agencies. Bitcoin is clearly a competitive threat.

  6. Alberto said:

    For me the most important thing here is… what about taxes?? If the system is P2P and anonymous, why paying taxes if they don’t know how much money I have?. Imagine a world where all salaries will be paid using P2P transactions. The IRS will never know how much I earned last year unless they come to my house and make me show them. They only could obtain money from fines and exported goods… Moreover, moving money among countries would be free for everyone not just rich people (You just have to move yourself to another country with your computer or mobile phone).

    • I am not a tax expert, but I imagine that existing IRS rules still apply. For instance, if you were a contestant on a gameshow and won a new car worth $50,000, the IRS treats that as $50,000 in income. Likewise, if someone was paid $50,000 worth of Bitcoins, I imagine the tax obligation issue would be the same. Even if there is some sort of loophole at present, I would expect that an absence of tax revenue for the government would cause them to wake up and force employers to disclose to the government Bitcoin compensation…and then tax it…either in local currency terms or in Bitcoins…

      • ALBERTO said:

        Of course IRS rules still apply but they need the info of your current income to ask you to pay… with Bitcoins that’s impossible now. Only if you spend the money in expensive goods like a house or an expensive car, they can ask you where did you get the money to buy it.

  7. Deepak said:

    hi ron
    what is your opinion on litecoins?
    they were 4.75/$ an hour back
    many people have been quoted as saying that litecoins are to bitcoins what silver is to gold,most probably from 10.04.2013 it will get listed on major exchange sites,that’s when people are expecting the next explosion to happen

  8. That is the correct blog for anybody who needs to seek out out about this topic. You understand so much its nearly laborious to argue with you (not that I truly would want…HaHa). You definitely put a new spin on a topic thats been written about for years. Great stuff, just nice!

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  10. Skeptic said:

    Even if governments have a dismal record of defending their currencies, at least I understand the mechanism by which they might reduce its value and can act accordingly. With bitcoins, I’m not sure I have the same degree of confidence — and that uncertainty is a dealbreaker.

  11. Kenneth Mulders said:

    Good overview – the development of Bitcoins and other digital currencies and affinity programs (with ‘points’) indicate some fundamental changes to the nature of currency, wealth and work in developed economies.

    As pointed out in your response to one post, goods deflation can seem to be ‘good’ (more and better products for the same or less money.) However, services deflation (somewhat masked by money supply inflation) is now becoming well intrenched since the Great Recession. We are becoming used to not relying so much on manufacturing in our economies, which will stand us in good stead as 3-D printers become more common, but what will we all do if Google drives the taxis and IT services are all outsourced to India?

    My (developing) theory is that evolving digital tracking and accounting systems are changing the definition of the value of how we spend our time – you can now earn ‘credit’ not just for shopping (affinity programs) but for simply watching advertisements, or even being a contributor to certain blogs. Stateless media of exchange for such credits (such as Bitcoins) are a natural development and, eventually, many fewer people will need to find a job for their livelihood.

    • Excellent Points, Kenneth! The future direction of social media suggests that influential people (mavens) will get paid for their sharing, advice and recommendations – to the point where these people can make a living at it. Yet, many analysts focus on the robot displacing the assembly line worker. Sound economic analysis must balance what is seen (jobs displaced) with what is unseen (opportunities created)… a difficult thing to do! Well done!

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  13. Jerry said:

    When a “currency” can lose 2/3 of its value in a day, it clearly fails the test as a store of value.

    Bitcoins = “Madoff money”. Issuers unknown. Backed by nothing. A thin veneer of technology and fools rush in.

    The Celtics beat the Bulls in the game where Jordan scored 63 points. Makes it silly to claim that he schooled anyone.

    • longbeach said:

      What a troll Jerry… Do you always take such a short data point and make wide conclusions?

      There are many factors during this phase of maturity that push and pull the apparent value of bitcoins.

      • Jerry said:

        Not trolling at all.

        I genuinely believe that bitcoins are a very transparent scam that will soon collapse.

        If it turns out I’m wrong, I’ll be happy to admit it. Hopefully you will do the same.

        • Jerry said:

          Just to clarify the depth of my skepticism regarding bitcoins.

          When bitcoin spam became rampant on social media sites a couple of months ago, I read everything I could find on the topic. Then I reported it on the SEC whistleblower site as a possible fraud.

          • longbeach said:

            You really are trolling now… Whistleblowing something in plain sight? Wow what acumen.

            I guess you missed all the rules and regulations that were passed on money laundering limit protections on exchanges dealing with bitcoin.. Yeah, just a passing fancy

  14. toni said:

    Isn’t wide acceptance of bitcoins based on some form of backing (not necessarily assets) but at least governmental… which raises at least the following 2 issues:
    1. Even though there may be a secondary market insured by agents/brokers. In case of busts & credit crunches, those may/will not be able to support it, hence the trust in this market could erode quickly & holders of bitcoins May be caught with their pants down !!
    2. not regulated by any agency, hence it can be a good medium for fraud, tempering, laundering or speculation… who will protect the holders?

  15. Investing in bitcoins is like watching a video tape of that basket ball game and betting on how many points Jordon scores. Some people already know the answer, and some don’t. There are individuals that own as 1,000,000 bitcoins out of the 12,000,000 or so in existance. More than half the total in existence are owned by less than 100 people. Without any sort of insider trading laws, collusion laws, etc, that makes the market just as fixed as if a single person was setting the price on their own whim. Certainly, you can try and guess what price they will pick and see if you can “win”, but the game is fixed. If at anytime it looks like that will change, they’ll just pull all the money out of the system and go find another SCAM to steal people’s money with.

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  17. Ed said:

    Very good writeup. People can speculate about BTC as much as they like but nobody truly knows where it’s heading (Personally I think it’s heading to the sky.)

    For those who want to get started with Bitcoin but are scared to invest, check out http://www.bitcoinreward.net. Gives beginners a nice easy way to earn some Bitcoin that they can play around with or trade etc.

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