Bitcoin: What kind of money is this?

Image Source: The Money Reviews

As at time of writing:

USD$1283.50 = 1 BTC

USD$1234.54 = 1 Gold Ounce

A (not so) brief introduction

For those unfamiliar with the terms Bitcoin, cryptocurrency and blockchain; worry not. In this part, I’ll do my best to explain it in as simple and clear way as possible.

Bitcoin is, first of all, a digital currency. Bitcoin can be sent directly from person to person, without the need for intermediaries (such as banks). Bitcoin transactions are recorded on a public ledger called the blockchain, named so because it consists of a chain of blocks of confirmed transactions. The blockchain is one of the distinctive features of bitcoin relative to other currencies: all confirmed transactions are visible to the public. Not only that, but the blockchain is maintained by virtually the whole network of bitcoin users, making the ledger pretty much impossible to fake or alter any confirmed transactions (immutability). Because of that, bitcoin is said to be decentralized, as opposed to most fiat currencies today whose supply is controlled by a central organization, namely the respective central banks.

Transactions take the form “Payer X pays Y bitcoins to payee Z”. The payers are pseudonymous, using digital addresses to send and receive bitcoins, much like an e-mail account. In that regard, bitcoins are a lot like an e-mail containing money. Payer X signs the e-mail with his public key, which nodes that confirm blocks of transactions for a fee, called miners, then trace the history of the blockchain to confirm that Payer X indeed has these bitcoins available to spend. Payee Z then can spend the bitcoins if and only if he can provide his private key, which is then confirmed against his public key – once again like signing into your e-mail account to forward an e-mail.

Besides that, bitcoins cannot be said to physically or virtually exist outside of the blockchain. What bitcoin users actually do get to store in so-called virtual wallets is their private key needed to spend their bitcoins.

Every transaction needs an input, which in turn needs to be an unspent output from a previous transaction. Thus, every bitcoin carries with it the history of all the transactions it’s been used in, since its production.

Blocks of transactions are fixed in size and can hold a finite amount of transactions. Miners, when confirming transactions, give priority to the transactions paying the highest fees storage size of the transaction, which in turn is determined by how many inputs and outputs are used in the transaction. Each block of transactions contains a hash of the previous block, which links them together to form the blockchain. For new blocks to be accepted there needs to be so-called proof of work. It is a solution to a problem which is difficult to find but easy to confirm. An analogy to it would be solving for x and y in x+y=10. The miner must make many attempts to find the correct solution, but another miner can easily confirm that the solution is the right one.

Finally, the supply of bitcoins to ever be produced is fixed at 21 million. Bitcoins are produced when new blocks are created and given to miners as reward. The rate of production is halved every 210,000 blocks – and currently stands at 12.5 bitcoins per block.

Now that the technical part is over, let’s talk economics

In this part, I would like to evaluate the “moneyness” of bitcoin. How good is it really as a currency?

The mainstream definition of money is a store of value, a medium of exchange and a unit of account.

A store of value is the function of an asset to be saved, retrieved and exchanged at a later time, and be useful when retrieved. In this regard, bitcoin appears to fulfill the criterion, at least in the short run. Many have argued whether bitcoin carries any inherent value, which has cast doubts on whether bitcoin has any value in the long run. Several responses to this would be that immutability of public information might carry some value indeed.

A medium of exchange is an intermediary used in trade to avoid the inconveniences of the barter system. Bitcoin clearly fulfills this criterion, evidenced by the many exchanges that exist for buying bitcoin and the ever-rising population of merchants willing to accept bitcoin as payment.

A unit of account is a nominal monetary unit of measure or currency used to value economic items. In this regard, bitcoin appears to fail in fulfilling the criterion, mainly because of accounting standards and the still low prevalence of bitcoin in economic life. People might still be trading with bitcoin, yet in the back of their heads they always translate the value back to a currency which they use more in their everyday lives. We can see that bitcoin satisfies two out of three conditions for money, with the third being subject to its adoption as a unit of account in the future - which in turn depends on the use of the currency itself.

Now let’s look at some more nuanced characteristics of money and evaluate bitcoin in that regard.

Homogeneity (or fungibility) allows for perfect substitutability of the individual units of the good (in this case money) with other units of the good due to their equality. Bitcoin has a bit of an issue with this, as every bitcoin has its own history, which, depending on its uses, could have different values. Bitcoins used for and proven to be linked to illicit activities, for example, actually carry lower inherent value to the payee, since nobody wants to be accused of assisting money laundering. The market has provided for mechanisms called tumblers, which basically take bitcoins from multiple inputs and mix them up, so as to mix up the trace history of the bitcoins one has in their possession and in a way erase a coin’s traces.

Ease of transport eliminates transaction costs for carrying and using the money. Needless to say, all you need to spend your bitcoins is a wallet program which can connect to the internet - so in this regard, and being a DIGITAL currency, bitcoin fares well.

Divisibility of the unit is one of the components bitcoin fares even better than traditional “good money”, such as gold. A bitcoin can be divided up to one satoshi, which is one hundred millionth of a bitcoin. I bet it’s pretty hard to find micrograms of gold in the market, or microcents.

Durability allows for storage of value. Bitcoin will be durable for as long as the internet exists and people keep using bitcoin. I won’t say there is no risk, but rather in the short term at least the risk is minimal.

The ability to verify the integrity of a money unit exists inherently by the very function of miners, which have been incorporated by design. Bitcoins are incredibly hard to fabricate or forge, and thus this condition is adequately satisfied.

Scarcity allows for comprehensible prices. Money’s use as a means of exchange requires stable exchange ratios between a unit of the money and units of other goods. If one side of the ratio is infinite, price calculation becomes impossible. Fiat money solves the problem by jailing anyone that tries to print their own version of the money. Bitcoin solves it by design – bitcoins have a fixed rate of production, and a fixed total supply.

Finally, the above give rise to the marketability of a good giving it liquidity. Bitcoin still lags in liquidity relative to other currencies, yet its increasing adoption is promising for the future.

Beyond the above, there are some additional perspectives on what constitutes good money.

Austrian Economists have a term called ‘Sound money’. Ludwig von Mises, in his Theory of Money and Credit, said "[T]he sound-money principle has two aspects. It is affirmative in approving the market's choice of a commonly used medium of exchange. It is negative in obstructing the government's propensity to meddle with the currency system.” Sound money is furthermore a stable money, that is not liable to sudden appreciation or depreciation and which is usually but not necessarily pegged to some physical good. In these two regards, bitcoin satisfies the first, in that it is decentralized and not subject to political tampering of the supply. Given that prices are expressed today in terms of fiat currencies, and big volumes of trading take place by institutional investors who try to profit through speculation, it unfortunately cannot be called sound yet – the price of bitcoin is too volatile.

John Nash, Nobel prize winning Economist, used the terms good and bad money. According to him, good money is money whose value is expected to be stable over time. Bad money is expected to lose value, as in instances of inflation. As long as the price of bitcoin is expressed in terms of bad money (yes, I mean fiat), it cannot be considered good money in itself. It does satisfy, however, as mentioned before, the Nonpolitical Value Standard, a criterion for Ideal Money. John Nash was inspired by an Austrian Economist – Friedrich von Hayek – and so it is not surprising to see similarities among the two. He also called currency that, while not achieving perfect stability, becomes stable over time as ‘asymptotically ideal’. In this regard, we can’t say for sure whether bitcoin satisfies the condition, as its lifespan is has been too short to say.

Overall, bitcoin has a lot of arguments in favor of considering it a currency, or even a good currency, and a lot of arguments against. While I am personally optimistic about its adoption in the future and further satisfaction of other criteria, it is up to the market to persuade more people to adopt this currency in their everyday transactions, and further make this currency good, sound or ideal money.





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