The Money Side of Bitcoin: Theory and History

Money is a unique thing; it is universally popular, but perplexing to nearly everyone. What is money? Why does it exist? How is it controlled? Money is pivotal to our lives as members of a civilized society, yet perhaps one in one million people will investigate into the nature of money, trade, commerce, and the rest.

Also read: The Encryption Cold War: Government VS Internet

A General Overview

Farming in EgyptMoney emerges through the free and spontaneous interplay between people in society. Whether through barter exchanges or extended gift systems, money develops as part of a logical search to discover efficiencies in trade. One hundred people, offering only what they individually produce, must convince owners of goods they want to accept their goods in kind. It is difficult to find a double coincidence of wants in most cases. Other things equal, as individuals prefer more trading partners than fewer, there exists a tendency in such a situation to offer more marketable goods as opposed to less marketable goods when seeking what one wants.

The farmer who requires the goods for his craft as well as furniture for his home, jewelry for his wife, books for his son, etc. must bring his produce to market to exchange for such items – or, at least, for intermediaries that can reliably be thought to carry the value for the exchange of such things be directly wants. As soon as one person accepts a trade for an object which has no direct use value to him, that item has become a medium of exchange. It has become a good whereby at least one person is confident enough in its market liquidity and proper technological functioning to accept it, for however short a time, in lieu of something he finds directly valuable. As certain goods compete with others in the marketplace of usage, the winners inevitably carry attributes that logically justify their acceptance such as scarcity, durability and fungibility.

Bitcoin’s History

This path is no less true for Bitcoin than it is for gold. Despite the differences in time scales, the same dynamics are playing out for this new currency. In the beginning, only a few true believers bought into the idea. Eventually, a gentleman named Laszlo bought pizza with bitcoin through his friend as an intermediary. The very first transaction set an initial standard for future transactions. However under or overvalued the initial price, Bitcoin finally did have a price. It had an economic starting point. Over time, as hobbyists began to mine bitcoin, they posted their electricity costs on internet message boards and markets eventually developed. Now, there are dozens, perhaps a hundred, exchanges throughout the world, and Bitcoin’s price keeps rising.

Money or Not?

FALSE-DICHOTOMY-copyA common mistake among both laymen and professional economists is to adhere to an unjustifiable polarization. They say either something is money or it isn’t. To the extent “money” is interpreted to mean “the most saleable good in society,” this is indubitably true. There can be only one “most popular” of anything. By this standard, however, the only thing that qualifies as money is the US Dollar. Euros, yen, pesos, and gold could not qualify as monies, because they are out-competed in liquidity by USD, and yet individuals in most countries can engage in rational monetary and economic calculation using other currencies.

To the extent “money” is interpreted more broadly, many things can count as money and quasi-money. The best way to understand money is as a spectrum. Certain goods are more money-like than others, and this is meant to convey that they are superior media of exchange. Physical US dollars are the most salable good on this planet, but there are innumerable runners-up that are widespread, but not universally traded. From this perspective, the emergence of a medium of exchange cannot be discounted in importance simply for not being “money.” No money emerges as such; it always emerges as a localized or niche good that becomes a medium of exchange, which becomes popularly used over time. Only once certain monies already existed in the form of gold and silver were governments and central banks able to arrogate to themselves monopoly minting and seignorage rights, printing rights, and finally the wholesale legal capture of money production entirely.

Fiat money, if it is to ever have value, must be based on a prior value, namely being the promissory note for an amount of gold or silver. Only recently have governments been able to decouple the historical bond between fiat notes and base metals. What is important when discussing competing media of exchange is not whether or not it has won the worldwide popularity contest, but its attributes: how easy it is to transport, to safeguard, to prove its integrity, how durable it is, etc.

It is with respect to these attributes that people say Bitcoin makes for very good money – it has all the right ingredients. It is scarcer than gold, easier to transport, cheaper to prove, more difficult to steal, and it resists fractional reserve banking. To declare Bitcoin a monetary failure because most of the money-users in the world are unaware of the desirability of these attributes is a non-sequitur, and amounts to an argument against all innovation. After all, very few people saw the value in automobiles before they became ubiquitous.

An Impossible Demand

perpetualmotionAnother mistake laymen and professional economists both commit is to define a money as simultaneously a medium of exchange, a store of value, and a unit of account. From there, they discount Bitcoin on the basis that it is merely a medium of exchange, and therefore cannot possibly be a serious challenger on the monetary front.

This mistake is correspondingly more difficult to avoid as, indeed, successful money does tend to exhibit these attributes. Good, successful monies are not only excellent transfer mechanisms, but they retain value over long periods of time and they are used as a referent when trading. While optimal or excellent monies portray these qualities, it does not follow that these qualities must be present at once, instantaneously, from the very first instance in which the good was pressed into service as a medium of exchange. In fact, this could never happen. It could not be the case that a money comes into existence with a corresponding state of it being an excellent way to store value over time. The attribute of something retaining value over time is a shorthand way of referring to a schedule of consistent value judgments on the part of everyone.

Gold, for instance, only stores value well because people have desired gold for thousands of years and continue to do so. Beyond its industrial purposes, gold is beautiful, shiny, and malleable enough to fit any shape or design. It is also rather rare, unlike iron. That it was useless in the building of homes, weaponry, armor, or other consumer goods meant it could only find a value-outlet through social reasons. Gold’s “uselessness” meant that it became a visible symbol of wealth. Those who were seen with gold jewelry were associated as having more than enough, an embarrassment of riches, in fact. The wearing of gold implied one did not want for food, shelter, clothing, etc. It operated as a display of wealth for the very reason that it served no “tangible” value.

People the world over consistently value gold – and they value it even more so because it has great network effects – and this is what allows gold to store value. It has nothing to do with the gold, per se. It has everything to do with perceptions. Goods gain the ability to store value when people who interact with it find it consistently valuable over time. A herd of cattle, a pocket of cowrie shells, a room of weapons – these goods are not media of exchange any longer, let alone monies. They are, judging by history, poor at storing value. One would have lost considerable wealth by today’s standards if one’s ancestor had “invested” in a herd of cattle in ancient Greece; this would not be true if one’s ancestor had invested in gold in ancient Greece.

Storing Value

storeofvalueWhen a durable good begins storing value, it implies there is a sufficient mass of people to buoy its price in day-to-day markets. It implies this mass of people recognize or believe there is a value to the good beyond its exchange value. There is an obvious status value one accrues from gold, as mentioned before. Bitcoin’s genesis as well is due to status value.

Bitcoins, as scarce units of a cryptographic system, became sought-after by hacktivists, Cypherpunks, and cryptographers. Whether they were testing if one could “hack” the network, such as by double spending Bitcoin, or due to purely collector’s motives, they became valuable, unique goods. It would still take some time for the value of a bitcoin to be expressed in market prices, but it retained value for specifically motivated individuals.

Over time, as individuals in wider and wider radii of the true believers began to expose themselves and investigate Bitcoin, they found that its use entails hitherto impossible opportunities for everyone. From sending money instantly across the world, to being one’s own bank, to circumventing censorship, to preventing identity theft and more, use of the Bitcoin network presented many options. It opened new vistas that ACH and SWIFT, as centralized, regulated systems, simply could not match.

As bitcoin units are required for the operation of these goals, and as they are scarce and limited by algorithm, the units themselves began to acquire market prices. Their scarcity implies that competing users of a bitcoin will have to bid it away from each other. As the network grows in participants and hashing rate, further trust will be given to the network from individuals accustomed to its proper and expected operation. As it survives countless sabotages, hacks, character assassinations, and intervening governments, it grows in the public mind.

Due to Bitcoin’s anti-fragile nature, such stressors actually enhance the system. It meets its challenges by evolving. Throughout this process, as Bitcoin grows in the public mind, it will grow in the pocketbook. It will be the vehicle through which more and more exchanges are transacted, and it will grow at the expense of fiat money networks. As its reliability becomes more assured in people’s minds, it will begin to acquire value-storing properties. As Bitcoin is an evolving, open-source project, it can and will be altered to adjust to new threats, altcoins, and needs of the individuals using it.

Accounting

A calculator, pen, and financial statement.As more and more people “buy into it” and begin using it for transactions and storing their wealth, Bitcoin will become so stable that people will begin using it as a unit of account. During this process of hyperbitcoinization, prices of goods expressed in fiat money will continue to climb due to the inflationary nature of fiat money in general, and specifically as the “demand for fiat” falls. Both the inflation schedule and a collapsing demand will create a vicious cycle where continued inflationary expectations lead to further erosion of demand, which itself leads to higher inflationary expectations. Over time, prices in terms of fiat money will increase drastically. As Bitcoin is deflationary, the prices expressed in terms of Bitcoin will fall rapidly, as has happened historically. This is another way of describing a shift in purchasing power from holders of fiat money to Bitcoin holders. For a time, two monetary languages will operate side-by-side until eventually no merchants will accept fiat.

It is during this final process that Bitcoin will satisfy the demands of mainstream economists and become a universal unit of account. Its enormous cost savings, security and privacy advantages, near-instantaneous settlement time, immutable creation schedule, digital nature, and countless other advantages will propel it into popular use. Those who recognize these dynamics can profit while Bitcoin is relatively niche and undervalued; those who wait until it has swallowed the world will lose out on the opportunity to gain from currency arbitrage.

Conclusion

It is a fact that cryptocurrencies are here to stay. Their open, digital, and distributed nature means that they can survive any attack by corporate or State actors. Bitcoin, as the earliest and most popular cryptocurrency, is by leaps and bounds stronger than any of its competitors. Short of a technical failure or the emergence of a phenomenal competitor, it will remain the elephant in the room and continue eating away at the dominance of fiat currency.

Arguments that Bitcoin cannot become money without State sponsorship – that Bitcoin is “intrinsically useless” – betray a fatal misunderstanding of the nature and growth of money. There are many today who use Bitcoin as a pure exchange vehicle, neither speculating nor holding on to any bitcoin beyond the shortest possible timeframe in which to use it for indirect exchange. A smaller group hold bitcoin speculatively, as they believe the network will grow and, as a result, Bitcoin will be able to retain value safely over longer stretches of time. There exists a group even smaller who use bitcoin as a unit of account. They do not hold bitcoin in order to trade it for more fiat in the future; to them, there is no trading, no “exit strategy.” They are exiting fiat and believe that Bitcoin will become a worldwide unit of account. Having such a long-term time horizon, these holders will be the greatest winners of this monetary transformation.

Does Bitcoin’s historical progression fit that of other monies? Let us know in the comments below!


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