Bitcoin and Gold

Economic textbooks say that money has several functions. The two most important are a medium of exchange and a store of value. The reason why a commodity can be used as a store of value is that is widely used as a medium of exchange. People hold it, knowing that they can exchange it for something that they want in the future.

Gold was once a common medium of exchange. Merchants had scales to weigh gold and silver. Small coins were developed to make buying and selling with gold easier. However, gold is no longer widely used as a medium of exchange. If you take a gold ring into Walmart and try to buy a toaster, they will look at you blankly.

Gold is now mostly used as a store of value. People who fear the future hold it, because they fear that other assets will lose value.

Ideally, a store of value will retain its value. However, in practice, people like a store of value that increases in value. However, the problem with a store of value that can increase in value is that speculators often pile in and push up its price. That has happened at times with gold.

Currently, bitcoin is not widely used as a medium of exchange. It is mostly used as a store of value.

Bitcoin has been designed to behave like gold. The amount available grows very slowly as digital miners work to produce it. This is good for its use as a medium of exchange, as it should grow in line with the growth of the economy as the number of transactions increases. The volume of a commodity used as a medium of exchange should not grow too fast, because it could lose its value.

However, scarcity can be a problem when a commodity is being used as a store of value, if more and more people want to use it that way. If an increasing number of people wanted to use gold as a store of value, then the price of gold would rise dramatically. Speculators would be then attracted to buying gold.

This is what is happening with bitcoin. The supply is limited to what is needed for a medium of exchange, but a rapidly growing number of people want to use it as a store of value (or increaser of value). The price has increased rapidly, which has brought in the speculators.
In our modern financial system is that banks have the ability to create credit. This allows them to fund speculation in whatever commodity is growing in popularity as a store (increaser) of value.

The problem with a commodity used as a store of value that can increase in value is that it can also decline in value. This could easily happen to bitcoin if attitudes changed.

We actually need a record of value that does not increase or decrease in value. If it could not change value, speculators would have no interest in holding it.

The best store of value is not a commodity or asset, because they can always become a target for speculation. A better store of value would be a record of value given, not an asset. I describe how this could happen in Money.

Bitcoin

Bitcoin has become a bit of fad. It a form of electronic money that grows slowly over time, in an imitation of the way that the volume of gold grows as more is mined. I don’t think bitcoin is the future, but it points to a few issues with modern money systems.

1. Money is a record of payments and receipts. Most of the money that people use these days is electronic. That will continue to be the case unless international communications completely breaks down (but that would be a huge economic disaster).

2. Money is a record of a “partly completely transaction”. The volume of uncompleted transactions can increase and decline over time, depending on what people are doing. More on this here.

3. Recent events in Cyprus have made people think again about the security of money in the bank. Depositors have had the value of their deposits arbitrarily reduced. Here in NZ, the central bank has announced a process for taking a haircut from deposits in a situation where a major bank is in danger of collapse. These events are not reassuring. People are beginning to realise that we need a better system of money.

4. Modern banking processes make international money transfers quite expensive. I have to pay $5.00 to bank a check issued by a major international business. This seems excessive, given there is almost no risk of the check bouncing, and the bank demands the right to reverse the payment and charge another fee if the check does not clear. People are looking for better ways to make international transactions in an electronic world.