Throughout human history, gold has always been favored as a currency for having other useful purposes aside from serving as money. By finding use as radiation shielding, a nonreactive tooth filler, or as computer hardware conductor, gold has something called “intrinsic value,” meaning it is something worth trading for. A challenger to the golden throne, and to the equally posh thrones of other currencies around the world, has emerged, and its name is Bitcoin. But bitcoins don’t possess intrinsic value—they’re simply a string of code, with no other use except as money, the digital result of computing power, energy, and time. So if bitcoins are by themselves worthless, why are they in such high demand, where the shutdown of Silk Road, the theft from Mt. Gox, or the Winklevoss buy-in is enough to grab headlines around the globe?
Cryptocurrencies are not a new concept, but none have attained the scale and reach of Bitcoin. The term first surfaced in a 2008 paper written by “Satoshi Nakamoto,” which outlined a secure, anonymized, and irreversible cryptocurrency, decentralized and controlled by no central authority. The concept gained momentum during the 2008 financial crisis, when widespread distrust of established banks and currencies had peaked, and since then bitcoins have been on an upwards streak, to the dismay of governments and left-behinds everywhere.
The recent and unprecedented theft of thousands of bitcoins from the Mt. Gox exchange in Tokyo has further fueled questions about Bitcoin’s legitimacy and stability. Most debate stems from how it works as money: Is it really money if it’s nothing more than strings of code? (Yes.) Isn’t all money pretend money too? (Yes and no.) And fundamentally, what gives a bitcoin value? Bitcoins are money, but the properties that make them so unique are the very things that will work against its own widespread acceptance. The answer lies in the most basic form of economics: bartering and trading.
In a barter-based economy, one with direct exchanges, money serves as a substitute, an IOU of sorts. A chicken farmer that typically traded three leghorns for a goat could instead give the trader a token representing his promise to pay three chickens. This token could be passed around to others, and was considered valuable because it could be returned to the first farmer in exchange for three chickens.
However, if our chicken farmer decides to renege on his promise to pay three chickens, the token then becomes worthless. The money is useless without someone to trade it with. There are two solutions to this problem: make the token itself something valuable, or ensure that a third person will still consider the token worth three chickens even if the farmer doesn’t.
While gold best illustrates the first solution, the third-person solution forms the basis for most “fiat” currencies: It’s why dollar bills contain the line “This note is legal tender for all debts, public and private”, or why British banknotes contain the phrase “I promise to pay the bearer on demand the sum of so-many pounds.” The token itself is a worthless slip of green cloth, but the government provides a “safety net,” ensuring that even if everyone stopped using the token as currency, it can be brought to the government, which will provide you with goods and services in exchange for that token. This promise to pay is what gives money value.
In contrast, if everyone stopped using bitcoins as currency, no government or organized body will accept a bitcoin as payment in exchange for goods or services. Retailers and governments that currently accept it do so only because it can currently be exchanged with another party back into goods or services. This is the major weakness behind Bitcoin: A bitcoin has value as long as other people still believe someone will give goods or services in exchange for that bitcoin. But once people start reneging on this promise, it loses value because there is no government that will give you a good or service in exchange for that token.
The only way Bitcoin can attain the same stability (and therefore widespread use) as established currencies is through the creation of a “safety net,” a group of people like a corporation, government, or structured entity large enough to ensure that even if everyone refuses to accept it, the group will still treat it as money in exchange for goods and services. Ironically, the creation of a structured and centralized group is the very thing Bitcoin was engineered to oppose.
The mechanics behind bitcoin are valid, but because bitcoins depend on other people accepting it as a currency, their actual value remains uncertain, creating volatility. Until a group large or powerful enough is able to provide Bitcoin with a safety net, it will always remain volatile, but the creation of such a group will stand against its very mission of being a decentralized currency.
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Originally drafted 28 September 2014
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