The economics of Bitcoin

by on April 19, 2011 at 1:23 pm in Economics | Permalink

The lesson here is that enough of you ask me about a topic, eventually I will blog it.  Here is Wikipedia on Bitcoin — it’s less than transparent, which I take to be informative in its own right.  If you are late to the party, here is the confusing opening paragraph:

Bitcoin is a digital currency created in 2009 by Satoshi Nakamoto. The name also refers to the open source software he designed that uses it, and the peer-to-peer network that it forms. The total value of the Bitcoin economy as of April 2011[update] is 4,500,174 USD.[1] Unlike most currencies, bitcoin does not rely on trusting any central issuer. Bitcoin uses a distributed database spread across nodes of a peer-to-peer network to journal transactions, and uses cryptography in order to provide basic security functions, such as ensuring that bitcoins can only be spent by the person who owns them, and never more than once.

Huh?  When I hear about monetary economics, I think first of convertibility, credibility, and repurchase agreements.  Then my mind turns to Ponzi schemes and frauds.  Finally there is government-issued paper money, which can be used to pay taxes.  Via Matt, here is the best piece I’ve seen on Bitcoin, and a follow-up.  Here is Jerry Brito on Bitcoin, more  links here.

I’ll still admit to some confusion, but I am inclined to think the following.  It is a privately created fiat currency, bundled together with an anonymity scheme for transactions.  The anonymity scheme means there is some reason to grant one-time seigniorage to the original currency issuers.  Eventually the anonymity scheme, in some form or another, will be available without the fiat currency.  At that point, or more likely before then, the fiat currency will fall to near-zero in value.  Hold it at your own risk.  The original issuers will have kept some of their initial gains.

In the meantime, it’s mostly a fun topic for the internet.  Private fiat currencies have potential value only during hyperinflations, or extreme deflations.  Even then (especially in the former case), people may prefer real assets and investment assets.  The new Bitcoin asset simply isn’t a useful one and I’ve yet to see a source on it which explains how it could be or should be.  That said, here is a list of sites which accept Bitcoin, on what terms I am not sure.

I thank numerous loyal MR readers for the query.

Jim Wise April 19, 2011 at 1:37 pm

Not disagreeing — there’s one interesting technical improvement over previous fiat currencies however — the mechanism by which bitcoins are generated prevents any single currency issuer from flooding the market with bitcoins unilaterally, by a technical inovation which requires actual computational resources to be expended in order to cryptographically generate new coinage.

There’s some discussion of this on the bitcoin site, here:

https://en.bitcoin.it/wiki/Introduction

However, given enough issuing parties colluding, the conversion rate between cryptographic operations and bitcoin issuance could be manipulated, breaking this protection. There’s a good short analysis of this problem here:

http://timothyblee.com/2011/04/19/bitcoins-collusion-problem/

And if that happens, it’s back to being a fiat currency, whose money supply is set by the issuer again.

David April 19, 2011 at 1:50 pm

You’ll also note that the collusion problem requires tens of thousands of individuals to collude for it to work, and each one of them willing to devalue their OWN currency.

In other words, it’s not a problem. It’s like asking US Citizens to make all of the dollars they own worth less and trying to get 51% of them to agree to it.

John April 20, 2011 at 8:19 am

I don’t think you understand how P2P network and distributed systems work.

John April 20, 2011 at 8:21 am

Retracting my comment — misread what David was saying.

Anthony April 20, 2011 at 2:24 pm

“It’s like asking US Citizens to make all of the dollars they own worth less and trying to get 51% of them to agree to it.”

What makes you think that’s a hard problem? Inflation is often politically popular.

Anton Tykhyy April 24, 2011 at 9:01 am

Isn’t it rather the case that it’s popular (with the electorate) if it gets to masquerade as welfare? Of course it might be politically popular with the political class for other reasons.

erehweb April 19, 2011 at 1:54 pm

For comparison of bitcoin to another alternative currency, Madison Hours, see my post at

http://erehweb.wordpress.com/2011/02/26/bitcoin-madison-hours-and-musical-banks-alternative-currencies-virtual-physical-and-fictional/

Both systems go against something most economists believe, and they’re both mostly useless.

Doug B. May 18, 2011 at 12:05 am

Bitcoin may or may not be useful as a currency in and of itself. It depends on whether the “bitcoin economy” grows sufficiently large.

Nevertheless, as an intermediate medium of exchange, bitcoin has uses beyond what you can get out of existing hard currencies.

It is a non-counterfeitable, divisible, irreversible electronic medium of exchange. These are all things we try to achieve with hard currencies, some better than others.

Having the same properties as hard currency, but being electronic, in and of itself makes bitcoin useful.

For example, the mastercard/visa duopoly can be replaced by bitcoin. Anyone who wants to accept bitcoin payments can do so, with all the same properties as cash, without having to pay some middleman.

Michael Nielsen April 19, 2011 at 2:03 pm

Tyler writes: ” It is a privately created fiat currency”. This statement is, I believe, misleading. It is not like other privately created fiat currencies because no single party or small group of parties has control over the currency, or the ability to unilaterally expand the money supply. There is no central bank and no central mint. I believe this makes such systems potentially different from other privately created fiat currencies.

Joshua Johnson April 19, 2011 at 2:17 pm

Tyler,

Did you take into account the underground gray or black economy and the use it has there? If websites selling counterfeit goods or pirate software use this it could become the de facto currency of the underground digital economy where goods and services are exchanged knowing full well that you will be able to get other goods for your bitcoins that are generally not sold at your local Wal-Mart.

Just my $.02

Bill April 19, 2011 at 9:55 pm

You are absolutely correct. I have played around with darknets (ie Tor, Freenet, i2p), which are basically networks that hide the identities of the users, and I can tell you that are many unsavory things bought and sold using this currency. Fascinating though. I am just amazed at how dedicated these crypto nerds are at subverting authority.

Bill April 19, 2011 at 10:48 pm

I should add that the ability to anonymously make transactions makes Bitcoin particularly useful for underground exchanges. Since there is not a centralized entity that connects the buyer and seller (think Paypal), it’s not like the government can come in and shut down the middle man.You don’t have to trust the middle man either.

Here’s an analogy. The government would have a really tough time shutting down Bittorrent, because it is decentralized. Everyone shares and downloads content from each other. On the other hand, it is much easier for the government to come in and seize someone’s server that is providing copyrighted or illegal material. Bitcoin is like Bittorrent in that respect.

NYCer April 20, 2011 at 11:36 am

Please tell us, based on your research, what “unsavory things” are being bought and sold. It might be worth my time to explore the darknets/bitcoin

HTXer April 20, 2011 at 1:32 pm

drugs and guns

Bill April 20, 2011 at 9:20 pm

Unfortunately, much of it is child pornography. Then you have you paranoid, anarchist communities who discuss things like how to make bombs. Pirated material not so much, because transfer rates over these networks are very slow. Lots of technical/enthusiasts too. And yeah, drugs and guns. And finally, dissenters in oppressive countries use them quite a bit to talk with each other and access prohibited material.

Sort of a wild west of the internet. Reminds me of the early days before it became commercialized.

It is completely legal to participate in a dark net. I have posted links to three popular darknets.

http://freenetproject.org/
Distributed, anonymous data store. Get the Frost client to make finding content easier.

https://www.torproject.org/
Very popular. Designed to mask you on the open internet.

http://www.i2p2.de/

Jayson April 20, 2011 at 12:04 pm

Gee, sounds a lot like…EVERY other currency in existence.

Steven Kane April 19, 2011 at 2:22 pm

Can someone explain to me how Bitcoin is a fiat currency?

Here are the definitions of fiat from dictionary.com:

fi·at   
[fee-aht, -at; fahy-uht, -at] Show IPA
–noun
1. an authoritative decree, sanction, or order: a royal fiat.
2. a formula containing the word fiat, by which a person in authority gives sanction.
3. an arbitrary decree or pronouncement, especially by a person or group of persons having absolute authority to enforce it: The king ruled by fiat.

Bitcoin has no authority backing it because it is completely decentralized and no state is forcing anyone to use Bitcoin by any decree. Bitcoin is a completely voluntary virtual currency. 404 Fiat Not Found

Dan Weber April 19, 2011 at 3:26 pm

A fiat currency is backed only by trust. You can’t trade 1 Bitcoin for a given amount of gold, wheat, dollars, or bullets.

The US Dollar is also a fiat currency.

Steven Kane April 19, 2011 at 4:08 pm

Seems to me like a ‘currency backed by trust’ is a much more generic concept than a ‘fiat currency’, which to me seems to imply some authoritarian decree. If you were to mint pure gold coins and use those as a currency based strictly on units of mass, would that also be a fiat currency? The gold would not be redeemable for any other thing.

Scott April 19, 2011 at 4:38 pm

Steven is correct. There is little fundamental difference between a scarce commodity like gold acting as a currency and a scarce resource like bitcoins acting as a currency. Bitcoins cannot be described as fiat. And the scarcity that creates value for both gold and bitcoins is effectively the same, a fundamental and universal inability to create more than the defined limit. Gold being a fundamentally finite physical metal, and bitcoins being a fundamentally finite cryptographically enforced limit. There isn’t any value-added by a currency being tangible, all other things being equal. And bitcoins do have the value-adding attributes of easy transact-ability, and virtually zero storage cost.

Bernard Guerrero April 19, 2011 at 4:53 pm

All money is fiat money. Your ability to convert gold, dollars or bitcoins into other goods is dependent entirely on the market demand for and trust in the currency in question in relation to the demand for the desired object. Neither dollars nor bitcoins nor gold will get me to give you the last swig of fresh water while we’re adrift on a lifeboat.

PlasticLiving April 19, 2011 at 5:10 pm

I’m new to all this, sorry if this is a simplistic question…

So any currency with no intrinsic value (US dollar, bitcoin) is a fiat currency? As opposed to a currency with some other useful value (like say, rice)?

Is this the distinction? I’m confused because I always thought of gold as non-fiat. Isn’t gold backed only by the trust that others will find gold valuable in the future?

Bernard Guerrero April 19, 2011 at 5:13 pm

Yes.

Stephen Kane April 20, 2011 at 7:32 pm

No, Bitcoins are not fiat, and neither are any private currencies BY DEFINITION.

“Fiat” literally means “by decree”, and a decree is a rule of law issued by a head of state.

No head of state was involved in the creation of Bitcoin or has DECREED it as the national currency.

Noah Yetter April 19, 2011 at 7:03 pm

There are traditionally 3 kinds of money:
1. Commodity: has market value apart from its use as money, and generally came to be used as money because of that value

2. Fiduciary: represents a claim on another money good stored elsewhere for security

3. Fiat: represents nothing and functions as money only based on expectations of State action (e.g. the State will accept this currency in payment of taxes, the State will enforce legal tender laws favoring this currency, etc.)

Steven Kane April 19, 2011 at 7:33 pm

In that case, Bitcoin is not a traditional type of money because it doesn’t fit any of those 3 descriptions. I think the proper term is ‘virtual currency’.

Sigivald April 19, 2011 at 7:52 pm

#3 I’d clarify as not strictly requiring a State to back it up.

The obvious example being, say, Canadian Tire money (which eBay Canada allows as a payment option, last I checked!), or a notional “WalMart Dollar”.

As long as you can freely exchange the fiat instrument for goods of value (of sufficient variety or convertibility to be nigh-general purpose), I think it should still count as fiat money.

The important part about fiat money as opposed to commodity or token (fiduciary, in your use) money is that it does not pretend to be or represent some specific Real Object Of Value Beyond That Of Being Exchangeable.

Even though, as Bernard said above, a lump of gold or a pound of wheat can’t be exchanged for that last swig of water on a lifeboat, that still doesn’t make them “fiat money” – it means that lifeboats without water have no use for money at all, or that the categories here are simply irrelevant in that context, if the two statements aren’t merely equivalent.

Nate April 20, 2011 at 3:48 pm

A bitcoin is a commodity money. The commodity is a set of peculiar numbers that have the unusual property of being able to supply a distributed cryptographically secure medium of exchange. The process of finding new numbers from computation is the equivalent of mining them out of the ground. The temptation to call them fiat comes from the fact that they are so virtual and can’t be used for physical things like eating. However, the fact that these odd sets of numbers can provide anonymous secure exchange, may be enough of a commodity to make them intrinsically valuable. Anyone know if bitcoins are secure against Shore’s Algorithm?

Silas Barta April 19, 2011 at 7:24 pm

You can’t trade 1 Bitcoin for a given amount of … dollars

Right, unless you go here or something.

Dan Weber April 19, 2011 at 11:36 pm

No you can’t. The value of Bitcoin fluctuates, often by more than 10% in the course of a week.

You have no idea what a Bitcoin could be traded for next week. A silver note, as comparison, could be traded in for a given amount of silver.

Nathan Scott April 20, 2011 at 2:06 am

Sounds like an opportunity for arbitrage. I thought this was a website for economist.

Michael April 20, 2011 at 3:14 am

But you don’t know what a gold could be traded for next week too? :)

Silas Barta April 20, 2011 at 10:51 am

Sorry, I thought you were differentiating Bitcoin from fiat currencies.

Jon April 19, 2011 at 2:50 pm

Steven Kane, you should look at definition #3 from what you posted. A group of people have decreed it to be currency without authority to enforce it. That group of people are the ones who run bitcoin servers. There is nothing in particular (no commodities, dollars, etc.) to back the currency up.

The state doesn’t force me to use dollars except to the extent I pay income taxes. It is still a fiat currency.

Ryan Vann April 19, 2011 at 3:12 pm

The 3rd definiton, unless broadly (as in imaginitively) construed, doesn’t acurately apply to Bitcoin.

“The state doesn’t force me to use dollars except to the extent I pay income taxes. It is still a fiat currency.” You should reflect on this statement a bit more vigorously.

Jon April 19, 2011 at 3:40 pm

Arbitrary degree or pronouncement == “This collection of bits as processed by this software is money. Go forth and use it as such.”
a person or group of persons having absolute authority to enforce it == “If you don’t treat this as money, then we can’t make you.”

That seems pretty straightforward to me. It is the same definition that applies to almost all states. They may have regulations requiring you to use their currency for narrow means (income taxes), but they don’t have the power to make it an actually used currency. This is why in countries with weak currencies, stronger outside currencies can become the defacto currency in the country.

As to my statement about the state not forcing me to use dollars, it is very true. My employment contract stipulates that I will be paid in dollars, but there is no reason that I couldn’t sign a contract stipulating that I be payed in some other currency or even in bitcoins. It would probably not be hard at all to set up an arrangement where the appropriate amount of dollars are deducted in taxes and the remainder is paid to me in a currency of choice if both I and my employer so desired. Contracts in other currencies are in fact not that common in some places. This is actually one reason why there was a financial crisis in Argentina some years back. Many of the contracts were in dollars and some people owed money in dollars and brought in money in the local currency and got into trouble when they stopped being of equal value.

All of this being said, the government at most makes it a bit inconvenient if I want to be paid in another currency. The real reason that I stay with the dollar is that even if I had bitcoins or something else, there is not much I could spend it on. The network effect is a much bigger deal for currencies than any government requirements in the US.

Steven Kane April 19, 2011 at 4:38 pm

You are forgetting legal tender laws. As an example in the U.S., if I owe someone a debt, they can legally force me to pay them back in U.S. dollars.

Jon April 19, 2011 at 4:56 pm

You have this backwards I believe. If you owe somebody money, you can force them to accept US dollars based on the legal tender laws. But the creditor require you to pay dollars if your contract specifies that they be paid in bitcoins.

It is unclear to me how this relates to contract law though. If I contract to provide you with a certain number of widgets, it is unclear whether this constitutes a debt that can be redeemed in dollars. And whether they are widgets or bitcoins doesn’t seem like it would matter. I’m definitely not a lawyer, though.

Steven Kane April 19, 2011 at 7:41 pm

You are right, I did get it backwards.

Scott April 19, 2011 at 4:49 pm

You’re kidding right.

“a person or group of persons having absolute authority to enforce it”

If you have absolute authority, then you CAN make someone do something.

Jon April 19, 2011 at 4:59 pm

Oh dear. I lose on reading comprehension. I’ve somehow been reading that as “having no authority to enforce it” all this time. Whoops.

Trent B April 19, 2011 at 4:27 pm

Jon,

What do you mean with “That group of people are the ones who run bitcoin servers”? Do you know of some bitcoin servers somewhere and/or do you know the group of people running them? I have been searching for both for some time now without success. Help me out here.

Matthew Dutton April 19, 2011 at 9:51 pm

I make bitcoins with my spare cycles. Anyone can make them (with enough CPU power). That’s part of the appeal.

Here’s a start to setting your own up:
http://www.bitcoinminer.com/

The basic idea is that, eventually, the coins will be worth roughly the cost of the energy required to produce them.

Dan Weber April 20, 2011 at 9:20 am

From the Bitcoin FAQ:

It’s a common misconception that Bitcoins gain their value from the cost of electricity required to generate them. Cost doesn’t equal value – hiring 1,000 men to shovel a big hole in the ground may be costly, but not valuable.

This next quote isn’t relevant to what you said, but it is to what some others have said in this page:

Also, even though scarcity is a critical requirement for a useful currency, it alone doesn’t make anything valuable. For example, your fingerprints are scarce, but that doesn’t mean they have any exchange value.

Anthony April 20, 2011 at 2:31 pm

“For example, your fingerprints are scarce, but that doesn’t mean they have any exchange value.”

Except in certain limited cases to mafia doctors…

tom April 19, 2011 at 2:53 pm

“Private fiat currencies have potential value only during hyperinflations, or extreme deflations. ”

Also during periods of high taxation. This is where the anonymity comes in.

Jonathan April 19, 2011 at 3:10 pm

It seems plausible that a private fiat currency could be the cause of a hyperinflation as people gravitate towards a private money that they find credible in a world of diminishing trust in state fiat currency. Or rather, without such a private fiat money the public fiat money will remain credible for longer than it otherwise would.

As to Tylers assertion ‘Private fiat currencies have potential value only during hyperinflations, or extreme deflations.’ one could note that gold and silver have rallied a great deal and we have had neither hyperinflation or extreme deflation. Granted they are not fiat but in this context what’s the difference?

Ryan Vann April 19, 2011 at 3:26 pm

The Whiskey Rebellion or even recent rulings against the liberty dollar provide examples of how governments regard parallel currencies; I could only extrapolate that they’d be just as hostile towards fiat. So Tylers comments seem, at the least, untested.

I suspect he has Gresham’s Law in mind as a basis for this assertion, but rather than a general law of currency, Gresham was observing the result of specific national policies (including the forced acceptance of nominal valued currencies with different market values).

Jim Wise April 19, 2011 at 3:23 pm

David,

You make two points:

“You’ll also note that the collusion problem requires tens of thousands of individuals to collude for it to work, and each one of them willing to devalue their OWN currency.”

No, it doesn’t — it’s the miners who have to collude, not the users, and as the article points out, it really only requires a few major miners to be involved; once enough bitcoin transactions involve parties participating in the collusion, the network is effectively split into two currency networks, each with different ideas of fiat value of the currency, with neither able to accept the others’ transactions. It’s also worth remembering that as with other peer-to-peer networks, it will be the teams issuing the software people actually use to do these transactions that will decide how such transactions are issued. It doesn’t actually require collusion between end-users at all.

“In other words, it’s not a problem. It’s like asking US Citizens to make all of the dollars they own worth less and trying to get 51% of them to agree to it.”

Yeah, we do that every four years. It’s called an election.

Dan Weber April 19, 2011 at 3:28 pm

I’d like BitCoin to work, but I’m worried by the massive amount that BitCoins seem to be going up in value.

I want a currency that is a store of value. Let me hold BitCoins and come back to them in a few months and have them be worth about the same amount of wealth.

The way it’s rising so consistently screams bubble. I want to see what happens if it falls for a few weeks. Will all the speculators jump out of it and leave us with people just laughing at those who didn’t get out in time?

Unfortunately it seems that lots of the BitCoin community sees the rising value as proof that it is good, instead of a signal that it’s not yet ready for prime time.

gwern April 19, 2011 at 4:28 pm

> Unfortunately it seems that lots of the BitCoin community sees the rising value as proof that it is good, instead of a signal that it’s not yet ready for prime time.

Imagine bitcoin goes on to be a successful online currency that lasts for decades; imagine a graph of its value against the USD over those decades. In what part of the graph is there a consistently rising value? In what parts are there many fluctuations which average out to minimal change?

Dan Weber April 19, 2011 at 4:47 pm

I see no magic number for the “market cap” of all Bitcoins. It could be $21,000, $21 million, or $21 billion.

I want to have a few hundred dollar in Bitcoins so I can buy and sell stuff with tiny transaction costs. If the currency fluctuates by 10% a week, it’s not stable enough for me to leave them alone — which I have to do, because the transaction costs are not in transferring bitcoins, but in changing bitcoins to and from my national currency.,

mpkomara April 19, 2011 at 3:36 pm

Since Tyler linked to Bitcoin in June 2010 and that’s when i first got involved, I thought I’d give him a fair shot at getting a finder’s fee. I offer Tyler 100 bitcoins if he does a little more in-depth analysis than this weak post. anyone care to match my bounty?

mpkomara
full member, yo

Jeff Garzik April 19, 2011 at 4:05 pm

Speaking as a bitcoin developer…

Tim Lee’s analysis has a major error, with regards to collusion: bitcoins rely not only on the miners to produce transactions, but also the majority of interested parties (clients) to send and receive transactions, to hold and use bitcoins.

Clients do not blindly accept what miners produce; there are thorough checks. If 80% of bitcoin miners decide to issue themselves 100 bitcoins per 10 minutes (as opposed to today’s 50), they would immediately segment themselves away from the majority of bitcoin users, which would ignore these “invalid blocks.”

Thus, a major change in the “network rules” is only possible if the majority of the bitcoin community — users as well as miners — agree.

The holders of bitcoins have the most important vote.

Jim Wise April 19, 2011 at 4:16 pm

Sure, but only as long as the majority of bitcoin users are technical and interested in the protocol. If/when bitcoin sees mass market adoption, won’t it be the developers of the most widely used bitcoin clients/sdks who need to collude, not the many users of their products?

And even if the protections remain strong enough that if a plurality of miners change the rules, the network splits, won’t users have the incentive to go with the side of the split that allows them to keep spending their currency with the merchants they want to conduct business with as much as the side which has kept more strictly to the original value of the currency, again assuming that its the users and not the developers of their bitcoin software who decide?

(Software vendors will definitely have an incentive to go with whichever side of the split keeps the most people using their product. I suspect in such a split, `which client can I use to shop at the stores I want to shop at’ will be more important to most users than `which client is fighting inflation’; that’s how they vote in the real world, after all…

Yossarian April 19, 2011 at 4:54 pm

I love MR but your analysis and the awful article you referenced (Timothy Lee of Bottom-Up) lead me to believe that I should invest a lot of time looking into Bitcom myself. When generally wise analysts like Cowen are so illogically dismissive of a potential innovation it is time to look at said innovation as a potentially golden opportunity.

Jon Matonis April 19, 2011 at 5:01 pm

Tyler, I am confused and shocked by your analysis, especially given your NME days with RK. You should know better. It’s not that I really care about your analysis except for the fact that economist voices on the topic of bitcoin have a disproportionate impact at this point of its evolution.

First of all, you admit to still being confused. I agree with you that you are confused. So, why did you pen an analysis? Once you do some basic research, you will understand that bitcoin is essentially digital gold as far as scarcity is concerned. Gold is merely a byproduct of the big bang (atomic number 79). It has value because mankind has assigned it value through the ages. The bid/ask on bitcoin is no different than the bid/ask on gold. It has value because the market has given it value (probably for its digital properties in enabling a tax-free parallel economy). The central bank may have a monopoly on the issuance of legal tender but it does not have a monopoly on creating a mass illusion. Free individuals can generate a mass illusion just as a central bank creates the mass illusion of paper as value.

EorrFU April 19, 2011 at 5:15 pm

The achilles heel will be the inability to adjust the currency to meet the demand for bitcoins, especially since the creation of new bitcoins declines over time. Eventually deflation will cause serious problems and people will horde.

Dan Weber April 19, 2011 at 6:04 pm

This would be true if the Bitcoin were the currency for a nation (or similar).

We need enough US Dollars to represent the wealth in the US. If we never made new US Dollars, people would hoard them.

But the Bitcoin has no domain. It is one currency among many. Ideally each Bitcoin would have a stable value, and given a finite number, the total percentage of the world’s wealth represented by Bitcoins will slowly decrease each year.

Ghost of Murray Rothbard April 20, 2011 at 9:40 pm

‘At what point does a man’s cash balance become a faintly disreputable “hoard,” or the prudent man a miser?’
‘Actually, money does not “circulate”; it is, from time, to time, transferred from one person’s cash balance to another’s. The existence of money, once again, depends upon people’s willingness to hold cash balances.’

http://mises.org/money/2s9.asp

Gabe April 19, 2011 at 5:20 pm

Hording Silver seems to be causing it’s relative value to rise not fall. The FRN fell to 1/44 of a silver ounce today.

Ryan April 19, 2011 at 6:16 pm

Wouldn’t the infinite divisibility of each bitcoin help prevent liquidity traps from forming? And given the infinite divisibility of bitcoins, why is there a reason to believe they will necessarily represent a smaller and smaller percentage of the world’s wealth as time passes? There are only 21 million bitcoins, but there are infinite bitcoin bits.

Ryan April 19, 2011 at 6:18 pm

(Although it *is* worth noting that at present the client has, I believe, been written to only deal with transactions .00000001 bitcoin at a minimum. But there is no reason this minimum could not be lowered further.)

Ryan April 19, 2011 at 6:20 pm

Edit:
“There are only 21 million bitcoins” should read “there will only ever be 21 million bitcoins at most”
“transactions .00000001 ” should read “transactions of .00000001 “

Steve Roth April 19, 2011 at 6:33 pm

There is no such thing as “investment assets.”

Investment is a flow.

Assets are a stock.

In the national accounts, “investing” means putting money in real assets.

I think you mean “financial assets.” When we store our money in financial assets we call it “investing,” but it is actually (in the language of national accounts) “saving.” If you save, you by definition do not invest in real assets. (Though the money you put into the big swirling pool of financial assets — or an identical, fungible equivalent — may flow back out of that pool to be spent on investment, consumption, or paying taxes.)

loyal reader April 19, 2011 at 7:42 pm

Linking to the uninformed ramblings as “the best piece I’ve seen on Bitcoin” is sad.
I have been researching the Bitcoin for almost two months now, and that is quite the worst article i have come across.

Prakash April 20, 2011 at 1:14 am

Mencius Moldbug’s point on gold seems to be relevant here.
Money is the only bubble that does not pop. Whatever uses a material has had before it became money, once it becomes money, that usage shrinks big time.
After that, it is only a persistent mass illusion.

Satoshi has designed something that is brilliant. He/She will probably end up being the first person in history to end up making megabucks out of providing a
public good.

I don’t understand Tyler’s point about the anonymity protocol. What use is the anonymity protocol without the currency? People have been able to communicate
anonymously for a long time. It is only trade that has not been possible until now.

As for the eventual deflation, I really love the idea. A super-strong currency will become the ultimate storage asset.
People will revert to storing only one thing – the currency. Almost all financial manipulation will have to be done at some totally other level.
The great brain power pumping into finance can find itself other useful things to do.

Also, due to the anonymity, almost all taxes would have to shift to visible things, I’m hoping, land value.

Doc Merlin April 20, 2011 at 5:09 am

Tyler is ignorant of modern cryptographic techniques. There are already many ways to transfer money anonymously.

On the other hand, Bitcoins have demand because of guaranteed scarcity, and ease of transport, and infinite shelf life AND anonymous transfer and built in transaction receipts. These properties make them effective money.

Doc Merlin April 20, 2011 at 5:14 am

“The anonymity scheme means there is some reason to grant one-time seigniorage to the original currency issuers.”

There are no “the original currency issuers” thats not how it works. New currency is made by checking old currency to make sure that no fake currency is being made and no transactions are being faked. I know you don’t really understand the math behind this, Tyler, so you will have to either trust us, learn it, or remain wrong. Its called “cryptographic proof of work.”

Corporate Serf April 21, 2011 at 1:37 pm

This should tie up with the earlier discussion of economists not learning enough math. Though, Tyler and Alex are probably better than most.

Andrew' April 20, 2011 at 6:44 am

How are these factors different from most sovereign currencies? Taxes. What else?

ladderff April 20, 2011 at 7:16 am

The real question here is why we as a race are generally too stupid to adopt this and related technologies. We’ve all been able to sign and encrypt email, for free, since 1991, but people are still getting tripped up when incriminating emails they’ve written turn up. It’s free. Maybe if someone put a price on this sort of thing people would adopt it? Anyway it seems to me that this is the biggest obstacle to widespread adoption of BitCoin—that and all of the misapprehensions like those to which Tyler links.

Anthony April 20, 2011 at 2:44 pm

How many incriminating emails turn up *because the recipient leaks them*? All the encryption in the world is useless if the trusted party betrays my trust.

While failure to sign emails is basically laziness, which is *really* more valuable: the ability to prove a forged email a forgery, or the ability to claim a genuine email is a forgery?

Vandroiy April 20, 2011 at 7:55 am

The article does not take the strong natural monopoly into account. Another incarnation of an anonymous currency would require massive advantages to be able to compete with Bitcoin, because the latter already has begun establishing a market. Unless an investor pushes it, this won’t happen — and an investor is a massive disadvantage in terms of trust within the target audience.

Likely: it’s Bitcoin or nothing. Your scenario is not likely. If the world were to function the way suggested in the post, natural monopolies with far less design quality, like Windows or Facebook, would be long gone.

Cyrus April 20, 2011 at 8:14 am

Alta Vista? CP/M? MySpace? Hotmail?

Arthur B. April 20, 2011 at 8:14 am

You make a point that, like any fiat currency, bitcoin can fall to zero quickly. However, I don’t think the value of bitcoin lies in its anonymity… If anything, it’s a best pseudonymous and would likely be replaced by cryptographic transactions offered by bitcoin banks, for the security conscious.

Ultimately, the value of bitcoin will not be in feature X or Y, but merely in its adoption. If there are many people accepting bitcoins, bitcoin is valuable and it’s a good idea to accept it. There are different attractors for the value of fiat money. The one where it’s valuable is very strong, as demonstrated by the resilience of government fiat money, even in the face of absurd inflation.

Russ Nelson April 20, 2011 at 9:14 am

Why do people always get so confused about money? Money is a thing that people will always accept in trade. If they are being forced to do so, then it is a fiat currency. If they do so only because they know that other people will always accept it in trade, it is not a fiat currency. Is gold money? Can you always get people to accept it in trade? If so, then yes. If not, then no.

Why should the price of money not change? Money is, after all, just another thing, subject to the laws of supply and demand. If you are in a situation where you can barter for everything you need, you won’t need much money. If your life is uncertain, you will want more money than if your life is settled. The value of your currency becomes more unsettled if the quantity of it varies.

Dan Weber April 20, 2011 at 9:34 am

Here is a TL;DR for this page:

1. When economists complain about technical details of Bitcoin’s implementation, they are probably wrong.

2. When Bitcoin fans complain about economists not understanding Bitcoin’s monetary policies, they are definitely wrong.

KevinH April 20, 2011 at 2:48 pm

Thanks Dan. The comments were TL;DR also and so yours at the end was the perfect place to scroll to.

jhn April 20, 2011 at 4:49 pm

I don’t know what kind of money Bitcoin is, but it’s the same kind of money as gold: a scarce item with no intrinsic use (yes yes, gold has uses) that some people choose to accept and value and treat as money. Whether that counts as “fiat” or not seems kind of semantic.

Felix April 24, 2011 at 11:44 am

The central problem is that there is a lack of understanding for why even ordinary fiat currency has value.

For example, you find this:
“Theoretically, if you persuaded everyone that dollars were worthless, this would become a self-fulfilling prophesy”
(http://timothyblee.com/2011/04/18/the-bitcoin-bubble/)

That is SO wrong. Fiat currency has value because the central bank can create arbitrarily high demand for it, and that is because the (sound, non-QE-doing) central bank has more assets denominated in its currency (=loans) than it has currency issued. Therefore, by refusing to renew these loans, and forcing the creditors of its assets to pay back in currency, the demand for money rises infinitely (until the central bank chooses to stop it) because creditors would have to pay back more currency to the central bank than there is in circulation.

The reason that bitcoins have value is that they are scarce and some people think it’s cool to own them, just like some people think it’s cool to own stamps or pokemon cards. The value of bitcoins is no more stable than the value of pokemon cards, the value will fall to zero as soon as it is no longer ‘cool’ enough to own them.

Dominic Sayers May 19, 2011 at 9:00 am

The recent spike in the BTC/USD rate is probably to do with the “cool” effect, as a result of recent media coverage. But your comparison with Pokemon cards is pejorative. If you had said fine art, vintage wine or vintage cars then that would have been, like stamps, a reasonable analogy with a scarce and useless commodity whose value fluctuates considerably but which is still collected by grown-ups.

BitCoins are not as aesthetically pleasing as any of those examples but they are a great deal easier to use as a medium of exchange. This is a quality of money that has been overlooked entirely in this thread. This affordance of BitCoins is another reason why they have value.

I am not an economist. Or a widely-read financial blogger.

Mark Herpel April 24, 2011 at 1:07 pm

I think Bitcoin is GREAT and I wish there were more of these systems.

Mark Hotels May 14, 2011 at 3:00 pm

There is a marketplace where Bitcoins are convertible to euros, dollars, etc… Hence it is as real and practical as these other currencies.

“It is a privately created fiat currency, bundled together with an anonymity scheme for transactions. The anonymity scheme means there is some reason to grant one-time seigniorage to the original currency issuers. Eventually the anonymity scheme, in some form or another, will be available without the fiat currency. At that point, or more likely before then, the fiat currency will fall to near-zero in value. Hold it at your own risk. The original issuers will have kept some of their initial gains.”

The above does NOT sound at all like how bitcoins are supposed to work. Perhaps you should reread both the weusecoins.com blurb as well as the original paper by Satoshi Nakamoto. EVEN MORE IGNORANT, the description of bitcoin as a fiat currency is ABSOLUTELY WRONG. As an earlier poster said, people are NOT forced to use bitcoin *by fiat* (e.g. by decree) so BITCOIN IS ABSOLUTELY NOT A FIAT CURRENCY, D-U-H.

Mark Hotels May 14, 2011 at 3:08 pm

@Jon “Fiat currency” has come to imply “unbacked currency” but this is NOT its precise meaning.

Bitcoin is “unbacked currency” but NOT fiat currency. In fact, a currency people are forced to accept by “fiat” can still be a backed currency.

The dollar is a fiat currency because you have no choice but to accept it as payment and, READ CAREFULLY, courts (backed by the power of the state) will consider a loan paid with dollars to be effectively discharged _whether or not you believe dollars are worth anything_.

Accepting of Bitcoins as tender, however, is NOT legally enforced but rather an option you exercise.

Calling bitcoins “unbacked” (or in other words, not backed by any “commodity”) is pretty accurate. Calling it “fiat” is sloppy.

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