The Nature of Bitcoin, Part 2: Gold, the Dollar and Future Value

| Originally published on on January 17, 2014 |

In the previous post I discussed the interplay between the Bitcoin protocol and the Bitcoin currency and some of its implications. To sum up, there are two interesting points to make:

1) Bitcoin is often thought of as a one-dimensional virtual currency. This is incorrect as the underlying protocol enables much more extensive and complex functionality.

2) At the same time, the Bitcoin currency is sometimes referred to as just one “application” of many that can be based on the protocol (I said exactly this in my frameworks post). This is not exactly right either as we saw that the protocol and currency are both intrinsic to the system.

Once you understand the nature of Bitcoin, a protocol that enables valuable work that is in turn compensated via the Bitcoin currency, you realize that:

  • both protocol and currency are completely interdependent
  • together they enable novel and complex functionality that has value
  • the currency therefore has value and can be used like money.

So how does Bitcoin compare to gold and the dollar? In light of the above assertions, I believe it compares favorably. 

Let’s address this in two ways: first understanding the value behind gold/the dollar and then looking at the value of Bitcoin.

To frame this, I’ll refer to a portion of a post by Brad DeLong (also used by Krugman), where he talks about the underpinnings and the ceiling values of all three:

Underpinning the value of gold is that if all else fails you can use it to make pretty things. Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year (yes, I know).

Placing a ceiling on the value of gold is mining technology, and the prospect that if its price gets out of whack for long on the upside a great deal more of it will be created. Placing a ceiling on the value of the dollar is the Federal Reserve’s role as actual dollar source, and its commitment not to allow deflation to happen.

Placing a ceiling on the value of bitcoins is computer technology and the form of the hash function… until the limit of 21 million bitcoins is reached. Placing a floor on the value of bitcoins is… what, exactly?

Let’s start with his views on gold. Regarding gold’s ceiling, I have a quibble: in the long term, the supply of gold is not infinite, so price could go up arbitrarily based on demand. But let’s look at where demand for gold comes from. It has three broad usage categories: jewelry, industrial applications and a store of value (it is not scalable anymore as a medium of exchange). The first two uses are well understood – they have defined sizes and relatively slow growth rates. So demand (and price) could skyrocket if for some reason it were perceived as a relatively strong store of value. 

 Regarding his views on the dollar and the comparison to Bitcoin, I will raise three specific points:

  • This is an extremely US-centric point of view. Let’s say we believe that the dollar is in great shape – that still leaves 95% of the world’s population living with currencies and central banks that have proven time and again that they can fail (for more on this see This Time is Different by Reinhart and Rogoff).
  • The dollar supply has been growing at a fairly high rate, especially recently, which to some degree contradicts the “promise” that the Fed will not let its value sink. But I won’t overstate this point as I don’t think the dollar is in danger of failing in the short or medium term given the size of the US economy (and the current fragility of other currencies).
  • Paying taxes is largely a domestic affair. So you could have taxpayers using dollars for this purpose, while at the same time the dollar’s relative value drops compared to other currencies or commodities. I don’t see this as something that underpins its value in a broader stage.

However, I believe the broader and more important point is that by doing a hard comparison between Bitcoin and the dollar, detractors are implicitly assuming that Bitcoin must either become some sort of official national (or even reserve) currency or be a complete failure. But why resort to such extremes? It is much more likely that Bitcoin will be used in conjunction with existing currencies and commodities, and it could still be very successful. Knocking Bitcoin now because it could not possibly replace the dollar in the short or medium term (no one knows anything in the long term) is a red herring. Granted, detractors framing the discussion in this way may just be reacting to hardcore supporters’ assertions that Bitcoin will soon “take over”. But that is not a realistic position either.

So now let’s complete the discussion: what underpins Bitcoin and what is its ceiling value? Here I also disagree with DeLong’s post.

We have already talked about where Bitcoin’s value comes from: the ability to complete a fast, trusted transaction with anyone in the world without relying on a 3rd party. That is what underpins Bitcoin. It is no less valid than gold’s ability to make “shiny things” nor a central bank’s theoretical promise to not debase its currency (too much).

What is the ceiling? Unlike the dollar, there is no central bank with a mandate to avoid deflation. Unlike gold, whose uses are discrete and well understood, Bitcoin could be used in ways that complement large industries and in ways we do not yet imagine today. Its eventual price will be based on demand, which will depend on how many transactions are taking place on the Bitcoin network and the average Bitcoin amount transferred in each transaction.

My bet is that the number of transactions taking place will be orders of magnitude higher than we have today. Why?

Let’s explore an often used parallel: Bitcoin is to finance as TCP/IP is to communications. In the 1970s, 1980s and even 1990s, people could barely imagine what would result from the Internet (which is underpinned by the TCP/IP protocol). Heck, Krugman (admittedly a very smart man) thought the Internet’s impact on the economy would be no greater than that of the fax machine’s! What a difference a decade or two make: now we have predictions that 50 billion “things” will be connected to the Internet by 2020!! 

So, is it crazy to think that in the fullness of time a very large number of transactions from industries that deal with money could migrate to the Bitcoin network? Or that new types of transactions and contracts will be invented given our emerging capabilities? Sure, it might be crazy.

But in the event that it does happen, the Bitcoin currency will be greasing the wheels of this new economic engine. It could be worth a lot.