TLDR - Cryptocurrencies are the future of currency, not of money.
There’s a lot of talk about bitcoin these days, and from the tone of the article you can generally tell who’s got theirs and who doesn’t. The spectacular rise of BTC from a fraction of a cent to $1000 has basically split opinion on the whole into two camps. The'I-got-mine-see-how-smart-I-am’ camp goes on and on about how BTC are going to make them rich and the ‘oh-noes-i-have-no-bitcoins-i-suck-bitcoins-suck’ keeps predicting doom for BTC and eventual retribution for those who are violating the commandments against avarice and pride. In this to-and-fro, it’s easy to lose sight of the long term. BTC has been around for a very short while in the grand scheme of things so let’s try and see where this whole scene might end up in the near long term.
Before we begin, let’s draw a distinction between wealth, money and currency. These definitions are quite amorphous and endlessly debated but let’s take these generally as givens for our purposes.
- Wealth is all the stuff you have which is valuable - your house, land, bank deposits, stocks and bonds and so on are your wealth.
- Money is that part of your wealth that is denominated in a fashion that other people are generally happy to accept. So your bank deposits are money but your 30 shares of Apple are not money and neither is your house. No one is going to accept a fraction of a share of Apple in exchange for a sack of potatoes, but they will accept fractions of a dollar. Money is in this sense a widely accepted token of wealth and as such represents wealth in its most liquid form.
- And lastly, when the 'money’ gets a token that can be handed over to another person to signify change of ownership of the money, that token is known as currency. Rupees, Dollars, Cents etc. are forms of currency.
Currency gets its value from the money it is a token for. Money gets its value in very interesting ways. Here’s a small riddle I like to ask people new to these concepts - Is gold money because it is valuable or is gold valuable because it is money? Think about that for a bit (or not) and then read on….
Money gets it value from at least two sources that I can think of
- the properties of the thing being used as money and
- the social, political and economic milieu (and of late, technological as well as we see with BitCoin)
For millennia, gold has been the ultimate form of money because of intrinsic properties of gold that make it the ultimate token of wealth. Easily divisible, hard to counterfeit, stable supply, totally indestructible and lack of any other use for gold made it a very convenient token of wealth. Because of these properties, people were happy to accept gold in exchange for goods and services and because people were happy to accept gold, gold became more and more useful as money.
However, we haven’t been using gold as money for several decades now. 99% of money in the world today gets its value not from the paper it is printed on but the entire dynamic geo-political system that collectively subscribes to the notion that money has value. It’s a brilliant trick this one, and one not easily pulled off and even less rarely sustained. These days money gets its value chiefly from these three sources
- You can pay taxes with it (since, like forever)
- You can repay debts with it and
- You can buy oil with it
The second point was the one I found most interesting. If you look at a Federal Reserve Dollar, it says that the note is legal tender for settlement of debts. What that means is that if Moe owes you money and he offers you dollars, you have to accept them, no matter your opinion of the US Dollar. If Moe goes to a judge and says “Here’s the two thousand dollars I owe Moe”, the judge will cancel the debt against Moe, even if the USD has gone the way of the Zimbabwean Dollar in the mean time, and 2000 dollars won’t even get you a cup of coffee any more.
If you look carefully at the above three points, they all have one thing in common and then we can conclude that money gets value these days from the coercive power of the state. In fact, any money that doesn’t intrinsically have value as a token of exchange due to its own properties gets its value from the coercive power of government. This is your common or garden variety 'fiat’ currency system.
So where does that leave BitCoin? Pretty much squarely in the former camp. BitCoin is the new gold with some pretty major differences. Like gold, it is indestructible, uncounterfeitable (allegedly), infinitely divisble and so on. As for the differences, there are two major ones - one in BitCoin’s favour and one working against it. The first is that you can send BTC down a wire and they can end up almost instantaneously anywhere in the world, blithely ignoring national boundries and so on. The second factor which works against BitCoin is that there is nothing stopping anyone from starting a competing currency. The supply of BitCoin is limited, but the supply of cryptocurrencies is potentially infinite. My belief, as of this writing, is that the latter effect will preclude BitCoin from becoming a global store of value.
Also, issues in the crypto and legal and regulatory acceptance of BitCoin represent risks to the value of BitCoin. It can’t be denied that not knowing who, what or where made BitCoin is quite a hurdle to its legitimacy. Is it a CIA backdoor? Do we really understand the crypto? etc are all questions. Imagine if no one knew who had made Linux. Would it still power almost the entire Internet? When national fiat currencies collapse, they give plenty of warning and there are huge resources and geopolitical machinations that step in to prevent outright collapse. There is no such system protecting BitCoin. A loss of confidence in BitCoin can happen overnight and there is going to be no one there who has the power to keep the currency going as a viable proposition. These risks mean that people will hold on to BitCoins only as far as their risk appetite goes.
So, what’s the value of a BTC? Essentially, its value lies in being able to provide frictionless, anonymous, instantaneous payments. For BTC to be anything more than a fringe player on the world financial stage, it must offer frictionless exchange with existing currency systems. For this, it will remain in demand. However, for a currency to truly become a force in the financial system, it must also operate as a viable, long-term store of value. And this is probably not going to happen with BitCoin due to the risks inherent in its structure, recent events notwithstanding.
The only reason people are demanding bitcoin right now is because the price is rising. The number of things you can buy with it are not proportional to the value of coins in circulation. This is a characteristic of bubbles.
If you’re in any doubt about whether currencies intrinsically have value, just think - when the Euro launched, did people rush to buy it? Not really ( I was there). The Euro was backed basically by faith in Eurpoean monetary and currency institutions, and the Euro did add value by taking away the currency risk from intra-European transactions, but beyond that, no new value was added by changing the currency. Currencies only measure value, they do not create it.
If you’re buying BitCoin simply because the price is rising, consider yourself warned.