Monday, December 18, 2017

What Is Bitcoin?

Exactly where does Bitcoin fit into the monetary scheme of things? Here are some questions and answers.

By Open Source

1. Is Bitcoin a form of money?

Bitcoin is not a physical good such as gold that you can hold in your hands. Nor does it fit into von Mises’s regression theorem. It is not a consumable economic good, or even a piece of paper. It’s frankly just a bunch of numbers in a database. But before we decide whether it is money or not, the first question becomes, “how are you defining money?”

The overly loose use of the word “money,” even among sophisticated economists, has caused much confusion in the field. In my world, I define money as a kind of claim check, which is a kind of contract. (For more on this, see Edward C. Harwood, Cause & Control of the Business Cycle, American Institute for Economic Research, E.E.B., Sept. 1974; and Money, Banking and Inflating, E.E.B., Apr. 1986.)

Sometimes a purchasing transaction is immediate. (I sell you a computer and you give me an ounce of gold in return.) Sometimes a transaction has an element of time. (I sell you a computer and you give me something that I think will buy me an ounce of gold in the future.) In the first transaction, the gold is considered something exchanged for its own value. In the second, the thing exchanged is a kind of contractual promise of stable purchasing power in the future.

Gold itself has both qualities: intrinsic value, and holding value based on contract-like trust. A dollar, although no longer tied to gold, still has value as a contract. So does Bitcoin (in spite of it being wrongly but conveniently classified by the government as a commodity). Neither has intrinsic value; but both have contract value, although to varying degrees, and certainly less than gold.

Bitcoin will have to prove itself to be a trustworthy store of value over the long term. As it stands, there are risks. But there are risks with the dollar, too. We have the habit of accepting the dollar contract even though it loses value at an average rate of 2 percent a year. Bitcoin’s value is very volatile at the moment, and therefore its utility as money is limited. But it may become more stable in the future, in which case its potential for acquiring trustworthiness–and therefore usefulness–accrues.

2. Is Bitcoin too volatile?

Admittedly, much of the current rise in Bitcoin’s exchange value vis-a-vis the dollar is due to speculative activity for a quick buck. But there may come a time when its value stabilizes. Remember that Bitcoin is not something of value in and of itself like gold; it is a contract, just like today’s dollar. The contract medium that is Bitcoin may come to a dollar exchange value that is relatively stable, or at least stable enough, perhaps because of its purportedly limited supply, or because it proves to be reliable, or because some people find it useful somewhere in the world for whatever reason.

If we could take away its speculative volatility, Bitcoin’s price probably would still vary. But the variance would be the same juggling that would go on if the government were to declare that within the next two months the US will return to the gold standard. The “price” of gold would seem to climb in dollars, but in reality it is the dollar that would immediately drop way below the current $1,200/oz and gyrate until it found an equilibrium between dollars in circulation and available ounces of monetary gold.

This is just as true of Bitcoin under what are similar circumstances. For sure, Bitcoin is volatile right now mainly for speculative reasons; but it may also be searching for its exchange value vis-a-vis the dollar and other currencies if and when it were to become more ubiquitous as a purchasing medium.

3. Is Bitcoin nothing more than a speculative bubble?

Possibly. It may just go down in history as today's version of the 16th century Tulip Mania. Some are even calling it a Ponzi scheme because there seems to be nothing behind it. However, once the speculative froth has been beaten out, and if Bitcoin’s utility can be quantified (admittedly a big if), its “price” (i.e. dollar exchange value) will drop to–or rise to–the level it needs to be at to fulfill its contractual duties. That may be zero or it may be many thousands. We just don’t know yet. And it may fluctuate wildly until the market determines whether it is useful as a medium of exchange, and/or as an alternative to other failing monetary units, and/or something else.

4. Are Bitcoin transaction fees too high?

They do seem to be increasing. But keep in mind that credit cards charge an average of 2 percent for every transaction. Think about it: 2 percent of every purchase you make with your credit card goes to the supplier of credit, not the manufacturer or retailer. And this is assuming one does not avail oneself of the credit option. If you do, you will pay up to 20 percent more to the credit supplier just for the privilege of not paying within the month. So apparently, people are willing to fork up transaction fees.  And in some countries the extra cost and/or risk is less than it would be with the local currency.

5. Are Bitcoin transactions irreversible?

This seems to be true, and this is where Ethereum’s smart contracts may come in handy. PayPal already works with the dollar and has established a great system for purchasing safely and efficiently at a distance. It arbitrates disputes and can reverse transactions. Some of the cryptocurrencies like Ethereum are doing this using blockchain technology, and they are even more efficient than PayPal. This could be tremendously useful, and not only in the US but in foreign countries where bank accounts and legal systems are not ubiquitous and/or reliable. Cryptocurrencies, even with all their drawbacks, now permit people around the world to use smartphones and digital units of account that bypass weak local currencies and insecure banking systems.

6. Are Bitcoin transactions anonymous?

Quite the contrary. Every transaction is traceable. The only thing keeping it semi-private is the password or wallet key feature that is tied to each user. Other forms of money are much more anonymous (e.g., cash, certain kinds of paper assets, gold), though not as convenient. In the US, it won’t be long before the government starts forcing Bitcoin and other cryptocurrency dealers to hand over records and/or to file reports to the IRS. Remember that all Bitcoin users owe capital gains taxes (and perhaps even sales taxes) on every transaction, for example if the value of a seller’s digital currency has risen between acquisition and sale. (Talk about a wrench in the works!)

7. Could Bitcoin replace the dollar and other currencies?

I believe Bitcoin will never replace the dollar because of this taxation feature. It is what has prevented gold from being used more widely as a purchasing medium. As it stands, governments have three choices if they want to retain their monopoly on money: Reduce Bitcoin to a crawl through taxation; make it illegal; or create a parallel system that would out-compete it. The last would be expensive and the second would be unpopular, so I will bet they will choose the first.

8. The dollar is backed by debt. What is behind Bitcoin?

In fact, Bitcoin is backed by nothing, at least not in the traditional sense. But first, let’s clear up one point: The dollar is not backed by much either. Some say it is backed by debt. More accurately, it is backed (and only to a percentage) by US creditworthiness, which in turn is backed by the country’s potential source of payment of its debts, i.e. the American taxpayers and the relative strength of its political-economic system. This is certainly better than nothing, but it’s not something to crow about, especially since the US came very close to a dollar collapse in the late 1970s and almost did again in 2008. What will the next showdown look like?

Today, the Fed is putting us in even greater peril of another dollar collapse, so in fact the dollar isn’t much better than Bitcoin with regard to what’s backing it. In fact, it is this current dollar fragility that explains, in part, the interest in Bitcoin, because Bitcoin and others like it are outside the dollar system and therefore might preserve and even increase in purchasing power if the dollar (or another currency) were to collapse.

9. Is Bitcoin just a ledger of unbacked liabilities?

This seems inaccurate. There are no liabilities behind Bitcoin, backed or unbacked. It is a ledger of a series of contract terms in the form of exchange transactions. The whole notion of assets and liabilities is avoided by Bitcoin’s structure. In fact, that’s the beauty of it. Bitcoin is a set of records of contracts on a medium that is not paper but rather digital memory, and it is allegedly permanent and inalterable.

The contract can be verified and preserved in a way that is unique to the modern world: electronically. Because it is (purportedly) un-inflatable, Bitcoin completely avoids the whole idea of assets and liabilities “behind” each unit. It seems to completely obviate the need for something of trusted value (gold or paper dollar) altogether, since the contract itself is said to be 100 percent reliable.

That is, until the lights go out.

Bitcoins (computer records) have not yet been proven to be permanent and stable. To that degree and up to now, they are fragile. Bitcoin creators can decide to create more, or fork, or cause some other deterioration of its current qualities; or dealers can go broke, or get hacked, wiping out all the Bitcoins they are holding; or a war could damage the electrical infrastructure. Then what?  But today, that is also true of all accepted monies.

Today, money is all about trust. Much of the advancement of western civilization came about because of trust among contracting parties. Before banks, the money used between contracting parties was often a commodity such as gold. As banks evolved, as trust in bankers evolved, and as stability evolved, money evolved as well to include paper instruments promising to pay gold, such as a bank note. With further evolution, banks began creating credit backed by real bills, which is a type of short-term loan contract based on things coming to market. In this case, the borrower reimbursed the loaned credit in a timely fashion as the things were sold, and the trustworthy banks retired it from circulation as promised. (For more details, see the above-linked books by Edward C. Harwood.)

This tried-and-true banking system based on a promise to pay gold or gold-equivalent instruments broke down during the 20th century, and along with it trust has eroded. During those years we allowed our government to replace gold and real bills with Treasury debt. We have become accustomed to using dollars as money based on the value of Treasury bonds that purportedly back it; but ever since we gave the government this power, the dollar has lost around 2 percent purchasing power every year. Over time this is something like a 98 percent loss in value. Some people believe the system will hold up anyway, but since debased currencies tend to fail over time, some monetary historians (and I) are worried about the dollar. So are some Bitcoin investors, apparently.

Only patience will reveal if this technological version of money will take hold in the world economy. Personally, I would prefer gold and gold-backed money, but we don’t have that option, do we? We use dollars every day, all the time, even though these dollars might collapse within our lifetime.

So, in your opinion, which will be first? Bitcoin or the dollar?


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