What Backs Bitcoin

As bitcoin goes mainstream, we’re seeing a rise in strong opinions about it. It’s the mac-vs-PC of the currency world.

JP Morgan CEO Jamie Dimon, famous for scoring a 25 billion dollar taxpayer bailout, thinks bitcoin is a fraud. Nobel economist Robert Shiller thinks it’s a “fad” and a bubble.

The always entertaining Paul Krugman thinks bitcoin is a waste of electricity. And Blackrock strategist Turnhill is afraid to price it because he says bitcoin’s got no “inherent value.”

On the other hand are the people who actually own and use bitcoins. Hodlers, [Hold On for Dear Life], who are often quite passionate about cyber-currencies. They’ve been very right so far, and don’t mind letting the world know.

The two sides are miles apart: skeptics think bitcoin and other cybercoins are snake-oil floating tulip-like upon the delusions of basement-dwellng anarchists. While basement-dwelling anarchists, some of whom now live on yachts in Monaco, think cybercurrencies are the wave of the future. A wave that will dethrone the devil’s very own paper money, along with that innocent if barbaric relic, gold.

Watch the video.

So who’s right? Is it cybertulips or is the US dollar about to get crushed like Amazon destroying a bookstore?

Today I’m going to address one main concern of critics, that there’s nothing “backing” bitcoin. This is what Turnhill was getting at with “no inherent value” and it’s a fundamental misperception of how currencies work.

The key here is a currency — like anything else in the economy including goods, services, or assets — doesn’t get its price from some mythical “inherent value.” Rather, prices come from simple supply and demand. Supply is the amount of the currency in circulation, and demand is how much do people want it. In the case of currencies, people demand them for two main reasons: to enable transactions, and to act as a store of value — for savings.

This means any valuable currency, including bitcoin, has value for the simple reason that it offers a feature bundle that beats competing currencies for some people, for some transactions, or for some savings. The currency to beat for bitcoin is, of course, physical dollars, electronic dollars, and to a lesser extent gold or new cybercurrencies with better features.

Value comes from usefulness, not from melting

So, first off, what does it mean to “back” a currency? The term comes from the olden days when paper money could be exchanged for something you can drop on your foot — typically gold or silver. You’d take your paper to a bank and trade it for gold — in the case of the US dollar, 20 bucks would buy an ounce of gold.

Now, this world is long gone at this point; first the Fed, then Richard Nixon repudiated backing. Which is why today the dollar can’t be traded for any backing commodity — if you give it to the bank they’ll just give you another dollar in its place, and give you a funny look.

Of course, you can still buy gold with dollars, just as you can buy a car or a pleasant night on the town. And you’ve probably noticed 20 bucks no longer buys an ounce of gold nor, for that matter, does it buy a very pleasant evening on the town unless your date likes McDonalds.

In the case of bitcoin, like the dollar, it is backed by precisely nothing. You can’t “redeem” a bitcoin for ounces of gold. And, also like a dollar, you can buy all sorts of things with a bitcoin — a coffee, a car, a house. And, of course, unlike the dollar bitcoins have gone up in value, not down, so you can buy a very pleasant evening on the town with a bitcoin today.

Stepping back for a moment, if we’ve learned one thing from the much-feared unbacking of paper money, it’s that backing mattered suprisingly little. It matters for controlling inflation, yes, but not for the actual price of a currency: dollars, pounds, yen still hold value decades after complete unbacking.

So backing is nice but it’s overwhelmed by supply and demand. Just as the main value of a shovel is its ability to dig dirt, not the melt-value of its iron, the main value of a given currency is its ability to enable transactions and savings. Transaction demand representing what’s in your wallet, and savings demand representing what’s in your bank or under your bed if you swing that way.

Value is in the eye of the beholder

Now note the currency doesn’t have to win at everything; it merely has to be best for some transactions, for some savings applications, and only for some people. If so, it has value — it’s worth something. Specifically how much value depending on how many people, how many transactions, how much savings, all set against the supply in circulation. If, on the other hand, nobody uses the currency to transact or save then, yes, it’s worthless.

In the next bitcoin video I’ll get into real-world numbers, asking precisely what transactions or savings are best suited to bitcoin, to other cryptocurrencies, or to gold for that matter. But for now the point is that, given its quasi-fixed supply, bitcoin has value not because tulips or ponzi, rather because it’s useful to some people for some transactions or some savings.

As for the debate itself, because we can see usage of bitcoin continues to grow along with the price, there’s nothing fundamentally odd or worrying about bitcoin’s soaring price, even granting that short-term bubbles are always happening across financial markets. Finally, getting out the crystal ball, it follows that bitcoin’s long-term price will tend to simply follow that demand: more or less transactions, more or less savings, for more or less people.