Saturday, November 23, 2013

Bitcoins, gold and currency

Bitcoin(s) are widely discussed in places from conspiracy blogs to the main stream media and even the government..

Depending on the news source bitcoins are a replacement for fiat currencies, a replacement for gold, an anti-establishment currency etcetera etcetera.

We decided to look at a couple of attributes of money/currency for easy comparison.

Dollars (Fiat currency)
Cost of production / extraction
Aside from particle accelerators humans do not produce gold, we only extract it .Real resources are used to extract and process gold.
Real resources are used to produce bitcoins. Bitcoins are created through a calculation intense process but ultimately that is/was somebody's decision. Somebody decided bitcoins existed where there were none before.
In effect the creation of bitcoins requires one to burn coal/ resrouces to create something which ultimately is somebody's edict.
Production of physical dollars requires resources. In the case of certain coins the value of resources consumed may exceed the assigned value of the coin. Keep in mind though that this is a choice, not a physical necessity. Virtually no resources are used to produce electronic dollars.
Store of value
The value of gold is in the eye of the beholder.  In specific circumstances the value can even be negative to the holder. Go swimming with your pockets filled with gold coins.
(marginal) cost of production has no bearing on value.
The value of bitcoins is in the eye of the beholder. Judging by valuations visa viz other assets they don't keep their value very well. Bitcoin's value can in/decrease significantly without any apparent reason.
The value of fiat currency is a function of the value of other currencies as well as the supply / demand characteristics for dollars
(negative) carry
It requires resources to store gold. One can argue that over time the cumulative storage cost will exceed whatever value gold has. Ask yourself what the cumulative cost was to keep a gold coin, created and  stored away in 3000BC, safe and secure until now.
It requires de minimis, but greater than zero resources to store bitcoins. As technology marches on eventually storage costs are likely to go up because required hardware and software safeguards will increase.
Until bitcoins can be lent out and generate a return greater than the safekeeping costs they generate negative carry.
Dollars come in two forms, physical and electronic. The former has storage costs if not lent out but with respect to the electronic form market liquidity allows for saved dollars to be lent out which provides an opportunity of positive nominal carry.
Gold has established trading / exchange mechanisms with known price discovery and market depth. (marginal) cost of production  - a longer term de facto floor in an increase of the quantity of gold extracted -  is relatively well known and flows from non-tradable stocks to tradable stocks are widely known and followed.
Bitcoins have relatively poor liquidity with little market depth and significant bid/offer spreads. As the number of bitcoin holders and transactions increases though that likely will change.
Dollars currently have established trading / exchange mechanisms with known price discovery and market depth. This was not always the case though and is likely not always to be the case going forward.
General observations
The main problem with gold as hypothetical centerpiece of a financial system is that the quantity of gold grows at a slow rate, by en large determined by physical boundaries on the rate of extraction and the difference cost of production and sales price. Therefore the connection between the real economy and the available stock of gold is only very loosely connected. Gold as currency may have made sense in a time when the real economy grew very slowly - more or less keeping pace with the increase in available gold - but as rates of change between the quantity of gold available and the real economy diverge the apparent relationship has become more tenuous. Gold does have a real demand as disaster insurance.
The number of bitcoins which will be created is (at this point) predetermined and seemingly arbitrary.
To my knowledge there is no mechanism to reduce the number of bitcoins which exist.
 Similar to gold it makes no sense to have a static number of currency units in a dynamic economy. IF bitcoin creators - the functional equivalent of the much maligned commercial banking system - were to decide to increase the number of bitcoins they will face the same issue that the monetary authorities and the commercial banking system face now.
Dollars can be created and destroyed at will. In order to keep the quantity of dollars in line with the real economy society has to be able to accurately measure the size of the real economy, and collectively have the discipline to change the number of dollars in existence accordingly.
Historically though most fiat currencies have been inflated into oblivion, largely because individual interests were not the common interest.

 A number of people say that the difference between currency and money is that money has to be a store of value and currency is not. The moment any currency is used in exchange for anything - which usually is the main purpose of a currency in the first place - the value becomes relative rather than absolute. The notions that a currency can be a store of value and a medium of exchange are by definition in conflict.

That aside, the generally accepted aspects of money are:

  • Unit of account
  • Medium of exchange
  • Store of value
  • Measure of value

Bitcoins are a medium of exchange, but when the value relative to other media of exchange can move by huge amounts in a very short period of time  it's hard to see how they can be considered to be a store of value, or a measure of value. With respect to Unit of account, are (for example) dollars measured in bitcoins or are bitcoins measured in dollars)?

Finally, bitcoins already are a fiat currency ("Let it be done"- the collective decided that bitoins can be used in exchange of value) but if/when the supply of bitcoins are arbitrarily changed all bets are off.