Digital gold, or over-priced fad?
What are bitcoins comparable to?
Many have compared bitcoin to digital gold, but it is perhaps more directly comparable to fiat currencies such as the US Dollar. Bitcoins and fiat currencies are not backed by any sort of physical commodity, and share the following physical features:
- Able to act as a store of value
- Medium of exchange
What gives fiat currencies value?
What gives currencies their value is the confidence people have in it. What gives people that confidence, has been arguably the backing of a government. Governments encourage trust in a currency by accepting it as legal tender and delegating regulatory oversight to a central bank. The government also accepts it as the medium for paying taxes and doling out fiscal spending. Thus, market participants gain the confidence that a currency is a stable store of value because they know the government is not going to allow (as much as possible!) the value of the currency to fluctuate too wildly in a short period of time.
So what is the value of a bitcoin?
To determine the value of bitcoin, we can observe how it performs as a currency. To begin with, anything in the world with the following traits are technically desirable as currencies.
If a currency possesses abundant supply, the resulting inflation would invariably lead to critically high, economically ruinous prices
- Ease of counterfeiting
The supply of currencies should be something that is limited or controlled, depending on your economic regime. If currencies can be easily counterfeited, fake currencies would negatively affect the value of a currency.
- Minimum denomination
If we used currencies that were difficult to split up – e.g. seashells, we would find it very difficult to get the flexibility to pay for cheaper items
There is a reason people don’t use a certain small island’s 4-tonne stone coins as legal tender – they’re hard to keep in your wallet. Currencies should be easy to store, and easy to transfer ownership of.
- Ease and cost of transportation
Gold bars meet every criteria listed so far, but traditionally come with a cost and time lag to transfer ownership of – particularly between borders. Fiat currencies thus possess advantages over gold in this regard.
Leaves meet every criteria listed so far as well – but as they obviously do not last for more than a few weeks at a time (optimistically), they are not very useful as money. Currencies should be reasonably durable.
Bitcoin is valuable because it meets – and exceeds several criteria to be a currency
Bitcoin has a limited supply of 21 million, that will be reached in 2140. “Halvings” occur every four years, meeting the criteria of scarcity. This is seen as an advantage by some over fiat currencies, particularly as governments have been injecting trillions of dollars in recent years to stimulate the economy.
Bitcoin is practically impossible to counterfeit given certain hard-coded design features, while also entirely preventing the problem of double-spend as well.
Bitcoins are also divisible into as small a quantity as desired, meeting the criteria of minimum denomination.
Finally, bitcoins are digital currencies that are relatively easy to transfer ownership of, and given the highly digitised environment most people live in, meets several criteria of being practical, durable, and easy to transport.
However, bitcoin has a fatal flaw – it is not a stable store of value
As previously mentioned, a critical criteria of currencies, is in its ability to act as a stable store of value – it has to be able to reliably buy the same goods tomorrow, as it can today.
Bitcoin’s price increased over 300% in 2020. Under such circumstances for a “regular” fiat currency, automatic exchange rate mechanisms would have kicked in to prevent an economic collapse. For comparison, the US Dollar Index moved from 96.8 to 89.9 in the same period of time, a far gentler fluctuation.
Price of Bitcoin (blue line) against the Dollar Index (red line)
Bitcoin has value as a store of value – but is far from stable enough to be a currency
In summary, bitcoin has great potential as a store of value more akin to gold, rather than as an actual currency. Critical differences exist between gold and bitcoin however, which we will explore in future topics.