The Economics Of Bitcoin – How Bitcoins Act As Money

A video reading of this article can be found here.

I’m going to start off with a simple example of how and why Bitcoins act as trade facilitators and move forward into comparing when more complex transactions take place.  Then I will analyze the properties of Bitcoins that make them act as facilitators of trade and a store of wealth.

So let us assume the following situation:

Bob lives in California and wants to buy a widget from Frank who lives in New York.

Frank has decided to sell his widget for 100 dollars.

Bob has reviewed Frank’s product through Frank’s website and agrees to purchase the product from Frank for the agreed upon price of 100 dollars.

To facilitate this transaction, the two have agreed to use Bitcoins exchanged through Mt. Gox.

Now let us suppose that there is only one Bitcoin in existence and Frank is in possession of this Bitcoin.

Frank logs into Mt. Gox and places his Bitcoin for sale on Mt. Gox and sets his price at 100 dollars.

Bob logs into Mt. Gox and buys the Bitcoin for 100 dollars.

After this series of transactions completes, Frank is now 100 dollars richer and Bob is in possession of a Bitcoin.

That Bitcoin now has a market determined value of 100 dollars, so Bob now sends the Bitcoin back to Frank as payment for the widget.

At this point Frank ships his product after he has the confirmed payment of one Bitcoin.

So the end result is Frank is 100 dollars / 1 Bitcoin richer, while Bob is richer to the tune of one widget.

Of course, this is a very round-about way of conducting a trade, but as we can see there was no loss of value.

Now we are going to inject Larry as a third party buyer and seller of this Bitcoin.

So let us suppose that still only one Bitcoin exists and it is in the possession of Larry.

Larry has decided that his Bitcoin is worth 100 dollars and will sell it for that price, so he puts his Bitcoin up for sale on Mt. Gox at the asking price of 100 dollars.

So Bob logs into Mt. Gox and purchases this Bitcoin for 100 dollars and then sends the Bitcoin to Frank as payment for the widget.  Frank then responds by shipping Bob the widget.

So now we have Bob +1 widget, Frank +1 Bitcoin, and Larry +100 dollars.

To finalize the transaction, Frank logs into Mt. Gox and puts his Bitcoin back up for sale for the asking price of 100 dollars.

Larry sees the Bitcoin back up for sale and decides he will pay 100 dollars for the coin because he would rather hold Bitcoins than dollars, and thus, Frank is now 100 dollars richer while Larry is richer by one Bitcoin.

In this final example, Larry represents the entire free market in Bitcoins.  Larry actually represents thousands of people all willing to buy and sell Bitcoins in a constantly changing market.  As long as Frank does not decide to hold the Bitcoins over an extended period of time, his exposure to changes in market prices is incredibly small.  Frank may make a little extra money or he might lose a little money in the exchange as the market price of the coins fluctuates during the period of time he is in possession of the coin to the period of time he sells the coin back into the market for dollars, but this is a small risk he is willing to take for the ease transacting in Bitcoins and because he doesn’t have to pay any credit card fees on the transaction.

Through this example we can see that Bitcoins act in exactly the same manner as if one were exchanging physical nuggets of gold represented by electronic gold receipts.

To prove my point, lets go through this same example using a digital receipt for gold bullion we shall call a GLD.  You’ll notice that there is absolutely no difference between how the series of transactions unfolds.

Larry has decided that his GLD receipt is worth 100 dollars and will sell it for that price, so he puts his GLD up for sale on Mt. Gld at the asking price of 100 dollars.

So Bob logs into Mt. Gld and purchases this GLD for 100 dollars and then sends the GLD to Frank as payment for the widget.  Frank then responds by shipping Bob the widget.

So now we have Bob +1 widget, Frank +1 GLD, and Larry +100 dollars.

To finalize the transaction, Frank logs into Mt. Gld and puts his GLD back up for sale for the asking price of 100 dollars.

Now the only difference in all of this is that the GLD receipt represents a fixed amount of a physical commodity (gold), while the Bitcoin does not represent anything at all.   As far as the money market is concerned, this representation of a hard commodity is totally irrelevant in regards to how GLD acts as a currency.

The important question in all of this is why are people willing to use gold as a store of value?  Why do people willingly buy and sell gold in exchange for dollars?  If we can answer that question, we will also have an answer as to why people buy and sell Bitcoins in exchange for dollars.

The answer lies in the specific properties of gold that lend itself to acting as a store of value.

People buy gold with dollars as a store of wealth because of the following specific properties gold has:

1.  Scarcity - Its supply is very stable and does not fluctuate much.  There is enough gold around that everyone can get access to it, yet new sources of gold are limited enough that the supply of gold can not easily be inflated.  Thus, the supply of gold will not be increased and can not be increased at a very high rate in proportion to the existing supply of gold.  This is obviously important in a money because, as the law of supply and demand dictate, the more of  something there is, the less valuable it will become.

2.  Fungibility - All gold is uniformly the same.  Therefore, no one cares if they are getting a specific gold bullion bar in exchange for dollars, they only care about the amount of the bullion they are receiving.

3.  Divisibility - As gold’s value fluctuates, people want to know they can sell any amount of gold in the future for the same rate as any other amount of gold.  So if I take an ounce of gold and cut it up into grams, each gram will proportionately total up to the same value as a full ounce.  Let us contrast gold with diamonds to make my point.  If I divide up a diamond that weighs an ounce, each piece of that diamond will be worth faaaar less in total than what the ounce diamond would be worth on its own.   So by dividing a diamond, each piece loses a tremendous amount of value as compared to the whole.  This is not the case with gold, since gold can be melted back into a larger piece at any time.

4.  Recognizably - People need to easily be able to validate that the product they are receiving is actually the product claimed.  Gold can easily be identified by its physical characteristics and tested to ensure its purity.  This means that people can not be easily deceived into buying a counterfeit gold product.

It is important to note that anything which meets the criteria I just listed can act as a money.  People do not care in the slightest that gold can be turned into artistic jewelry pieces in their decision making process about why they are holding gold as a store of value.

The fact that gold can be turned into artistic pieces simply provides a reassuring alternative use for gold if people decided that gold is no longer of monetary value.  So this way I know that if people stop buying gold as a store of wealth, I’ll still be able to sell my gold to a jewelry shop at a tiny fraction of its current value if it came down to it.  But this reassurance that gold will always have some tiny fraction of value to jewelers in no way influences the reasons why people use gold as a money and why gold has a market determined value of nearly 1600 dollars today.

Because Bitcoins have no other use besides acting as trade facilitators, they have no such reassurances of minimal value – but this fact is totally irrelevant from a monetary perspective, just as it is totally irrelevant from the perspective of gold.

All that matters as far as the money market in Bitcoins is concerned is that they have all of the aforementioned properties that make gold a money – which they do.  Thus, Bitcoins can act in exactly the same capacity as a store of wealth as gold.  The only valid economic arguments that can be made against Bitcoin are those arguments which attempt to demonstrate why Bitcoins don’t meet the above mentioned requirements.

After thoroughly reviewing the risks involved and the way Bitcoins are created and transacted with, it is my opinion that any arguments which attempt to demonstrate why Bitcoins somehow don’t meet the above requirements are not adequate to call for its discontinued use as a currency.

For example, there is an ultra tiny fraction of risk that Bitcoins could be double spent if a person were to acquire more than 50% of the computing power of the entire network.  I find this risk to be so small that it is not really a serious threat to the stability of the currency.

In summary, Bitcoins are money because of the properties they have.  They act in exactly the same capacity as gold when used as a money.   The fact that Bitcoins are not represented by a physical commodity is totally irrelevant from the perspective of their use as a store of value.   The free  market has decided Bitcoins do have value and can be used as a trade facilitator because of the properties they have; therefore, they are free market money.