Mises Institute weighs in on Bitcoin.Submitted by Sethster82 on Thu, 04/04/2013 - 15:27
I found this article to be very helpful and figured I'd pass it along:
The Moneyness of Bitcoins
Mises Daily: Thursday, April 04, 2013 by Nikolay Gertchev
The Production of Bitcoins
A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.
This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle. The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.
Bitcoins come about as the uncertain pay-off for an energy—and hardware—-consuming process that is extended through time. The per-time pay-off varies, based on the efficiency and sophistication of the more-or-less specific hardware used for the mining. Individual miners have started to pool their efforts, and this cooperation has tremendously reduced the uncertainty that each individual miner bears.
Due to this costly production process, bitcoins, although virtual, are constrained by scarcity. While a bitcoin has no material shape or content, the algorithm that generates it has been designed to replicate the competitive production of a scarce good. First, entry in the business of producing bitcoins is open to anybody. Second, the production process is capital and labor intensive, extended through time, and also uncertain. Third, production is subject to decreasing returns, thereby conforming to the generalized scarcity faced by acting individuals in the better-known physical world. Thus, bitcoins turn out to be the exact opposite of the “Linden dollars” of the Second Life “virtual world.” The latter are produced by a monopolist central authority, out of thin air, and without any other limitation but the very discretion of that same monopolist authority.
However, it is not their costs of production that bestow on bitcoins the status of an economic good. After all, scarcity is not rooted in the absolute quantitative limitation of something; it comes from the insufficiency of the stock of that something, perceived as useful in some regard, relative to the individuals’ needs. Hence, we must ask ourselves how bitcoins have come to be valued at all. This leads us to an analysis of their demand.
The Demand for Bitcoins
At their inception, bitcoins were created and first held within a “crypto-punk” community. It could then be safely assumed that they served the purpose of conveying a specific antiestablishment worldview. The first demand factor, initially for producing bitcoins, and then unavoidably but only indirectly for holding them, was rooted in their capacity to project a certain point of view. In a sense, bitcoins were comparable to an artistic medium of expression, such as music, literature, and painting.
Thanks to that initial source of value, bitcoins had a reference point that positioned them relative to other goods and services. From there onward, the technological features that characterize them led to an expansion of their demand. Bitcoins are imperishable. Storage and protection against theft or accidental loss come at a very low cost, as these are accessory services rendered by standard antivirus and back-up software. Marginal transaction costs are also practically zero, once the fixed cost of establishing and maintaining a network connection has been accounted for. All these aspects are common to real wealth assets. Thus, the second demand factor for bitcoins is explained by their capacity to store wealth at a low cost. From the status of a good which, as a “worldview-conveyor,” was largely used for personal enjoyment (and hence consumption), bitcoins evolved into an investment good that has become attractive well beyond its original crypto-punk community.
The growing investment demand also spurred the development of intermediary dealers in bitcoins. There are a number of exchanges where bitcoins can be bought and sold against currencies. Specialized online storage, presumably with increased security, has also been made available. Intermediation, though open to free entry, is likely to remain rather monopolistic, given the very low margins associated with transacting in and with bitcoins.
This latter aspect, namely the intrinsically low transaction fee, contributes to a third demand factor for bitcoins, namely as a means of payment. A number of online vendors, who are mostly specialized in web-related services and online sales of rather exotic items, accept final payment in bitcoins, not the least because of the guarantee for almost absolute anonymity. This last component of the demand for bitcoins is still nascent. After all, a very limited set of items can be purchased with bitcoins, and sellers still price their goods in dollars, euros, etc. The price is then converted into bitcoins, according to the prevailing exchange rate, at the final stage of finalizing the payment method of the transaction. Thus, while bitcoins do appear to serve as a means of payment, they are definitely not used yet for business calculation. This is most certainly attributable to their still very limited demand to hold as a means of exchange. Nevertheless, couldn’t they become full-fledged money in the foreseeable future?
Bitcoins as Money
Prima facie, bitcoins possess all the qualities required from a money (a generally-used medium of exchange). They are perfectly homogeneous, easily cognizable, conveniently divisible, storable at practically no cost, and imperishable. Also, they seem to be fully shielded from counterfeiting. In addition, because they exist as a consumption and investment good, they are appraised on their own, thereby satisfying the Misesian regression criterion for the free-market inception of a medium of exchange. However, in order to become a viable alternative to existing monies, bitcoins must generate a sufficiently large demand so that their usage becomes generalized. Without the certainty that they can be transacted for any other good in the economy, a demand to hold them as money could not develop. It is with respect to their capacity to become and remain commonly used that bitcoins suffer from a relative disadvantage.
Indeed, bitcoins are embodied in a specific and highly capital-intensive technology. They can become convenient enough for standard personalized transactions only if both parties of the exchange possess the necessary technology that gives access to bitcoins. Bitcoins can do the job already for internet-based impersonalized purchases, because the marginal cost of the exchange technology they go along with is already almost zero for those who possess it. However, the transposition of that technology in the physical world of common face-to-face shopping (getting a haircut, buying a sandwich, or purchasing vegetables at the local grocery shop) would imply extra costs. True, these costs would decrease progressively as portable smartphones with permanent internet access become more widely used, not only by buyers, but also by sellers. The key point, however, is that bitcoins could become a generalized medium of exchange only through the accessory use of other, specific and physical, goods in an economy that has reached a very high level of technological development. This is a tremendous disadvantage, for at least two reasons.
First, at any given moment, the level of technological development is not uniform for all individuals within the same (national) economy. While some have access to the latest technology in a given field of activity, others prefer to stick to older versions. This is definitely due to the cost of replacing existing capital goods, but also to individual preferences, and sometimes to personal wealth. Consequently, bitcoins could become money only at the point when the technology that embodies them becomes commonly used. We are not there yet.
Second, an economy in which the medium of exchange is dependent so much upon the widespread use of a specific technology would be extremely vulnerable. Technologies are not given; they are the result of individual choices with respect to capital accumulation and allocation that must be made time and again, and are subject to reversal. Then, if the medium-of-exchange-linked technology is abandoned, because for instance no sufficient savings are available any longer, the economy will have to find another medium of exchange. This transition phase might then involve significant disruptions in the structure of production. A technology-linked medium of exchange does not provide enough flexibility to economic relations and might be viewed as complicating, rather than facilitating, some actions, such as shifting from one technology to another. This is a significant drawback of any virtual currency.
In trying to understand whether the increased popularity of bitcoins is reflecting the emergence of a new money, we have actually come to a fundamental distinction between virtual and material media of exchange. The latter are technology-independent and matter-embodied; the former are technology-embodied and matter independent. This distinction is not trivial as it emphasizes the great advantage that material money offers: it is good enough for anybody and at any time, and is independent from individual choices with respect to investment, allocation and maintenance of capital. Virtual monies could be programmed to reproduce some aspects of material, whether commodity or fiat, monies. However, they will always be dependent on specific capital investment decisions. The latter reduce their degree of commonality as well as of adaptability to changing economic conditions.
In conclusion, virtual monies, of which bitcoins seem to be the most perfected specimen up to date, do not allow acting individuals to manage the uncertainty of the future as well as material monies do. They could serve to intermediate exchanges among those who invest in the technology that creates them, stores them, and transfers them. Nevertheless, they could never achieve that degree of universality and flexibility that material monies carry with them by nature. Thus, on the free market, commodity monies, and presumably gold and silver, still have a great comparative advantage.
Nikolay Gertchev holds a Ph.D. in economics from the University of Paris 2 Panthéon-Assas and currently lives in Belgium, where he works for an international organisation. Send him mail. See Nikolay Gertchev's article archives.
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