There seems to be some longstanding confusion about Bitcoin. Not about how it works; there are plenty of articles which explain that quite lucidly— it is confusion about what Bitcoin represents, and what its role could be. I regularly hear these ideas repeated in seriousness:

• Bitcoin could one day supplant ordinary currency
• The decentralized / algorithmic nature of Bitcoin makes it safer than “normal” currency
• Bitcoin is like gold, and gold is good for counting wealth, therefore Bitcoin is good for counting wealth.

I originally penned this article nearly two years ago (before setting it aside). At that time, it seemed like Bitcoin was a passing fad— I believed then, as I believe now, that Bitcoin’s merit (or lack thereof) doesn’t stem from its popularity (or lack thereof), though the mood around Bitcoin has since entirely reversed.

Bitcoin advocates back then would have dismissed Bitcoin’s slide in popularity as proof of its invalidity, though today they’d probably be just as likely to point to its popularity as evidence of its success. I want to cast aside whether Bitcoin is Hot Right Now, as well as questions about implementation details (like the size and existence of transaction fees, the scalability of the blockchain, or transaction delays), and ask whether the fundamental idea is sound. In particular, I think the assertions listed above reveal some really interesting things about the way money actually functions, and what kind of value Bitcoin actually offers. So let’s dive in.

How Bitcoin works

You don’t need to know a whole lot about Bitcoin to understand its basic premise: You have an artificially scarce resource, which in this case happens to be very large numbers with a special mathematical property. That property is what makes the numbers rare, and thus computationally time-intensive to find. As time progresses, the property is designed to become more and more stringent, so new Bitcoin numbers become increasingly difficult to create. The total number of bitcoins in circulation is fixed ahead of time by the algorithm, regardless of how many people are using Bitcoin; and eventually no more bitcoins will be found. Bitcoins cannot be faked, because anyone can verify whether the mathematical property actually holds or not.

Ownership of bitcoins (or parts of them) can be transferred easily, because a large network of computers keeps track of who gave what to whom. There are more technical details which ensure the security of the whole system, but they’re not important to this discussion. What is important is that it is commonly said that this scarcity is what gives Bitcoin its value. And there are some problems with that.

Is Bitcoin like gold?

People often say Bitcoin is like gold and highlight the fact that, like gold, it’s valuable because it’s scarce, and because other people believe it’s valuable.

I’d like to get a small point out of the way: Mere belief isn’t the sole reason for gold’s value. If everyone suddenly stopped caring about how pretty and shiny gold is, it would still have some utility which could be cashed in on. Gold actually has some very useful properties: It’s conductive, it’s extremely malleable, and it’s chemically inert (making it very resistant to corrosion). Assuming its scarcity remains roughly the same, the value of gold can therefore only drop so far, because if the price went down far enough, it would suddenly become profitable to make all sorts of nifty electronics and corrosion-resistant gadgets out of gold, and demand would stop falling somewhere above zero. ⁽¹⁾We can try to get a crude, first-order estimate of the industrial value of gold by comparing it to copper, which has similar properties. If we assume the practical utility— and thus the demand— of gold and copper are similar, then we can estimate the price by comparing the supply. Extracted copper is roughly 6,000 times more abundant than extracted gold, so assuming similar demand, we’d expect the scarcity of the latter to drive its price to about 6,000 times that of copper’s (current) 20 cents per troy ounce. That puts gold’s “utilitarian” price at right around $1200— which is almost exactly its actual current price. Since gold has some additional utility due to its “wealth density”, one of these might be somewhat mis-priced. Gold’s utility beyond a material yardstick of wealth is one thing that lends some credibility to its value.

This is not true for Bitcoin. A bitcoin is a number, and that number has no utility outside of its ability to be accepted by someone else. Unlike gold, the the minimum value of a bitcoin is zero— its value if everyone stops believing it works. This is one reason why a bitcoin is a risky way to hold assets.

This is a common argument against Bitcoin, and I know what many of you are going to say next:

Well, the dollar is the same way, isn’t it?

Yes, just like Bitcoin, the minimum value of a dollar⁽²⁾I am going to use “dollar” for the rest of this article to stand in for an arbitrary unit of traditional fiat money. Obviously everything works pretty much the same way for any other currency; feel free to mentally substitute with yours. is also zero, and a dollar has no value outside of its ability to be “accepted by someone else” in exchange for something valuable. So could we imagine a society where BTC is on the same footing as the dollar? Is popularity the only thing distinguishing the two? If both have no inherent value, what’s the difference?

Let’s talk about where the value of currency comes from

Some people still (surprisingly) believe the value of the dollar is backed by gold. This has not been true since 1971, and that is not going to change, either. The dollar is fiat money, which Continue reading →