Gold vs Bitcoin

A wet Sunday afternoon has let to the exploration of my Netflix ‘to watch’ list, which is normally compiled by clicking through ‘more like this’ for about 20 minutes before I go to bed.  Today this led me to alight on End of the Road: How Money Became Worthless.

It’s been a while since I dug around the dark conspiracy-filled underbelly of the internet so I was not immediately looking for signs of film that had been produced by a team that all have a room in their basement lined with guns and cans of beans.

However, after a while all the pieces start to come together and by the end I was half expecting someone to accuse all the world’s ills of being caused by Jews and the Illuminati.  Although it is littered with comments which can quite easily be rebutted by appeal to logic, solid evidence or at the very least well-established conventional economics, there are some things said which I think worth responding to, in particular in the context of the current debate going on about Bitcoin and whether it is a currency that should be taken seriously.

The gist of the film is that currency backed by gold is the natural order of things and that the “experiment” that the world has been part of since the abandonment of the gold standard in 1971 is going to come crashing down, due to all the horrendous fiscal crimes which fiat money allows governments to commit.  Put slightly less alarmistly: a currency which is backed by gold means that the amount of money in circulation is determined by the value of gold, and this is something which is relatively stable over time – gold has always been valuable and trusted as a store of wealth.  Therefore governments were not able to print money unilaterally without very obviously risking credibility .

However, when the US ceased allowing dollars to be converted to gold in 1971, the countries involved in the first Bretton Woods system of international financial exchange moved to a fiat currency system where their own currencies were backed by reserves of dollars, rather than gold.  The film alleges that the value of the dollar in this system is held up by a giant ponzi scheme comprised of the US government, the international banking system and “the media”. This ponzi scheme results in enormous national debt which is used to fuel the economy, and then is financed by printing money.

There are umpteen other tinfoil hat arguments made, but the response to the question “is it preferable to have a currency backed by gold” highlights some issues about bitcoin.

What is a currency for? The purpose of a currency is to facilitate exchange, i.e. for me to transfer value to a you in exchange for something you are giving me.  A good currency is one where you can then take what I have given you and use it to buy something from someone else.  (This is why currency is generally superior to bartering – relying on someone simultaneously offering what I want and wishing to accept what I will give for it is very, very difficult). It’s also helpful if the currency is easy to move around and can be subdivided into small enough units to pay for sundry items.  The bottom line is that currency is a measure of value and key for success is that it is trusted by all parties.

How can a currency be improved by having a fixed exchange rate with gold? If you are suspicious of a currency: you don’t trust other people not to tinker with it, including the government, then you might want to have assurance that the money you are given for selling a product can be converted into something that you do trust, like gold.  If you live in a world where your government is debasing the coinage, then demanding convertibility to gold is a rational response! However, this sort of activity ultimately leads to instability and a government that wants to stay in power (as opposed to a divine monarch) has an incentive to maintain a stable currency.

So a backing with gold is one way of making a currency trusted, but clearly not the only way.  Furthermore, the value of gold is only derived from the fact that its supply is constrained and that humans like shiny things, and have liked them for a long time.  Other natural substances that are in similarly short supply (semi-precious gems, amber, meteorites) do not hold the same mystical value as gold.  It has been  demonstrated that people are happy to use anything as currency as long as other people will accept it and the value it represents doesn’t change unpredictably.

Which brings me on to bitcoin. To date there has been some debate over whether bitcoin will ever be recognised as medium of exchange with the same level of acceptance as any national fiat currency.  The strength of feeling on both sides of the argument has led some to stake a pair of alpaca socks on the outcome.

Bitcoin is gradually moving towards two of the criteria for being an effective currency:

  • after you have dedicated a gigabyte of your home computer’s hard drive to the background data, you are away (it’s mostly portable)
  • the current bitcoin system allows it to be subdivided into one ten-millionth, i.e. 0.00000001 bitcoins. At the time of writing this means that the smallest unit a single bitcoin can be divided into is equal to about 0.5c (1btc = 494usd)

Therefore the only quality that bitcoin lacks is general acceptance and trust.  The dramatic changes in its dollar value over the last two years, partly fueled by speculation, have not helped this.  The graph below illustrates the extent of this continued variation. (apologies for some of the sins of this graph – I’m still getting my head around Excel  2013 and was too lazy to boot up Stata).

bitcoin value

N.B. it should say week-on-week change

 

Therefore, I would probably side with the pessimistic side of the bet.

 

 

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