More might mean less if you buy into the bitcoin revolution

The chart accompanying this article highlights the dramatic rise in the price of bitcoin, the virtual, digital currency, since 2009. Encryption techniques regulate the generation of bitcoin units that can be used in the transfer of funds. Yet an understanding of what constitutes sound money is more important here than any understanding of technology in determining whether bitcoin is a currency, an asset or a mirage.

Paper money and credit facilitate trade, and to be accepted as payment, each must be trusted and have intrinsic value. We receive payments for our goods and/or services and lodge our payments into the banking system. We trust the banks to safeguard our money. This trust was broken in 2008 and led to bank runs all over the developed world.

Yet central banks stand behind domestic banks, and in 2008 they stood behind domestic banks in the US, UK and eurozone to safeguard depositors’ monies.

The system was tested yet survived, with old lessons having to be relearnt. But what backs the central banks? Governments, of course. A sound banking system and a currency is underpinned by a government’s ability to raise revenue through taxes.

Most times, bank deposits represent sound money. Banks can use client deposits to lend out as credit, thus expanding the supply of money as trade expands, while at the same time earning a return for the bank and depositors. Money in a trusted banking system is a medium of exchange and a store of value.

Of course, paper monies have not always acted as a store of value. The German reichsmark after the First World War and, more recently, the Argentinian peso and the Zimbabwean dollar were worthless as a store of value, because governments spent recklessly and printed money in huge quantities to try to pay for that spending.

When you lodge savings with a bank, you get an IOU, and you’re dependent on the bank making good on it. Not so with gold. When you accept gold in trade settlement, you have an asset with a value that is not dependent on a third party.

If bitcoin is a novel way to settle trades outside the banking system, why limit the supply?

Also, there is a base demand for gold, for jewellery and industrial uses. It costs $820-$850 to get an ounce of the metal out of the ground, so it has intrinsic value. Its price has matched inflation because new gold supplies are limited. In this way, gold has been a better store of value than most paper currencies.

Yet, as the supply of gold cannot be increased at the same pace that trade expands, there has never been enough gold to facilitate the settlement of faster expanding trade.

Bitcoin is in limited supply. It is earned by those who verify transactions using blockchain technology over the internet, so one could suggest that a base intrinsic value for bitcoin is the value of the programmer’s time.

Unless that technology is going to lead to revenue flow for bitcoin owners, the currency appears to have limited intrinsic value. It simply represents a new medium of exchange for settling trade in goods and services and, like gold, operates outside the banking system.

If bitcoin and blockchain technology speed up and/or lower the cost of settling trades, this is a positive development. The technology looks robust, because banks are already adopting blockchain.

That does not mean bitcoin is a good investment. The internet is revolutionary but, in itself, makes no money. If bitcoin is going to revolutionise trade settlement, its supply should be expanded at the same rate as trade.

Fans seem to be placing all their faith in bitcoin’s strictly limited supply, but this is mixing up money’s role as a store of value and a medium of exchange.

A colleague argues that bitcoin offers anonymity. Without doubt, there’s a huge market for a non-transparent currency: think tradesmen working for cash; small-scale drug trafficking; and online film and music downloads. There is demand for transacting in a currency with no trail.

If this is the attraction of bitcoin, surely authorities will clamp down on such trade. Even if they are behind the curve, anonymity does not explain why the supply of bitcoin has to be limited.

Most likely, we are witnessing a speculative development, where the limited supply of bitcoin is leading to higher prices as the demand to own it multiplies. These higher prices bring in more speculators who drive the price still higher.

If bitcoin is a novel way to settle trades outside the banking system, why limit the supply? If it is increased, as we think inevitable, the prices will fall to their intrinsic value, which, in bitcoin’s case, is far below today’s price.

If we have misunderstood the bitcoin revolution, we stand ready to change our view. As John Maynard Keynes once said: “When the facts change, so do I — what do you do, sir?”

Humility is an essential tool for survival in the investment game.

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