Bitcoin, Gold and Private Money

by George Hatjoullis

The bitcoin logo

The bitcoin logo (Photo credit: Wikipedia)

The only characteristic that a private money need have is that it is accepted as a medium of exchange. The more widely it is accepted, the more successful it is as a private money. The usual list of attributes of money that one will find in economics text books are those that contribute to its acceptability as a medium of exchange.

Bitcoin is a very efficient form of private money for the digital age. It is divisible, durable and costs very little to store. It is highly mobile geographically and requires no third-party intermediation. it is ideal for peer-to-peer transactions. It is the cash of cyberspace. It is possible to steal, though forgery may be more challenging. Like cash, Bitcoin is ideal currency for unregulated or, colloquially, black market, transactions. It is this electronic cash-like characteristic that has most likely been behind the success of Bitcoin. The progress and use of Bitcoin will for this reason be closely monitored by authorities worldwide.

Bitcoin is private cash and is produced privately. The seigniorage, or gain from simply producing and providing the cash, accrues to private producers. The seigniorage accrues to the miners. The total production and rate of production is controlled. This is important and understanding how it is controlled is vital to the continued acceptability as a form of money.

A key issue is the function as a store of value. The value of fiat money fluctuates with the rate of general price inflation. Bitcoin has a currency value, typically quoted in US dollar. There is no need to use Bitcoin as a store of value. One can always buy at the prevailing rate of exchange (at least in principle). However, this rate of exchange may not be stable. For those using Bitcoin to transact regularly holding some Bitcoin as liquidity will be attractive. If Bitcoin is successful more and more liquidity balances will build and during this process the exchange value of Bitcoin may increase. This may well have been the experience to date.

Of course, as with any commodity it is subject to speculative excess. Wide variations in exchange value over short periods will undermine the attractiveness of the Bitcoin as a form of liquidity. This however is inevitable in the early stages as liquidity balances build. The success of Bitcoin as money can be measured through the volume of use in transactions and average size of liquidity balances. However, data may not be easily available.

Bitcoin is often compared to gold as a private money. However, the comparison is anachronistic. Gold is not used as a medium of exchange. It is used as a store of wealth. Gold is expensive to store, transport and secure. It is not easily divisible. It is a poor alternative to Bitcoin as money. It may however be a better store of value. It has a well-developed derivatives market where physical gold can be hedged in large size.

The gold price dropped precipitously recently triggered by the prospect of gold sales by the Republic of Cyprus [ see my blog Gold, Oil and Bitcoin]. It has since recovered some ground. However, the prospects for the gold price longer term may not be good. Financial anxiety is diminishing and this may see further price falls. There are alternative asset classes that offer better vehicles for storing value.

The demand for a private medium of exchange however may be growing. The internet has been successful at piercing national boundaries and regulatory frameworks. National authorities will work ever harder to keep the internet within the official regulated sector. However, arbitraging regulations and boundaries seems to be a popular human activity and was/is one important driving force in the investment banking sphere. It is likely to continue to be so in cyberspace. Private money will facilitate the arbitrageurs and black marketeers and thus is likely to be in great demand.

This is an interesting development to monitor from a distance.