On Bitcoin as a Currency

Much ado has been made about the “digital currency” called Bitcoin. There are many advocating for the use of Bitcoins and at least as many advocating against. There is quite a lot of FUD (fear, uncertainty, and doubt) being levelled at Bitcoin. For instance, there are claims that its primary use is criminal enterprises. That is hardly a fair criticism, however, because one of the major uses of any fiat currency in the world is also criminal enterprises. If Bitcoin should be disallowed due to its use by criminals, then so must every single fiat currency in circulation today. That is, however, hardly a reasonable outcome.

Bitcoin has also been called a pyramid scheme or a ponzi scheme or any number of other classic scams. Those calling it such clearly know nothing about what those schemes actually are. Sure, the creators and very early adopters made out like bandits, or could have if they chose to, simply due to having accumulated a lot of bitcoins due to mining in the early days. However, it is most certainly not a ponzi scheme (no investors) or a pyramid scheme (profits for an investor do not depend on an every increasing number of particpants under them in the hierarchy).

So far, it may sound like I’m advocating for Bitcoin. That is not strictly true. I have no objection to Bitcoin’s existence. (Full disclosure: I have profited a nontrivial amount from early mining but nowhere near what I could have had I had more foresight.) In actual fact, I’m advocating both for and against Bitcoin.

As a security or fungible commodity, Bitcoin is stellar. Anyone who treats it as a commodity similar to gold, platinum, oil, wheat, etc., will have no problems with it. Commodities often swing wildly in price and that is something that investors who are prepared for it can handle easily enough. There are two notable feature of Bitcoin that makes it very much like a regular commodity. The first is that it has the notion of mining. That is, new Bitcoins are created through a process known as mining. The precise mechanics of mining and how it relates to Bitcoin is beyond the scope of this discussion but it does happen. The other notable feature is that there is an absolute cap on the final number of Bitcoins that will ever be created which is enforced by an exponential decay in the mining reward. These two combined make Bitcoin behave very much like any limited resource commodity.

The two notable features of Bitcoin that make it behave very much like a commodity also make it unsuitable as a general circulation currency. The very same features that make gold, silver, copper, and other limited resources unsuitable for large scale commerce make Bitcoin unsuitable. Well, except for one. Bitcoin doesn’t take up physical space and have to be stored in vaults and moved in trucks. The precise reason why a limited resource is not suitable as a currency is beyond the scope of this discussion, but the primary reason is liquidity. Liquidy is the measure of how easy it is to conduct trade. To make a long story short, too much liquidity leads to inflation and too little liquidity leads to deflation and possible economic parallysis. If economic activity increases, the demand for currency to support that activity increases. If the supply of currency does not increase to match, liquidity decreases. Thus, a limited commodity cannot be suitable in a case where economic activity is expanding. This is precisely the situation with gold and other precious metals. It is also the case with Bitcoin. (I should probably note that there are activities like hoarding (otherwise known as saving) which take currencies out of circulation and otherwise reduce liquidity until such time as the hoarded amount is spent for some purpose.)

So, as a day to day currency, Bitcoin is not terribly useful. However, just as commodities like gold are useful as occasional mediums of exchange, so, too, can Bitcoin be, just as long as it is treated as a volatile commodity just like gold would be. When one stops considering Bitcoin as a currency but instead as a commodity like gold, it stops looking any more like a scam than gold does. In fact, the behaviour of the Bitcoin exchange markets start to make a great deal of sense.

Of course, as the volume of Bitcoin trading increases, the liquidity of such a market, and also to some extent the volatilty, will even out some. However, it will always be a limited commodity and should be treated as such. Just as the price of gold has continued to increase, on average, when compared to fiat currencies, so too, will Bitcoin, and for the same reason.

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