In the process of researching Bitcoin to help me decide whether to buy some as an investment, I’ve come across some confusion about money in some prominent articles.
This article says:
the demand for Bitcoins is driven by the volume of Bitcoin-denominated transactions.
the value of a currency is built on its reputation, and five months of bad news and depreciation have done serious damage.
Money serves several different functions. To be widely accepted, a currency typically needs to serve as a medium of exchange and as a store of value. But gold is a good example of a quasi-currency that functions as a fairly good store of value (at least for people with long time horizons). Bitcoin shows more promise of functioning as a store of value than as a medium of exchange.
If Bitcoin were only a medium of exchange, it might make sense to say the volume of Bitcoin transactions drives the demand for it. But if most people who are buying Bitcoins are hiding them under their mattresses on EMP-resistant media (cd-rom?), the price of Bitcoins can rise indefinitely without an increase in transactions.
It isn’t very useful to lump many beliefs about a currency into a single reputation. Bitcoin has different reputations for different traits.
A currency should have a reputation for being in limited supply and for not having that supply increase too rapidly. I’d say Bitcoin has developed a better reputation for this than the US dollar, and might exceed gold’s reputation.
A currency should be easy to store and transport safely. This is an area where Bitcoin’s reputation is the subject of much confusion. There’s currently an unpleasant tradeoff between secure ways to store Bitcoin and convenient ways to have them available to spend. It make take a major rewrite of operating systems (e.g. to use Capability-based security with a good UI) for it to be possible to have Bitcoins be conveniently accessible but hard to steal. Confusion over the risk of theft has probably driven a fair amount of the recent Bitcoin price volatility. My guess is that it’s better that theft has happened now than after people become more reliant on Bitcoin. It will either drive the creation of more secure software (with benefits much wider than Bitcoin use) or discourage people from relying on insecure ways of handling digital money.
Finally, it’s important that a currency have a reputation for being something that people will value in the future. This is a source of significant uncertainty, because it depends on people’s perceptions of the alternative stores of value, the alternative media of exchange, and the risk of Bitcoin theft. Bitcoin has the potential to be a better store of value than gold, because a transparent algorithm can better guarantee a limited supply than the difficulty of mining a metal. People who started watching Bitcoin prices a few months ago in response to a flurry of publicity attach a low reputation to its prospects as a store of value because the recent price crash is more vivid in their mind than the earlier boom, but that’s a temporary phenomenon that doesn’t deserve much attention.
For most uses as a medium of exchange, Bitcoin doesn’t offer much advantage now. For most transactions, the small cost savings aren’t enough to persuade consumers to give up the ability to dispute a payment, or for stores that accept Bitcoin with an option to dispute payment to offer a discount for Bitcoin purchases. And I expect governments and large financial institutions to create obstacles to its use as a medium of exchange. There are a few small uses where it works better than any existing alternative – e.g. Wikileaks, where the existing financial system refuses to support online payments. Bitcoin anonymity doesn’t appear strong enough to attract people engaged in illegal businesses. Online gambling companies might get some advantage from using Bitcoin if the obstacles to transferring money to gambling sites exceed the obstacles to buying Bitcoin, but I’m guessing the obstacles are and will be at least as large for buying Bitcoin. So I expect very slow adoption of Bitcoin as a medium of exchange.
I do think there’s a nontrivial chance that Bitcoin will become widely used as a store of value, and that might replace a significant amount of demand for gold a decade or two from now. A decline in demand for gold as a store of value might well snowball, as extrapolating that trend would imply that gold becomes a less reliable store of value. That doesn’t yet make me reluctant to buy gold, but a Bitcoin price over 0.1 ounces of gold might make me reconsider.
I will probably invest a small fraction of my net worth in Bitcoin, but I don’t feel any urgency about it.