Many economists and financial commentators believe that in the unregulated market of the internet economy, new forms of money can be created that bypass central-bank and government supervision. The latest development is the emergence of a new electronic means of exchange, the bitcoin (BTC). The BTC is the invention of a programmer who called himself Satoshi Nakamote, who launched the bitcoin on January 3, 2009.
The basic idea behind the BTC is to create, by means of a mathematical algorithm, a substance that is scarce and fungible.
Nakamote devised a software system that enabled people obtain bitcoins as a reward for solving complex mathematical puzzles. The resulting coins are then used for online trading. Nakamote also arranged that the number of BTC can never exceed 21 million.
Some experts maintain that BTC will displace the existent fiat money and will usher in a new era of free banking, which will finally put to rest the menace of inflation.
Unfortunately, this is a pipe dream. Electronic money will not replace fiat paper money. The belief that it can stems from a failure to understand the nature and function of money and how it emerges on the market.
To see where this view goes wrong, let’s first see how money comes about. Money emerges out of barter conditions that permit more complex forms of trade and economic calculation. The distinguishing characteristic of money is that it is the general medium of exchange, evolved from private enterprise from the most marketable commodity. On this Mises wrote,
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. [1]
In short, money is the thing for which all other goods and services are traded. Furthermore, money must emerge as a commodity. An object cannot be used as money unless it already possesses an objective exchange value based on some other use. The object must have a pre-existing price for it to be accepted as money.
Why? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services.
The benefit money offers is its purchasing power, i.e. its price in terms of goods and services. Consequently for something to be accepted as money, it must have a pre-existing purchasing power: a price. This price could have only emerged if it had an exchange value established in barter.
Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears. The reason for this acceptance is that people now possess previous information about its purchasing power. This in turn enables them to form the demand for money.
In short the key to the acceptance is the knowledge of the previous purchasing power. It is this fact that made it possible for governments to abolish the convertibility of paper money into gold, thereby paving the way for the introduction of the paper standard. Again the crux here is that an object must have an established purchasing power for it to be accepted as general medium of exchange, i.e. money.
In today’s monetary system, the core of the money supply is no longer gold, but coins and notes issued by governments and central banks. Consequently coins and notes constitute the standard money we know as cash and employ in transactions. Notwithstanding this, it is the historical link to gold that makes paper money acceptable in exchange.
Observe that a bitcoin (BTC) is not a thing, it is a unit of a non-material virtual currency. A BTC has no material shape, hence from this perspective the notion that it could somehow replace fiat money is not defensible.
BTC can function only as long as individuals know that they can convert it into fiat money, i.e. cash on demand (see, e.g., Lawrence H. White “The Technology Revolution And Monetary Evolution,” Cato Institute’s 14th annual monetary conference, May 23, 1996).
Without a frame of reference or a yardstick, the introduction of new forms of settling transactions is not possible. On this Rothbard wrote,
Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media – in almost all exchanges – and these are called money. [2]
It was through a prolonged process of selection that people had settled on gold as the most marketable commodity. Gold therefore had become the frame of reference for various forms of payments. Gold formed the basis for the value of today’s fiat money.
Besides, BTC is not a new form of money that replaces previous forms, but rather a new way of employing existent money in transactions.
The fact that the price of BTC has jumped massively lately implies that people assign a high value to the services it offers in employing existent money. This is no different from the case when in a country which imposes restrictions on taking money out people will agree to pay a high price for various means to secure their money.
[1] Ludwig von Mises, The Theory of Money and Credit, pp. 32-33. [2] Murray N. Rothbard, What Has Government Done to Our Money?
“Observe that a bitcoin (BTC) is not a thing, it is a unit of a non-material virtual currency. A BTC has no material shape, hence from this perspective the notion that it could somehow replace fiat money is not defensible”.
Nor is the virtual money in my bank account.
For the little that it’s worth, I am not convinced by this paper at all.
Frank writes:
“In short the key to the acceptance is the knowledge of the previous purchasing power. It is this fact that made it possible for governments to abolish the convertibility of paper money into gold, thereby paving the way for the introduction of the paper standard. Again the crux here is that an object must have an established purchasing power for it to be accepted as general medium of exchange, i.e. money.
In today’s monetary system, the core of the money supply is no longer gold, but coins and notes issued by governments and central banks. Consequently coins and notes constitute the standard money we know as cash and employ in transactions. Notwithstanding this, it is the historical link to gold that makes paper money acceptable in exchange.
Observe that a bitcoin (BTC) is not a thing, it is a unit of a non-material virtual currency. A BTC has no material shape, hence from this perspective the notion that it could somehow replace fiat money is not defensible.”
And yet, bitcoins ARE trading with a value that is entirely driven by monetary demand. This would appear to represent a counter example to Mises’ regression theory.
In addition, it is simply a baseless assertion to state that the historic link to gold is the reason that fiat currencies have value today. Given the number of people with no knowledge of this historic link, and that the historic link (after being weakened over a period of the prior 40 years) finally ended 42 years ago, I find this VERY hard to believe. It seems far more likely that fiat currencies have value because they are convenient, because people don’t understand their inflationary danger, and because governments insist on paying and being paid in them.
The article has a whiff of religion about it in which author simply trots out quotations from masters. Niether Rothbard nor Mises inhabited a world in which Bitcoin could be envisaged. In addition, we should admit the idea that they were fallible human beings.
A far better conclusion to this article would be ‘no one knows if Bitcoins will be accepted by the market. It will depend upon whether people choose to trust them over gold, fiat currencies etc. I, Frank Shostak, personally wouldn’t.”
Well said, Tim.
In addition, it is simply a baseless assertion to state that the historic link to gold is the reason that fiat currencies have value today. Given the number of people with no knowledge of this historic link, and that the historic link (after being weakened over a period of the prior 40 years) finally ended 42 years ago, I find this VERY hard to believe
The value of the dollar today is certainly not linked to the gold standard — Shostak wasn’t saying that. But on the day after the link to gold was severed, the dollar maintained its purchasing power based on what it had been the previous day. The second day after the break, its purchasing power was calculated based on the first and so on.
It was, however, the original definition of the dollar as a weight of gold that gave people confidence in it — that confidence was maintained after FDR ended its convertibility. The current purchasing power of a currency is based on a long chain of data.
How nice of you, Mr. Lucas, to simply cut and paste a big chunk of Dr. Shostak’s thoughts before making your point. Hard to believe, I know, but most of those who read the Cobden Centre’s daily post actually read that before glancing at the comments. While it is certainly true that if a number of people accept the Bitcoin as a medium of exchange, it will be so. However, it more than likely will be as Dr. Shostak says unless a central bank gets aboard that bandwagon. When he writes, “Electronic money will not replace fiat paper money” Dr. Shostak does overlook that presently it already has. I go to work. Periodically my employer requests his bank electronically transmit an agreed upon amount from his account to mine. Without benefit of any actual money, my bank dutifully adds that amount to my balance. I go to the store to buy bacon, eggs, bread and tea. When I check out I pay the cashier by credit card. I buy my gasoline with a credit card. I pay my bar bill with a credit card. I hand my credit card to the waiter at Tony’s Fine Eats. The amounts of my purchases are added to my running tab at the credit card company which bills me once a month on average. Upon receipt of that monthly bill, I simply go on line and ask my bank to electronically transmit payment to the credit card company which then electronically deducts the amount from my running tab. It’s possible that so long as I avoid parking by a meter, or some such, that I could go through life without ever resorting to any physical money. We truly live in a cashless society. Central banks, especially the U.S. Federal Reserve, no longer ‘print’ the stimulus by which they hyperinflate our money supply. They simply ‘purchase’ bonds electronically. When I mortgaged my house and financed my car, I never saw any actual cash. The only paper involved other than the obligatory paperwork were bank checks (cheques). So on this point Dr. Shostak is incorrect. We already accept what he asserted we never would.
Er, what I said in fewer words, I think.
Sorry that you found my copying and pasting annoying. I thought that it was standard practice in order to highlight a specific part of a given article upon which to comment.
Nice article by Frank Shostak. I’ve just got one technical / pedantic quibble as follows.
I agree with Frank Shostak’s claim that, “Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears.” (E.g. the pound was originally based on gold . . . but no longer.)
But that strikes me as inconsistent with his later claim that “BTC can function only as long as individuals know that they can convert it into fiat money…”. In other words I’ve no idea what determined the value of the original Bitcoin (perhaps one Bitcoin equalled one US dollar), but after Bitcoins get going they can (just like the pound Sterling) lose all contact with what originally gave them value.
And that is exactly what has happened with Bitcoin: given the gyrations in its value, it’s obviously lost contact with just about anything.
Those running the Bitcoin system would actually make Bitcoins far more attractive IF THEY DID tie it to a basket of currencies. Plus obviously are more attractive still if they can be converted to any other currency.
But my point is making Bitcoins convertible is not an absolute essential if it’s going to fly as a currency.
That money did evolve from barter is no reason at all why any new money must evolve from barter.
BTC is already accepted as having value.
The historic link to gold is what made fiat currencies acceptable to those people who first accepted them. People accept them today because they have some confidence they will be accepted by others for goods. Gold no longer has any relevance to fiat money.
It is not money. Only gold and silver are money.
It’s like fiat, in that it’s a currency.
The difference is that Bitcoin did not force itself to be accepted like fiat.
It was created by the market, for the market.
I don’t see Mr Shostak’s problems.
If it is accepted by the market, as it increasingly is, then who cares if it has intrinsic value or not?
It cannot take over from gold and silver. But that’s not its purpose. Its purpose is as a medium of exchange to facilitate online trade anonymously over borders, all over the world.
This is anarchy!
“It is not money. Only gold and silver are money”
That’s just ridiculous. Even Mises and Rothbard, beloved though they were of these two elements, didn’t make such a claim.
Money is whatever people accept as money.
Money is the most marketable commodity in a market.
I agree with you that anything can, and has been, used as money; cows, slaves, shells, fur etc etc…
However, gold (and silver until recently) are used for nothing else. All the gold ever mined is still above ground. It is not consumed at all (except in very small quantities in electronics).
A good money also needs the following characteristics:
Portability
Divisibility
Durability
Fungibility
A store of wealth
Money is a medium of exchange, an unit of account, and a store of value.
Gold (and silver to a lesser extent) has proven itself to be the universal money of choice in the free market over thousands of years.
While anything can be used as money, gold IS money…
It is not for you to say what money is, Captain Skin, since this will be the decision of millions, not just of you. You can, therefore, only observe what characteristics people have valued in money in the past and speculate on the future if you wish. The world is very different today than it was 10,000 years ago. Maybe the people will chose a different money. Certainly those that bought Bitcoin believed in a different future from you and who knows – maybe they will turn out to be right.
Bitcoin is basically fiat money, without central banking. The fact that some people trust a distributed system of anonymous users more than a central bank says a lot about central banking.
The fiat money supply can be expanded without limit. The Bitcoin supply expands only to a fixed upper limit. That seems like a pretty important difference to me.
Also, unlike fiat currencies, Bitcoins can’t be produced at a whim by any one party. Instead they are ‘mined’ by anyone who’s prepared to devote their resources to the task. In that sense it has more in common with gold.
I really can’t understand the antagonism displayed by certain sections of the Austrian community towards Bitcoin. Consider it dispassionately, and you’ll see that Bitcoin has a lot going for it.
Hello mrg!
I worry about 3 things principally.
Firstly, I don’t know how secure the whole system is – could it be hacked, particularly as computing power increases?
Secondly, how easy it would be for authorities to destroy it/shut it down/ban it?
Finally, I wonder whether there could be another better electronic currency (more secure, convenient, less easily destroyed etc.) that could supersede it, rendering bitcoins worthless.
Do you have a view on any of these things?