Revised February 14, 2014
Bitcoins are digital fiat currency passed directly between two people without the need for a trusted third party, such as a bank. In this respect they resemble banknotes. Bitcoin with a small “b” is a privately created and issued medium of exchange, the value of which is the subject of this note. Bitcoin with a capital “B” is a public ledger that records all transfers, hence changes of ownership, of bitcoin. Thus Bitcoin is the means of payment of bitcoin. Unfortunately the two, bitcoin and Bitcoin (the medium of exchange and the means of payment) are often mixed carelessly in discussions of bitcoin. This note is primarily about bitcoin—the medium of exchange—rather than Bitcoin—the means of delivering them.
While a growing number of digital competitors claim to overcome one or more of bitcoin’s (and Bitcoin’s) technical weaknesses, bitcoin is the frontrunner among cryptocurrencies with the most developed supporting infrastructure. It is the very nature of money that its usefulness depends on how widely it is accepted (so called network externalities) and thus the dominant currency tends to suppress potential competitors and is itself hard to displace. Thus while bitcoin is likely to continue to dominate over its cryptocurrency rivals, the key question is whether it is likely to seriously challenge national currencies such as the U.S. dollar or the Euro.
Though Bitcoin’s digital and peer-to-peer (P2P) nature poses serious technical issues for bitcoin, a key question for its future is whether it will ever achieve a stable value, the most important quality of a successful currency. In this note I will review the factors that determine the value of a currency and how they might apply to the long run value of bitcoin and thus its prospects of ever achieving a stable value. With regard to the protocols and algorithms underlying big B Bitcoin, many have claimed potentially dramatic improvements in how payments are made, and titles of all sorts more generally are maintained and transferred.
The difference between cash (physical banknotes and coins) and other means of payment such as checks, wire transfers, Visa, and Paypal, is that the payment of cash is made directly between the parties to the payment, i.e. peer-to-peer. All other means of payment involve trusted third parties, such as banks, credit companies, and exchanges, that keep records of the ownership of money and its transfer from one party to another. These alternatives describe means of payment, not what is being paid, i.e., not money. These various means of payment can be used to make payments in any money desired. Wire transfers of bank balances can make a payment in whatever currency the bank balance is in—U.S. dollars, Euros, Renminbi, gold, or what ever. This distinction between means of payment and money is very important.
Money by its nature combines the functions of a medium of exchange (the thing paid), a store of value (the inventory of that medium held pending payment), and a unit of account (the unit in which things are priced).  All combine to promote money’s raison d’être—reducing the cost of exchange.
While a medium of exchange can potentially be anything acceptable to the payee (barter), and almost any durable good can store value (uncooked rice), the unit of account function of money stands out as its most central and critical quality. As such, the value of that unit—the value of the money—what it can buy—is basic to its usefulness. Like standards of weights and measures, the nominal value of money is almost universally established by governments, while its real value is determined by markets. The various means of payment of that money—can be and generally are privately developed and provided (Visa, Paypal, bank checks, etc).
The value of a bitcoin
Bitcoin (small “b”) is a privately produced fiat money in every respect. So how is its value determined? Like everything else, its value is determined by the interplay of supply and demand.
The behavior of bitcoin’s supply is its strong point. New bitcoins are minted by a publicly visible formula at a decreasing rate until its supply approaches 21 million units in 2040. There are currently about 12.3 million bitcoin in existence. Currently an additional 25 bitcoins are minted every ten minutes and they are issued to miners for verifying that bitcoin used in transactions are not counterfeit. Their price is not fixed to anything and they are not redeemable for anything. They can be exchanged for dollars or other national currencies for whatever buyers are willing to pay and sellers are willing to accept.
Thus the story of the determination of the value of bitcoins is on the demand side. Such a system is the opposite of the gold standard or my real SDR currency board system in which the value of the monetary unit is fixed and the supply adjusts to the market demand at that price. Bitcoin is a system with centralized control (via a rule) of the supply of money and decentralized (market based) determination of its value, while the gold standard was a system of centralized determination of the value of money and decentralized, market based determination of its supply.
Who demands bitcoins and what factors influence that demand? Money of any kind is demanded and held in order to have some available when we want to make a payment or to buy something. Money holdings also reflect the lack of synchronization of the timing of receipts of money, such as for wages, and its expenditure. An inventory of ready cash (and or bank account balances or credit) is needed in order to make payments. The bigger each person’s inventory of money is, the easier it is to make any payment that is needed or desired. However, as with any other inventory, there is a cost to maintaining it. A very large amount of empirical evidence supports the theoretical expectation that the more expensive it is to hold cash between its receipt and expenditure, the less people will hold. When the interest rate opportunity cost of holding money is high, cash holdings, like all other inventories, will be reduced. When inflation is higher (a tax on holding cash), cash holdings will be lower. When the cost of holding money in one or the other of these ways is more uncertain, e.g., because of fluctuations in its value, cash holdings will be lower as well.
The value of a bitcoin, or any other money, is measured by what it can buy. This has two dimensions, a) how widely it is accepted in payment; and b) how much it can buy where it is accepted? Thus the best measure of the value of a bitcoin in the second sense is its exchange rate with the U.S. dollar as the dollar is widely accepted and its purchasing power is quite stable (though any other good or basket of goods could be used as well). Bitcoin’s value is famously highly unstable and unpredictable (and it is still not accepted in very many places).
Over the three months between November 1, 2013 and February 1, 2014 its price (exchange rate) on the Mt. Gox exchange has ranged from around $200 USD per bitcoin to $1,200 and is currently (February 14) around $425 per bitcoin ($220 on Feb 16). These reflect huge bitcoin inflations and deflations. The price on the Mt. Gox exchange plunged from the mid $900s last week to the low $400s this week after it announced the suspension of withdrawals as a result of a bug in the bitcoin software (a claim denied but some). Coindesk has removed Mt. Gox from its bitcoin price index until this problem is resolved, which in mid day Feb 14 was $659 dollars per bitcoin.
As a result of such volatility, virtually nothing is priced in bitcoin, even things that can be purchased with them. Many who pay with bitcoin and most merchants that accept them never actually hold them for more than a few minutes. A toy selling for $100 can be purchased with bitcoin with minimal inflation or deflation risk in the following way. The buyer of the toy pays dollars to a seller of the bitcoin equivalent of $100 via an exchange such as Mt. Gox in Japan and instantly transfers them to the merchant selling the toy. After a few minutes delay while “miners” verify that the bitcoin being transferred (first to the buyer of the toy and then to its seller) are genuine and not electronic copies (i.e. counterfeit), the merchant sells them through an exchange for dollars. Thus the buyer pays dollars and the seller receives dollars but with bitcoin transferred between them. The risk of exchange rate movements is thus minimized. Trusted third party transaction processors like bitpay or coinbase absorb the exchange rate risk over the up to ten minute verification periods. While such trusted third parties provide badly needed support for bitcoin transactions, they undermine the alleged uniqueness of direct peer-to-peer payments.
The above practice is needed to reduce the risks to merchants of “accepting” (fleetingly) volatile bitcoins and thus promises to promote the broadening of their usability. So far the use of bitcoin is a negligible fraction of total payments but not trivial and is growing. However, the fact that few bitcoin transactors actually hold them, and the fact that all bitcoins in existence must be held by someone, implies that the demand to hold bitcoin today comes almost totally from speculators. As long as speculators think the value of bitcoins will continue to increase they will be willing to continue to hold or add to the stock they now hold. This will maintain or increase their value. The moment speculators lose such optimism or decide to cash out while they are ahead, the price of bitcoins will fall and bitcoin prices have experienced a lot of both. The dollar price of bitcoin has skyrocked to unbelievable levels (over $1,200) but it could just as easily fall to zero.
For the value of bitcoins to stabilize, the transaction demand for them (the demand to hold modest inventories of them in order to make payments with them) will need to increase to the point that it crowds out or at least dominates the speculative demand for them. This is not impossible, but in my view is very unlikely.
The future of bitcoin
The use of bitcoin at this point is driven more by ideology than economics. Its promoters like the fact that bitcoins’ supply and value are not controlled by any government and that transactors can be anonymous (or at least Pseudonymous). But there is no compelling reason for anyone to replace the dollar as the American economy’s unit of account with bitcoin, which has been wildly more volatile than the dollar. If goods and services are not priced in bitcoin, however, it will always suffer from the added cost of exchanges between bitcoin and the dollar or other national currencies at the time of a payment.
Bitcoin enthusiasts point to its current low cost of transfer when making payments as a source of its attractiveness and thus its future demand. However, this claim is subject to two challenges. The first is that the means of payment used by bitcoin (i.e. Bitcoin) is equally usable for any other medium of exchange. The entire payment infrastructure that has been developed and continues to develop for bitcoin could be used to make payments with U.S. dollars or other currencies if in fact it provided a superior means of payment. This is the model used by rival cryptocurrency Ripple. Two simple modifications could replace bitcoin with U.S. dollars in the existing Bitcoin system. Rather than being fixed by a rule, the number of dollars in the bitcoin like system would be whatever people paid for, dollar for dollar, and existing Bitcoin exchanges would accept and hold traditional dollars (currency or deposits) in exchange for the same quantity of digital dollars to be used via the Bitcoin system.
The systems of mobile phone payments in local currencies that are growing rapidly around the world are similar in many respects but require the central accounting records of a trusted third party. These systems are driving down the costs of making payments and are instantaneous (faster than bitcoin, which must first authenticate that the bitcoin are genuine). A P2P system has inherent technical challenges and is likely to always be slower than systems relying on trusted third parties.
The use of M-Pesa in Kenya to make small payments of Kenyan Shilling and remittances from abroad has grown at a spectacular rate. Over 70% of Kenya’s adult population used the system by the end of 2012. Based on the record keeping of a trusted third party, M-Pesa payments are simpler and quicker than bitcoin payments. Such new technologies are also driving down the costs of making payments. Cash in and out when buying or selling M-Pesa is almost all in cash requiring street vendors or physical windows rather than virtual exchanges with all digital payments as with bitcoin. However, should bitcoin be used in Kenya it would also need physical cash in – cash out facilities, which would increase its costs relative to those in more advanced economies.
The cost of M-Pesa or Bitcoin type payments should be less than credit payments such as Visa, or Master card because users must pay for the currency in advance of its use and because credit payments can be reversed with charge backs. Each has its advantages and disadvantages and there is room for both
The second challenge to bitcoin’s claims as a superior, lower cost means of payment is that its business model will ultimately require the introduction of fees (some already exist for trusted third party services now being provided). The miners, who perform the service of authenticating bitcoins used in every transaction, are currently remunerated on the basis of the first to complete the authentication of a payment block (public ledger of transactions) earning newly minted bit coin. Over time as the number of bitcoin minted declines to zero and the number of transactions to authenticate increases (should that happen) the remuneration to miners will fall and will need to be supplemented with fees to ensure that the authentication service continues to be provided. Aside from providing its own medium of exchange, Bitcoin is one among many means of payment. Competition and further technical innovations promise to lower the cost of making payments in any currency and it is difficult to see any particular advantage for Bitcoin and considerable disadvantages in this regard.
If a well-defined transactions demand for bitcoin does not emerge to sustain its value, and it is difficult to see why it would, its value will remain at the mercy of the whims of speculators. My expectation is that it will never achieve importance and that it is likely to vanish all together, giving way to more robust means of payment of more stable mediums of exchange. However, it deserves the chance to compete.
Appendix – What are bitcoins?
Bitcoins are digital monetary units created according to a well-specified rule, which will gradually increase their total supply to 21 million sometime beyond 2033. Newly minted bitcoins are paid out to “miners” who perform the services of vetting the authenticity of each bitcoin being transferred from one address to another. This is a critical service to prevent the multiple use of the same bitcoin (double spending problem) given the ease of making electronic copies of what are digital codes to begin with.
Bitcoin may be purchased from those who have them at a mutually agreed price. Such transactions may be conducted face to face or via exchanges established for this purpose. A significant infrastructure has been and is being developed to facilitate these exchanges between bitcoin and national currencies, thus introducing an important role for trusted third parties.
The digital records of the receipt and transfer of bitcoins are maintained in thousands of copies of Block Chains (public ledgers) on the internet. The approach uses public key and private key encryption much like email, where our email addresses are public for everyone to see but our passwords are (hopefully) known only to us. If I receive an email from your address I can be confident it came from you if you keep your password secret. Apps have been developed for bitcoin users to separate their transactions from all others. These “wallets”, make the process more user friendly. If the record of a bitcoin users private key (password) is lost because the hard drive crashes (without back up) or is lost or stolen, the bitcoins held by that user are lost to him/her without recourse. For this purpose and to further simplify the transaction and exchange process, trusted third parties provide on-line wallet and related services. Though at least one on-line wallet service has absconded with the bitcoin deposited there (rather like hacking your email by discovering your password and changing it to something you don’t know).
The ultimate purpose of bitcoin is for making payments for the purchase of goods and services or the discharge of debts. They may be used to make a payment to anyone (person or merchant) willing to accept them anywhere in the world. Given the extreme volatility of their value, a number of trusted third parties have been established to take the exchange rate risk by guaranteeing the exchange rate at which bitcoins can be acquired and resold as close to simultaneously as the authentication process permits (usually no more than ten minutes). Thus a merchant selling goods priced in dollars can accept the bitcoin equivalent (at the moment of the settlement) and resell them for dollars without holding them more than a few minutes.
Bitcoin payments are final, i.e. cannot be reversed without the agreement of the recipient to send them back. They are currently cheaper than most existing means of payment. Information on ownership and transfers is decentralized with many copies of the history of all transaction publically available to anyone. They are somewhat slower than some other means of payment (the average time to authenticate and thus complete a transaction is currency around 9 minutes) but much faster than most bank transfers. The authentication of transaction may become problematic as the number of them increases and the remuneration of miners is reduced.
In my judgment, the use of Bitcoin for making payments and transferring titles and records of all sorts offers much more promise for future efficiencies than do bitcoin or any other private media of exchange, especial fiat currencies of which bitcoin is the purest example.
An easy to read guide to most aspects of using bitcoin can be found at: http://www.coindesk.com/information/. A more detailed and outstanding guide is also provided by Jerry Brito and Andrea Castillo at the Mercatus Center, George Mason University: http://mercatus.org/publication/bitcoin-primer-policymakers
 For a fuller discussion, see my article on the Future of Money in the 2012 Winter issue of the Cayman Financial Review http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/
 See Section 8 of the Constitution of the United States.