Bitcoin Isn't Money

Bitcoin might be the biggest news about currency since Zimbabwe's hyperinflation, but the irony is that it's not even money. It's just your run of the mill speculative financial asset.

I recently wrote a piece about Bitcoin for Global Risk Insights called "Bitcoin offers free currency movement in China, for now." Since I wrote it, I've still been wondering about the mysterious digital currency.

Currency is a mind-blowing concept if you stop to think about it: Hundreds of millions of people all believe certain pieces of paper are worth something, while others are just trash. How does something so worthless begin to earn the trust of the world? Usually it has to do with a government guaranteeing its value, but it doesn't necessarily need to happen that way, as Bitcoin's founders are trying to prove.

Bitcoin's purpose is to be a currency without the backing - or as its proponents would say, baggage - of any type of government. When governments runs currency, its value can be eroded by printing money to pay for extravagant public spending (like many Bitcoin supporters and libertarians think the US government is doing to the dollar). Instead, Bitcoin is decentralized, with a computer program slowly and predictably introducing Bitcoins into the world (until there are 21 million of them, at which point the fun is over and the world will just have to enjoy the Bitcoins it already has). Bitcoin has a sense of freedom that government-issued currency doesn't. The story of Bitcoin has been so powerful for just that reason.

But shadowy internet figures don't just wake up every day and create legitimate currencies. So how does Bitcoin become one? That's the million Bitcoin question (which could be anywhere from $500 million to $1.2 billion depending on the day): Trust in currency is a self-fulfilling prophecy. If other people don't trust it, then you shouldn't trust it either. If other people do trust it, then you can trust it, too. 

Regardless of how it gets there, there are a few signs that a currency has arrived. Unfortunately, they're all conspicuously missing from our digital wunderkind.

Money is different from a stock, bond, or security in a number of ways. At the core of the difference is that employers doesn't pay employees in Treasury Bonds and no one pays for milk in mortgage-backed securities. (Okay, some executives and start-up ventures get paid in stock options, but that'snot many people and it is just a part of their salary). In monetary economics, there are a few more specific ways of saying this. Here they are, and why Bitcoin doesn't exhibit them.

Medium of Exchange

You buy stuff with money. It's an easy way to value and exchange goods, accepted by a wide range of individuals and businesses. Without it, all transactions would have to be bartered. Each time I wanted to buy something, I would have to find not only someone who is selling it, but someone who is selling it *and* wants to trade whatever I can offer.

"Good sir, I will offer you 1 hour of blogging services in exchange for 4 pints of lager." If the bartender didn't want my service, I'd have to remain thirsty until I found a pub that did.

In other words, money makes it a lot easier for an economy to work. Everybody receives their salary in the same currency and then can trade it for the goods and services require, regardless of what that business owner will use it to buy. 

Bitcoin certainly has been a medium of exchange. It was the currency of choice for Silk Road, the now-defunct website that allowed users to anonymously buy drugs and guns online. Needless to say the US government wasn't a big supporter of Silk Road, and its days are now numbered.

Store of Value

There are a few other websites, mostly selling computing products, that accept Bitcoin - but their business has been wildly volatile. Day to day, the value of a Bitcoin varies so widely that potential customers have been hoarding their Bitcoins instead of spending them. When Bitcoin reached its highest value at the beginning of December, Bitcoin retailers were anecdotally reporting that their sales dropped 20% in a week. That's because when a currency is deflationary - meaning it rises in value with time - it's more valuable to stash the currency under your mattress because you'll be able to purchase more with it tomorrow.

In other words, Bitcoins are not a good store of value - the second major characteristic of money. The purpose of money is partly to allow consumers and firms to carry resources from one period to another. As a simple example, think about the typical work week. It spans Monday through Friday, leaving the weekend for leisure, shopping, and family time. If we weren't able to save our earnings from Friday to spend on Sunday, then we'd have to either spend our whole paycheck Friday or work a little bit on Sunday. Luckily, we are paid in dollars or euros or pounds so that we can hold onto our earnings until we decide to go shopping.

Now that example is only over the very short run, a couple of days at most. Think about the same problem over the longer term. Sure, the value of the dollar slips a bit each year due to inflation, but for the most part it is stable. I worked for the last two years to save up for grad school, and that was only possible because I was able to store the value I provided my employer in dollars.

Now only if we could say the same thing about Bitcoin:

 Bitcoin has lost more than 50% of its value since December 4th. Good thing your 401(k) isn't in Bitcoins!

Bitcoin has lost more than 50% of its value since December 4th. Good thing your 401(k) isn't in Bitcoins!

If your paycheck came in Bitcoins, you would have taken a serious paycut between December 4th and December 18th (which makes me wonder: are the employees of Bitcoin exchanges paid in dollars or yen, or Bitcoins? Because if not even the exchanges are paying in Bitcoin, then that's a pretty damning indictment). Let's look at the Pound Sterling and Euro compared to the US dollar over the same time period:

 Woah, that's pretty stable! Especially after seeing that Bitcoin graph!

Woah, that's pretty stable! Especially after seeing that Bitcoin graph!

On top of Bitcoin not looking like money anyway, most Bitcoin owners weren't using it like money. They were using it like a speculative asset or laundering tool. Some hedge funds bought heavily into it (which isn't to say their idea was dumb. If you got into Bitcoin before November, you'd still have a return of over 100%). The money laundering bit is really interesting. Outside of Silk Road, Bitcoin was most valuable for helping Chinese residents sneak their money out of China, skirting around tight capital controls. This phenomenon probably is the main reason that Beijing stepped in, which I had predicted in my GRI article a few weeks ago. China has been in the process of liberalizing its banking and financial system steadily for over a decade, but doing so very slowly. Bitcoin was just too fast of a change for China. This is especially true when it comes to the impact of liberalization on exchange rates, since the capital controls are in part to hold the renminbi artificially low against the US dollar. 

So there we have it: Bitcoin isn't money, and it isn't even worth much compared to two weeks ago. And it is now essentially banned from its largest market. If I were Bitcoin, I'd be down in the dumps right now. Like listen-to-The-National-on-repeat in the dumps.