What’s Bitcoin Backed By?
Ancient currencies, like grain, were backed up by the currency’s intrinsic use value. The US dollar, up until the latter half of the 20th century, was backed by gold. Now, it is backed up by a government willing to accept taxes in them. Second Life’s Linden Dollars are backed by a price peg on Linden Labs’s exchange for USD. But what is Bitcoin backed up by? The answer seems to be nothing: there is no central authority that guarantees Bitcoin’s value, so, according to some, there is no reason why the value of bitcoin should be anything higher than zero. But the true answer to the question is a different one, one whose validity is rather counter-intuitive: Bitcoin is backed up by the market.
Let us examine what is meant by the statement «the US dollar, up until the latter half of the 20th century, was backed by gold». This means that the government was willing to exchange USD at a fixed price for gold, so a merchant who accepted 20 USD knew that he could go to the US government and trade it in at any time for one ounce of gold; by owning 20 USD, the merchant effectively owned gold. However, this ownership is not absolute; it rests on the US government. If the US government were to collapse, whoever ended up owning Fort Knox would have no reason to give away his gold in exchange for pieces of paper, and the pieces of paper would rapidly become worthless. Thus, the US dollar was only as stable as the US government, and it is the same with any other backed currency; Linden Dollars are only as stable as Linden Labs (incidentally, as the Mises institute points out, not very stable: the Linden Dollar is only backed with a fractional reserve), so-called local currencies are only as stable as the agency that issues and redeems them.
However, there is another factor backing up a currency’s value, and this is the one Bitcoin relies on: it is backed up by every merchant willing to accept it in exchange for services. Just as the merchant accepted USD with the assurance that the US government will accept it in exchange for gold, someone accepting BTC does so with the assurance that at least one of the merchants that he buys from will accept it from him, and each of these merchants in turn makes the same calculation. This system is often conflated with a Ponzi scheme, where an individual puts in money in with the expectation that he can convince two others to join, giving a commission to the originators of the scheme and the rest of their money to him, giving him a net profit, and a speculative bubble, where an individual buys a commodity or security at a high price with the expectation that the price will go up even higher, allowing him to make a profit — both are essentially aspects of the Greater Fool Theory. However, while Bitcoin’s value does function similarly, there is a fundamental difference between the two: one is sustainable, and the other is not. In a Ponzi scheme, if an investor only finds one sub-investor to put money in below him, then the Ponzi scheme creator will take his commission and the investor will suffer a net loss. Thus, the Ponzi scheme must have an ever-growing number of investors in order to survive, making its demise inevitable. A speculative bubble is similarly unsustainable; unless the price keeps going up, an investor will get zero profit and will have wasted his time. Bitcoin, however, is sustainable: when a merchant buys 5 BTC worth of food from one vendor, buying into the scheme, and then sells 5 BTC worth of his product to someone else, cashing out, the merchant still benefits, since he values food, which he cannot produce himself, more than his product, of which he has an excess. Even if the value of Bitcoin falls by 2% between the two exchanges, the merchant most likely still values 4.9 BTC worth of food more than 5 BTC worth of his own product, and thus has a net profit despite the 2% loss. Thus, the Bitcoin «Ponzi scheme» can keep on circulating around forever, and, unlike a speculative bubble, can even survive if Bitcoin falls in value.
This model of a currency is not limited to Bitcoin; fiat currencies rely on it and even gold relies on it to maintain a value far above its intrinsic use value. In fact, fiat currencies rely on this model just as much as Bitcoin does — the idea that fiat currencies are backed up by the fact that you can pay taxes with them is false since the government makes no promise that a certain amount of USD is valid payment for a certain number of future years of taxation; if the value of the USD falls by 90%, then the taxes that must be paid in USD will go up by 900% and the portion of one’s taxes that a dollar can pay will, as a result, itself go down by 90%. Thus, both with fiat currencies and with Bitcoin there is no centrally set price floor, and fiat currencies are thus no better than Bitcoin.
However, there is one issue with the «sustainable Ponzi scheme» model: it relies on the fact that the benefit the merchant gets from getting food indirectly in exchange for his product exceeds the loss that the merchant might suffer from currency depreciation while the merchant is holding on to his currency. This necessitates a certain level of stability in Bitcoin’s value. Unfortunately, Bitcoin currently does not have this stability. But how does this stability arise in major fiat currencies? The reason is that there are services available at fixed prices in those currencies. If the value of a USD falls by 50% in 1 hour, merchants throughout the US will not hear about this value for a few days, and people will be able to cash out their USD in exchange for services. Eventually, supply and demand will cause prices to increase to match the value change, but the process will take a few days, creating a dampening effect. Long-term contracts such as subscriptions, cell phone plans, rent and employment, where prices remain sticky for a few months, provide a further level of dampening — if someone knows that having $4000 USD around will allow him to maintain his car lease for 6 months no matter what, and he does not have $4000 cash on hand, he will buy the currency for any price up to the value of that lease to him, pushing the trade value up. Bitcoin, on the other hand, does not have these kinds of services, and, even worse, many merchants have their products and services dynamically priced based on the BTC-E trading value of the BTC. Thus, the value of a bitcoin, both in terms of its exchange rate with USD and its ability to be used as payment for services, might potentially fall by 50% in less than one day.
Bitcoin is, in terms of how it is supposed to work, backed up by the economy in the way that I have described, but in practice, the currency’s value is floating freely, increasing and decreasing with the tide of speculation. Bitcoin’s stability is showing signs of improving and the larger the size of the market, and thus the market depth, the less the likelihood that a single spike of sellers will cause a sudden decline. However, while large volume provides insurance against sudden random spikes of buying or selling, it does not provide insurance against drops in price caused by changes in public opinion — with twice the volume, there are also twice the people who would try to cash out if the future of Bitcoin suddenly looked less favorable, and the price of Bitcoin would drop just as much.
Some says the speculators backing up Bitcoin are not interested in a quick profit; they are regular individuals who believe in Bitcoin’s long-term future. However, while speculation and public opinion do push Bitcoin’s value up, they cannot be relied upon to keep its value stable. The only thing that can do that is a genuine economy in goods and services, where individuals expect to profit from the scheme not by Bitcoin’s value going up while they hold onto their coins, but by the basic principle of economics — the fact that what they’re buying has a higher value to them than what they’re selling. When this happens, bitcoin will cease to be a commodity and truly become a currency.
Update: Thanks for your useful comment Tom Mornini, I just wanted to point out that Bitcoin must find a way to be used in everyday shopping, for example every supermarket should accept bitcoin like they accept credit cards.