This post is meant to delve into the monetary aspects of Bitcoin, and the differences between Bitcoin and the dollars in your pocket. Please feel free to correct and add to the discussion.
What is fiat money?From Wikipedia:
The term fiat money is used to mean:
any money declared by a government to be legal tender.[1]
state-issued money which is neither legally convertible to any other thing, nor fixed in value in terms of any objective standard.[2]
money without intrinsic value.[3]"Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money."
Bitcoin clearly does not fit definitions #1 nor #2. In my opinion, definition #3 is misleading, since
nothing has intrinsic value. Sure, Bitcoins might not have value if not used as money, but it does not follow that because they have no value if not used as money, that they therefore also have no value
if used as money.
Therefore, Bitcoin is technically a fiat currency per definition #3, but I see this as a "weak" definition, and not a strong one.
If Bitcoin is not the same as sovereign fiat currency, then what is it?Bitcoin is a digital currency which shares many of the properties of money, namely, scarcity, fungibility, and a means of exchange. The pattern of digital bits and the mathematical conventions in place enforce these aspects. Bitcoin is far more similar to a digital version of gold than it is to a sovereign fiat currency.
But what backs Bitcoin? How can it have any value if it is not backed?I would ask "What backs gold?" The answer is that the question is starting from the wrong assumption: Bitcoins do not need to be hard-linked to anything else. The need for a distributed, anonymous, and decentralized currency drives initial adoption. The value of Bitcoins will be driven by supply and demand; in essence, it is backed by what people are willing to trade for it; the same as gold.
What is the difference between monetary inflation/deflation and price inflation/deflation?Monetary inflation and deflation occurs whenever there are changes in the supply of money. Increasing the money supply is the definition of monetary inflation, and decreasing the money supply is monetary deflation.
Ok, but what is price inflation/deflation?Price inflation/deflation is what most people commonly refer to as "inflation" or "deflation", and it occurs when the general level of prices increases or decreases. In reality, price inflation and deflation is a
consequence of the change in money supply, it is the
effect and not the cause.
Prices can go up and down without there being changes in the money supply. For example, computer prices have been steadily declining, but this is due to increasing efficiencies and not decreases in the money supply. Oil prices have risen greatly over the past decade, but this is in part due to increasing demand in China and elsewhere, and is not solely due to monetary inflation.
Finally, the important question: What are the dynamics of Bitcoin, and how do they differ from sovereign fiat currencies?To be fair, any currency should treat all holders of the currency equally. Whatever happens should affect everyone equally. Let's look at the differences:
Sovereign fiat currency:
* Regime of monetary inflation
* Monetary inflation is great enough to cause price inflation
* The new money is never distributed to everyone equally, therefore, some people's holdings depreciate faster than other people's holdings. This entails a real redistribution in wealth between holders of the currency, and receivers of the newly-printed currency.
* As governments have a monopoly on the printing press, they can expand the supply of money far beyond the demand, thus setting up the stage for a credit bubble and bust.
Bitcoin currency:
* Regime of exponentially decreasing monetary inflation, then monetary stability. The inflation is distributed equally among hashes/second, with some variance due to the randomness of the problem to be solved.
Once the supply is stable, there will be a slight monetary deflation as Bitcoins are lost. This deflation will redistribute wealth equally to all other holders of Bitcoin.
* As the money supply does not inflate, prices of everything in Bitcoin will slowly decline. This benefits all holders of Bitcoin.
* New money creation is always distributed equally, in proportion to resources expended.
* There is no monopoly on the ability to create new Bitcoins, no government enforcement, and no arbitrary allocation schemes. The currency's value is driven entirely by supply and demand.
Bitcoin appears to be similar to gold in terms of monetary dynamics!This is true. The main difference is that gold is a very slightly inflationary regime, but again, it benefits people based on resources expended. The inflation rate is also very low. Gold also has commodity uses apart from its uses as money.
Bitcoins, on the other hand, will be a very slightly deflationary regime. Should the currency be successful and the value skyrocket, I fully expect that very robust backup and replication schemes will be put into place.
But Bitcoin is not a commodity! It is impossible for it to be used as money!Not true. Bitcoin is distributed, anonymous, and decentralized: All features that the market is looking for. This does not preclude a better alternative coming along, but neither does it disprove Bitcoin! I see Bitcoin as the next step on our path to a digital future, and I believe that it can succeed.
Discuss?Please feel free to comment and/or add to the discussion!
