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Author Topic: The economics of Bitcoin: How does it work?  (Read 4043 times)
Bitcoiner
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July 15, 2010, 04:33:09 PM
 #1

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:

Quote
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!

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joechip
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July 15, 2010, 05:11:54 PM
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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!

This speaks to my question from the other day.  The issue of commodity money vs. non-commodity money is inherent in the evolution of the use of the commodity as money.  That one commodity was chosen by the market through time as the one which could be universally exchanged for any other commodity is the process which bitcoin cannot replicate. 

The evolution of the marketplace which eschewed commodity money for fiat money (the current situation) is commonly brought up as a repudiation for commodity money by those with a vested interest in maintaining the fiat currency regime.  The question to be considered is what is the limitation of commodity money in a world where the property rights of the commodity can be transferred without physical transference of the commodity itself.  This was an issue under the International Gold Standard pre 1914, the necessity of moving large volumes of gold which created demand imbalances for it (or at least that is the claim of credit money apologists). 

If that was indeed the case, then a return to a truly hard money standard is impractical in today's markets, hence the rise of credit money to handle problems of liquidity to clear markets. 

Is Bitcoin (or something like it) the next step in the evolution of money itself... from commodity --> commodity backed fractional-reserve (Bretton-Woods) --> Full floating fiat exchange (Friedman's Wet Dream) --> Bitcoin (traceable, pseudo commodity [property rights enforcing], digital)?
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July 16, 2010, 01:20:38 AM
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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.

It is interesting to look at the history of precious metals as a means of exchange. In the modern period, to my knowledge only silver and even rarer metals (gold, and to a much lesser extent platinum group metals) have backed money or even been directly fabricated into money as coinage.

These metals cannot be created or destroyed*, only extracted from the earth and lost to it again, and are rare enough that a portable quantity of material can represent a significant amount of wealth. They also have industrial uses which places a backstop behind their value much more robust than that of paper notes.

At the same time, it is not MERELY permanence, rarity, and industrial utility that causes survivalists and investors alike to seek them during periods of economic uncertainty. Were that so, cries to go on the tellurium standard or the bismuth standard (or stockpile selenium or mercury for the upcoming post-zombie/Peak Oil/2012 apocalypse) would be as common as those for returning to precious metal standards. Mercury is rarer than silver, just as corrosion resistant, and shiny and heavy. So why has it never backed money and why does it currently trade at less than 5% of silver's price?

It seems to come down to tradition. Gold and silver have played a big role in monetary systems before so people seeking stability or a return to the past return to the same metals. Nothing is inherently valuable, but gold and silver retain value better than most things because of a collective expectation or self-fulfilling prophecy that they will**.

Where does this leave bitcoins? They don't have any alternative value in manufacturing electronics, chemicals, or jewelry. They don't have any tradition backing them either. Their strength is only as great as the traditions or collective expectation that grows up around them. Right now the future is very much in flux, but I'd prefer a future in which they're a viable medium of exchange. So I have made an inexpensive investment to learn about them and participate in the computing system that underlies them. Tradition has to start somewhere... and one day it might really pay off.

*Save by nuclear transmutation, which is so expensive that it runs no risk of materially affecting metal stockpiles.
**Well, sort of. The price floor is well established, ceiling is more dubious; they're still vulnerable to bubbles.
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July 17, 2010, 03:33:38 AM
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Nice posts, guys.

I think that Bitcoin has already passed the first test; thousands have already been traded on the exchanges! That surely shows that it has the potential.

Want to thank me for this post? Donate here! Flip your coins over to: 13Cq8AmdrqewatRxEyU2xNuMvegbaLCvEe  Smiley
ichi
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July 17, 2010, 01:59:36 PM
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I invite comment on my recent post Proof-of-work difficulty increasing thread.  Thanks.
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July 17, 2010, 02:05:09 PM
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I invite comment on my recent post:

Probably better to discuss it here.
Here is what you posted:

I value Bitcoin as an anonymous digital currency.  Although I'm not expecting to get rich, I'd like the ability to continuously generate enough Bitcoin to purchase desired services.

Is there any expectation that economic value per khash/sec (or client) per day will be at least somewhat stable?  Difficulty just increased 300%, and USD/Bitcoin just increased about 500% (although that may turn out to be a spike).  I do get that there's no necessary relationship.  However, perhaps there's an economic basis for one (however approximate it might be).

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July 21, 2010, 02:06:48 AM
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I invite comment on my recent post:

Probably better to discuss it here.
Here is what you posted:

I value Bitcoin as an anonymous digital currency.  Although I'm not expecting to get rich, I'd like the ability to continuously generate enough Bitcoin to purchase desired services.

Is there any expectation that economic value per khash/sec (or client) per day will be at least somewhat stable?  Difficulty just increased 300%, and USD/Bitcoin just increased about 500% (although that may turn out to be a spike).  I do get that there's no necessary relationship.  However, perhaps there's an economic basis for one (however approximate it might be).



That is the market demand speaking.There is obviously pent up demand for the free flow of transactions between willing participants. Smiley
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July 21, 2010, 03:42:05 AM
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I invite comment on my recent post:

Probably better to discuss it here.
Here is what you posted:

I value Bitcoin as an anonymous digital currency.  Although I'm not expecting to get rich, I'd like the ability to continuously generate enough Bitcoin to purchase desired services.

Is there any expectation that economic value per khash/sec (or client) per day will be at least somewhat stable?  Difficulty just increased 300%, and USD/Bitcoin just increased about 500% (although that may turn out to be a spike).  I do get that there's no necessary relationship.  However, perhaps there's an economic basis for one (however approximate it might be).



I would not expect to be able to continuously generate enough bitcoins to be able to purchase much of anything.  They are a medium of exchange, not a way for people to purchase things without doing anything for it aside from running their computers.  Yes, some people are able to do so (or were able to rather) but that is already changing at this point, and is going to become less and less a part of the model in the future.  At this point we need to focus on increasing the bitcoin economy to support the growth in users that it has experienced.  If you want bitcoins, figure out what to sell to get them.

Tarot Card Readings for Bitcoins, available via e-mail, phone, skype or IM of your choice.  Inquire for price, quite reasonable.
ichi
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July 21, 2010, 05:32:48 AM
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<snip>

I would not expect to be able to continuously generate enough bitcoins to be able to purchase much of anything.  They are a medium of exchange, not a way for people to purchase things without doing anything for it aside from running their computers.  Yes, some people are able to do so (or were able to rather) but that is already changing at this point, and is going to become less and less a part of the model in the future.  At this point we need to focus on increasing the bitcoin economy to support the growth in users that it has experienced.  If you want bitcoins, figure out what to sell to get them.
Yes, I've figured that out -- no BTC for me since Friday, with ~5,000 Khash/s total Sad

I guess that I'll have to buy them.

I gather that a few participants with massive CPU resources are getting most of each day's BTC.  Do we know the BTC-generation histogram?  Doesn't such CPU domination pose a security risk for Bitcoin?  Also, if BTC reward is very unlikely for most users, doesn't that eliminate any incentive for them to contribute more than minimal CPU resources?  Isn't that a feedback loop that drives the concentration of BTC-generation?
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July 21, 2010, 10:06:33 AM
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The expected number of Bitcoins has been going down, but the expected value is not really. 10 days ago coins were worth like half a cent. They've been between 6 and 9 cents lately. 15 times harder for 15 times more valuable coins.

It would be neat if someone could think of a way for users to agree to commit to pooling received coins. This would smooth it out a bit.

Play Bitcoin Poker at sealswithclubs.eu. We're active and open to everyone.
ichi
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July 21, 2010, 11:30:39 AM
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Yes, the total daily value isn't changing much.  It's just that most of us aren't getting any Cry

Who is?  And what's the distribution of Khash/s per node?  Is there evidence of NSA etc, or is it just botnets?
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