Better than Euro? What Bitcoin needs to succeed

I spent New Year’s Eve in a gold mine. A gold mine of the digital age. I was invited to a family I am friends with. There were computers in one part of the apartment. Numerous computers, side by side. All without cases. Hard drives could be seen, ventilations whirring, LEDs flashing. It looked like a laboratory. A digital laboratory. In fact, it is a mine. The family man has been mining cryptocurrencies. 

My 12-year-old son asked me what all these machines were for. I answered that this was for manufacturing money. He looked at me blankly. 

I tried to explain. Here is (hopefully a bit more systematic) what I told him. 

To understand what my friend is doing, one has to understand what money is. Money seems mysterious. The material value of paper money or coins is low, but you can still get so much for it. 

Economists tend to define money by its functions. These are the most important ones: 

  1. You call something money if you can use it as a medium of exchange. This means that money acts as an intermediary between the buyer and the seller. If you want to buy shoes, you don’t have to give a good or a service in exchange. Instead, you give money. The shoe seller relies on that he can buy something himself with that piece of paper or these round metal pieces he got. If many accept this way of exchange, it is of great benefit for everyone. Without money, there would be long barter chains before everyone gets what they need, for example, eggs for paper, paper for bread, bread for a bottle of water, water for shoes. 
  2. Money serves as a unit of account, which means that it is the ruler by which other values are measured. So the value of various goods and services can be compared quite simply, especially if the money is easily divisible, for example, in euro and euro cents.
  3. Money serves as a store of value. To serve as a store of value, money needs to be durable and stable in value. Then it can be put aside and used to make a purchase later. 

(If you want to learn more about defining money by its functions I recommend this text.)

So everything that serves the functions above can be called money. The prerequisite for something to be used as money is that people accept it as money. If all sellers decided that they would no longer accept notes and coins, then these would cease to be money. If they chose instead to accept chair legs as money, we would have to use chair legs that we would have to use when buying something. 

But not everything is good for money. 

There is an underlying requirement that something can be used as money: it has to be scarce (that’s why chair legs wouldn’t work well). 

Many things served as money in the past: gold, silver, sometimes even cigarettes and cocoa beans. The prerequisite was always that the items were scarce.

But scarcity does not mean that the amount has to stay the same. Change can be helpful to keep the value of the money (third function of money). In a dynamic economy, the amount of money has to change in order to keep the value of the money the same. To put it in a somewhat simplified way: if the money supply develops in parallel with the available goods and services, then its value remains stable.

Interim conclusion: Whether something is money is defined by whether something fulfills functions of money (medium of exchange, unit of account, store of value). In order to function as money, the following requirement must be met: The “something” must be scarce (but the scarcity must be adjustable), and people have to trust it in such a way that they believe it will keep its value. Only the credible limitation of the amount of money can turn something that has otherwise no value into money. For example, if people suspect that the owners of money (often state central banks today) will increase the amount of money sharply in the near future and thus decrease the value of money, people will not store that money. The money function “store of value” is then lost.

Now, let’s apply these considerations about money to cryptocurrencies, short crypto.

A crypto is a collection of binary data which is designed to work as a medium of exchange. 

This data has no value itself. All that code has to be accepted as money to become valuable. As we said, to become accepted as money this “something” has to be scarce, and people have to be convinced that it will remain scarce. That applies to crytos as well.

Bitcoin, the most famous crypto, is trying to achieve this in two ways: Firstly, the total amount of bitcoins is limited to 21 million (currently there are about 19 million bitcoins in circulation). That this self-restraint is credible, secondly, the production of digital money is very resource-intensive and complex. The production process is called mining and is performed using sophisticated hardware that solves an extremely complex computational math problem. And it is getting more complex, the more computing power participates. This is to keep bitcoin production at a stable rate (the last bitcoin is expected to be produced not before 2045).

With today so many people mining, a personal computer mining for bitcoin will get nothing. That is why so many computers are running simultaneously at my friend’s apartment. (If you want to delve deeper into mining bitcoins I recommend reading this text.)

With all that in mind, was I right to tell my son that money is made with these computers?

Let’s think again about what defines money: it’s their functions. More than most other cryptocurrencies (there are thousands), Bitcoins work as a medium of exchange. Wikipedia, Microsoft, AT&T – a lot of companies accept Bitcoin as a legitimate source of funds. And it’s easy to exchange bitcoins for another currency. In principle, bitcoins fulfil this monetary function. 

There is a but, though. Only a few people use bitcoins as a medium of exchange. Because bitcoins are, above all, an object of speculation. People buy, hold and sell bitcoins because they want to make money, not to use it as money. They store it not to keep the value but hoping that the value will increase.  

This is a problem. As long as bitcoin is primarily an object of speculation, it will not fulfil a central monetary function: the medium of exchange. And the “store of value” function neither since the price of bitcoins fluctuates extremely.  

There is an absurdity in this crypto speculation. The greater the likelihood that a crypto will become money, the higher the price of this currency will rise. But as long as there is a lot of speculation with the crypto, it cannot become money.

Will the high value of the currency bitcoin (on Sunday, 2 January 2022, 13:09, one Bitcoin is worth 41.426,36 euros), therefore, fall sharply sooner or later? Not necessarily. But the production of bitcoins has to change so that it gains more and better money functions. 

The amount of bitcoin should no longer be limited, but instead steadily expanded, roughly said parallel to the development of the global economy. That would dissolve the artificial scarcity and therefore reduce speculation. At the same time, buying and selling bitcoins and paying in this currency should be made much easier.

My guess: Those cryptos which do not take these steps, which just want to be an object of speculation, will sooner or later disappear from the market. Because they are of no use in themselves.

The American writer and humorist Ambrose Bierce (1842–1914) once wrote that money is a “blessing that is of no advantage to us excepting when we part with it.” Cryptos will only be successful if their makers adhere to this insight. Only then will they become money. Only then will they be of lasting value.

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