Many say Bitcoin is a fiat currency, that the value is derived from nothing. Really, Bitcoins are just 1's and 0's. Therefore, the value must collapse at some point, once the market discovers they own a useless commodity. At least, this is the most commonly held belief I've run into.
I entirely disagree. Bitcoin does have intrinsic value, in the same way many commodities do. Gold is the best example, and an interesting comparison. If gold currency makes you think of olden-times and Ron Paul, I entirely disagree again. I think gold, and Bitcoin, have much more to do with sheep, which you'll see below.
There's much to be said about the price of Bitcoin. But I think the value of Bitcoin is the much more important, and much more interesting, aspect of the puzzle. How does Bitcoin have intrinsic value?
It helps to start with an easier question: how does gold have intrinsic value? Gold is just a hunk of atoms. It's fairly similar to a rock. Not all that different from a stick. Why is gold so valuable? Because it's beautiful, right?
That is true, shiny things are inherently cool. But plenty of gold has been made into bars and coins and stashed away, instead of showcased as jewelry or a statue. It would seem beauty is in the eye of the beholder.
As it turns out, value is always in the eye of the beholder. A person who really loves strawberries sees much more value in strawberries than someone who doesn't like them, or someone who is allergic to them. A person who is careening through interstellar space sees value in a rocket to get home, but no value in much of anything else.
Those examples are obvious. But why is it that people see value in gold? Or Bitcoin, for that matter. The answer is that both gold and Bitcoin have intrinsic properties which make them inherently valuable as a trade item. People see value in gold, or Bitcoin, when they want to trade.
Imagine you have two sheep, and you want to buy one piece of bread. An entire sheep, to most, is much more valuable than a slice of bread. So how do you make a trade? Do you chop the sheep's foot off? That won't accomplish much. It would be better to have something more divisible.
Gold is great at that. It's the most malleable metal you can find on earth. It's not hard to make bars and coins out of it. Or just a bag of rock-shaped gold chunks. That way you can trade one sheep for a bag of gold, then trade one small piece of gold for a slice of bread, and have one sheep and plenty of gold left over. Gold is easily divisible, that makes it great to trade with.
There is another problem that traders often face, and it also involves sheep. Say that instead of using gold, you had offered one whole sheep for twenty loaves of bread. This seems like a fair trade, no need for divisibility. But what if, unbeknownst to both parties, the sheep has a chronic heart condition, and is doomed to die in three days? What if the sheep decides it doesn't like its new owner and begins attacking everything it sees?
Sheep are complicated, and can be vicious. So how does one know whether the specific sheep they're getting is actually worth it? Gold solves this problem as well, since it is easily verifiable. A simple scale is all it takes to verify that you're getting the amount of gold you expect. And, well, gold is gold. It can't attack you. So weighing it is pretty much all you need to know.
Surely now you see the connection to Bitcoin. It is important for currencies to have properties which make them convenient and reliable trade items, and Bitcoin has those properties. It has a lot of them:
- divisibility - Bitcoin can be divided to eight decimal places (more in theory), with little effort.
- verifiability - You don't need to weigh Bitcoin to verify the amount you got. That's verified intrinsically by the Bitcoin existing. More on this later.
- homogeneity through space and time - A Bitcoin is digital, so backups can be made easily. Not only that, but the Bitcoin network keeps track of every Bitcoin that has ever existed.
- scarcity - Just like gold, Bitcoin is rare. Only a set amount of Bitcoin can be mined.
- transportability - Gold is easy to transport, but not as easy as Bitcoin. Bitcoin can be sent around the world in minutes.
- resistance to counterfeiting - It is impossible to conterfeit a Bitcoin, just like it is impossible to create a gold coin without actual gold (not impossible, but extremely difficult)
One curious problem is that the dollar seems to have these "special" properties as well. Surely the dollar is not just some "fiat" thingy. The dollar is important! It's used by millions of people every day! They probably use it because of all those special properties:
- It's divisible - dollars break down to cents
- It's verifiable - easy to count
- It's homogeneous through space and time - not so much as gold or Bitcoin, but pretty solid
- It's scarce - dollars certainly don't grow on trees!
- It's transportable - modern banks allow virtual transportation of dollars (direct deposit, debit cards)
- It's resistant to counterfeiting - surprisingly so!
But many of these properties are not actually intrinsic to dollars.
Consider that a dollar is a piece of paper, it in no way can be transformed into metal coins. I've tried. Does this matter? After all, you can exchange a dollar for four quarters with just about anyone you meet. Whether this matters depends a lot on your perspective.
In fact, a dollar is not actually a piece of paper at all, it's more like a contract. A dollar bill states: "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE". When you swipe your debit card, similar wordage in contracts between card processors, banks, merchants, and the government (via legislation) ensure that your dollars can be used to absolve your debts, including your recently incurred $5 debt for the sandwich you're holding.
In fact all aspects of the dollar's functionality depend on these types of contracts. The government can print as many dollars as they feel is necessary, throwing a wrench in those "scarce" and "resistant to counterfeiting" properties. They can also influence how transportable the dollar is, with trade embargos or other forms of regulation.
The government can also affect the value of other currencies. For example, by making dollars the only legal tender for paying taxes, they add a lot of value to dollars for citizens who must pay taxes, and remove value from Bitcoin, gold and other currencies which are not accepted as tax payments.
This is the main difference I see between fiat and hard currencies. Fiat currencies are declared to have certain properties, whereas hard currencies have them intrinsically. In both cases, the market adopts a currency based on its usefulness.
Again, whether this matters depends a lot on your perspective. Perhaps the difference between fiat vs. hard currencies is unimportant, as at the end of the day, people have chosen to use them both. Really, your perceived value of Bitcoin, dollars, gold, or any currency depend on your unique situation: which government you live under, the types of transactions you do, and whether you are flying through interstellar space or allergic to strawberries.
But it also depends on your interpretation of the real source of the currency's value. Remember that the value of gold comes from the arrangement of gold's atoms. This atomic arrangement gives gold all the special properties a currency needs. With the dollar, its special properties come from the strength and ingenuity of the government.
But Bitcoin is not a solid object, and it's not backed by any central organization. Bitcoin is fundamentally information. In fact every Bitcoin exists in not only one place, but thousands of places, and no place at all. Such is the case with much information in the internet age. Bitcoin is information, and the value of Bitcoin is in the way this information is formed.
Bitcoin is only a computer program, but it is a remarkable computer program. The algorithms in this program allow a network of computers to trade imaginary coins, preventing falsified coins or bad transactions from coming into existence. Information on Bitcoins is determined via peer-to-peer consensus, meaning no central authority has the ability to change the rules. How Bitcoin works should be the subject of another article, but it is the programmatic mechanisms of Bitcoin which make the information trustworthy and useful, and give Bitcoin its value.
Bitcoin is indeed just 1's and 0's. The most important thing to remember is that other currencies are the same way: gold is just atoms and dollars are just contracts. The real question is: how does this all affect you? You have to think about the source of value for whichever currencies you use, and answer this question yourself.
Imagine you have two sheep, and one of them would like to hire you to fix his laptop. If he offered you Bitcoin, would you accept it? If Bitcoin continues to increase in dollar price, as hard currencies tend to, you could set it aside for a couple years and have a nice little Bitcoin savings account. Perhaps by then your favorite retailer might accept Bitcoin, so the dollar price wouldn't matter.
But perhaps that is too risky for you. After all, Bitcoin is a computer program. Who knows whether the Bitcoin network will withstand the test of time? On the other hand, perhaps it's too risky for you to accept dollars. Perhaps instead of fixing his computer, your sheep friend would like you to teach him an ancient form of ritual dance which is banned in your country. It all depends on the situation.
The real value of Bitcoin isn't definite. In fact, it's your own decision to make.