Why Bitcoins Are Just Like Gold

Plenty of people still have a difficult time wrapping their heads around what bitcoin is or why it even has value, especially as the virtual cryptocurrency continues to scale record heights. How isn't this a Ponzi scheme, many have wondered?

A good way to look at it is to compare it to gold. What gives a shiny metal that doesn't have a whole lot of real utility--outside of jewelry and limited industrial use--any kind of real world value?

The only reason gold has value is because one day, way back when, long before recorded history, society simply decided that this yellowish precious metal should represent “money.” From that day forward--as that idea spread virally across the globe (or at least the small part of the planet then settled by homo sapiens)--gold came to be worth something in the eyes of the people.

As a representative (and thus store) of value, it became a universal intermediary between goods and services. This was the natural, inevitable economic evolution of the barter system. As it retained its value over time--and eventually throughout human history--gold gained cultural credibility. That’s the quick and easy answer.

Why the chemical element Au? There’s its obvious aesthetic qualities. But gold’s longevity comes from scarcity; its limited quantities were never able to keep up with demand. Since the beginning of human history, a total of 171,300 tonnes of gold have been mined.

As the human economy evolved, we'd eventually transition from gold to paper money, but up until the end of World War II, gold remained a fundamental piece of the financial system in the form of the gold standard, by which governments pegged the value of their printed currencies to amount of gold they owned.

After the war, the gold standard was partially abandoned with the establishment of Bretton Woods, yet the world system remained implicitly tied to it even as countries adopted the U.S. dollar as their reserve currency, being that the U.S. promised to maintain the price of gold at $35.

Then in 1971, due to the financial strains of the Vietnam War, President Nixon ended the direct convertibility of the dollar to gold, thus establishing the U.S. as a fiat currency, money that was backed only by the credibility of the U.S. government. No longer elementally linked to the modern economy, gold still kept its value as an investment asset, given its historic credibility and cultural relevance. Today, one ounce of gold is worth over $1600.

Bitcoin, in its present form, has a stark resemblance to gold. Both are backed by no one. Both are, relative to fiat currency, inconvenient for day to day use. Your gold coins or bitcoins (yet) won’t do much good at the grocery store. Both lack intrinsic value. If the apocalypse arrived tomorrow, your gold and BTC won’t help you survive against the zombies. Both have value only because society has confidence that they will maintain said value over time.

Bitcoin, of course, has been around only since 2009, so it doesn’t have the same kind of long term credibility. But the supply of bitcoins, like gold, are also constrained, built into its elegant mathematical model. There’s hard limit of 21 million bitcoins to be mined, which is predetermined to be reached during the year 2140. So as bitcoin demand and adoption continue to outpace its supply, its price will increase in lockstep.

So why bitcoin? Because bitcoin is gold on steroids, designed for a society that lives through the internet. Bitcoin is designed with the ideals of the contemporary cyber movement in mind: decentralization, peer to peer, cryptography. Easily transferable in ones and zeros, it’s a storage of value for a virtual society. As a payment system, it's a temporal store of money that can be easily sent across the globe securely and speedily without counterparty risk. No matter the price of bitcoin, these benefits will always give it purpose. With bitcoin trading over $60, its market capitalization is approaching $700 million.

The benefits of this model are clear. Given its self-contained nature, it eliminates the need for inherent human interference. There’s no need for a central bank because bitcoin self-regulates. Certain aspects of it are, of course, vulnerable, such as mining, as well as security. Every month, it seems, we hear a new report of a hacked bitcoin wallet. Millions have been lost since 2011.

Yet these issues are self-correcting over time given bitcoin’s incentivization dynamics. Security of data and money is a concern that predates bitcoin and even currency; better practices and technologies can help prevent theft. And it wouldn’t make sense for any one entity, for instance, to attempt to monopolize mining, except to destroy it. After all, this part of the system is somewhat transparent, and bitcoin’s value will be retained in the degree that it is decentralized. If one entity controlled the world’s bitcoin output, it wouldn’t be worth very much, so trying to take over bitcoin doesn’t make financial sense.

Even destroying it poses problems, tantamount to eliminating the world’s gold supply. It’s possible that certain governments or companies even could attempt to cripple it, either through regulation or attacks on the system, yet destroying it completely, for now, seems out of the question. We have to look no further than BitTorrent. Despite years of assaults from the likes of Hollywood, the RIAA, and U.S. government, torrenting continues to drive the majority of internet traffic.

And as long as bitcoin survives, it will rebound. As long as it exists, it will grow. So ignore the warnings of hype and talk of a bubble, in the long run, it’s all more or less irrelevant. The value of bitcoin could crash again, like it did in the summer of 2011. Or it could keep skyrocketing. Whatever happens, neither gold nor bitcoin are going anywhere anytime soon. In the end, that’s all that really matters.

UPDATE: Heres charts for bitcoin and gold since the Nixon Shock. (via reddit)

@sfnuop

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