Bitcoins, Gold Bugs and Money

Bitcoins become more useful as a currency the more their price drops.

Libertarian income redistribution device?

Photographer: Ethan Miller/Getty Images/

“Bitcoin is collapsing,” BoingBoing recently tweeted. “Will Bitcoin ever rebound?” wonders CNN. “Bitcoin is headed to the ash heap,” USA Today proclaims.

But what all this weeping, wailing, and gnashing of teeth fails to grasp is that bitcoin isn't supposed to be an investment-grade financial asset. It’s supposed to be a medium of exchange. Surprisingly few people understand the difference.

The Washington Post’s Matt O’Brien is one of the few who does:

If Bitcoin were a currency, it'd be the worst-performing one in the world, worse even than the Russian ruble…But Bitcoin isn't a currency. It's a Ponzi scheme for redistributing wealth from one libertarian to another. At least, that’s all it is right now.

bitcoin chart

O’Brien is correct. The reason for bitcoin’s wild price volatility is that many people -- not just O’Brien’s “libertarians,” but many others -- fail to understand the difference between money and risky long-term assets.

Long-term assets are things like stock. As the human race invents more ways to create value, and as corporations find more ways to capture that value in the form of profit, the price of stock goes up. By buying stock and holding it, you get to share in that value. In return, you lower the cost of capital for the companies -- in effect, you lend them money, and when the stock price goes up (or the stock pays dividends), you get paid back.

But stock isn't money. If you don’t believe me, go to the store and try to use  a share of General Electric to buy a loaf of  bread. Eventually, security will gently escort you from the premises.

Money is a medium of exchange. It’s what you use to buy stuff. There can be multiple kinds of money that exist alongside each other -- for example, in some countries, you can pay for things in the local currency or in U.S. dollars.

But what money doesn’t usually do is increase in value over time. Sometimes it does, a little bit -- for example, in the long deflation of the 1800s. Usually, though, money slowly decreases in value, because of inflation. The central bank tries to keep these decreases slow and steady, so money isn’t risky.

So if money loses value slowly, why do people keep any money in their checking accounts? Because they need it to buy stuff. If you want assets that will tend to go up over time, you buy stocks,  bonds or real estate.

At least, if you’re sensible, that’s what you do. If you’re a gambler, you might consider something along these lines:

“At some point, people are going to switch to a using a different kind of money. I bet I can predict that switch, and get in ahead of the game. I’ll buy up a bunch of the future money, and when people switch to using that, I’ll be sitting on a whole pile of cash!”

That’s the implicit thought process of the people who buy bitcoins as a speculative investment. It’s also the implicit thought process of gold bugs. “Gold is money,” gold bug websites stubbornly repeat. But it isn’t. You can’t buy stuff with gold. David Andolfatto, vice president of the Federal Reserve Bank of St. Louis, explains this very well. Bitcoin is a bit more currency-like, but most things still can’t be bought with bitcoins.

What gold bugs hope -- almost certainly in vain -- is that people will switch to using gold as money in the future. What bitcoin speculators hope -- possibly correctly, possibly incorrectly -- is that people will switch to using bitcoins as money in the future. They’re not funding any sort of productive activity, they’re just making risky speculative bets about future currency regimes.

But speculative bets on bitcoin don’t actually help it become a true currency. More likely,  they hurt it. There’s a rule in economics called Gresham’s law, which is that when you have two currencies, people tend to hoard the one with greater material value and spend the one with less material value.

If people think bitcoin has value as a speculative asset, they will hoard it, and buy their groceries with greenbacks instead -- after all, they expect bitcoin’s price to go up, and the price of the greenback to go down. This makes it more difficult for bitcoin to establish itself as a medium of exchange, because no one wants to actually spend them!

So I suspect that the people who have invested in bitcoin-related companies and technologies are not too upset when bitcoin prices crash. The sooner people give up the hope that bitcoin will skyrocket in price, the sooner they will be willing to spend bitcoins in everyday life, the way they now spend dollars. The quicker bitcoin as an investment dies, the quicker bitcoins as currency can come to life.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.