Is the US dollar backed by more than Bitcoin?

Bitcoin is getting to be a frequent topic here at AWildDuck.* Regular readers know that I am bullish on the exchange medium. Not just as an investment, but as an emerging world currency. And, as the story continues to unfold, the fundamentals just keep getting better and better.

Bitcoin has been around since late 2010. Less than 3 years. As an immature exchange medium, its wild swings make it too volatile to be recommended in any portfolio with short term objectives. But with bungling at the largest and earliest exchange and a perceived tie to the criminal bazzar, Silk Road, events have muddied the inevitable path toward legitimacy. They amplify the small risk and delay widespread adoption.

I’m cool with that, because with widespread misunderstanding comes opportunity for those that see the long term picture—especially when it comes to a tectonic paradigm shift. As a long term investment, Bitcoin is a slam dunk. It can’t go down, any more than an original Rembrandt can lose value in the long run.

But, what surprises me, is that three years on, we are still faced with pundits who fail to appreciate the dramatic tipping point that is looming just down the road. They point to volatility rather than fundamentals. Perhaps, most frustrating, they point to the lack of government backing or a central bank as a deficit rather than a bonus and—in fact—the Raison d’être.

Bitcoins are backed by something even better than US dollars

Backing that beats US dollars

Here is a new article from a credible source that ought to understand the intersection of technology with economics:

When armchair analysts dig into the risk or folly of Bitcoin as a currency or investment, I bite my tongue. (Well, not this time!).

Let’s talk about item #2, If Bitcoin fails, it has no safety net. The argument is built around a premise that Bitcoin is backed by the “expectation of acceptance by others” while the US dollar is backed up by something more tangible (e.g. a government that can “step in”). That premise is wholly ludicrous. Both the dollar and Bitcoin have value that is backed by nothing tangible. And Bitcoin wins handily on the intangibles.

Background

In 1933, Teddy Roosevelt ordered Americans to redeem all private reserves of gold for printed notes. Americans were no longer allowed to own gold coins, bullion or certificates. (That left only the gold content of industrial products, jewelry and ornaments). For the next 40 years, the US insisted that it was still on a “gold standard”, because it amassed a stockpile of gold bullion in Fort Knox, Kentucky. With this as collateral, the government guaranteed the value of printed currency and it pegged the dollar value of what it printed. Of course, it was a guarantor only in theory, because it was illegal for US citizens to redeem their gold. They weren’t even allowed to own gold overseas.

From 1934 until the early 1970s, the value of a dollar was fixed at 1/35 oz of gold. In other words, the US government was effectively promising foreign treasuries the foreign trade settlement was bound by the transfer of gold at a value of $35 for each oz.

The dollar’s relative stability throughout the post war era was a result of the Bretton Woods agreement in which a large number of nations pegged their own currencies to the US dollar.* In fact, the value of the dollar increased, even though it was still worth 1/35 oz of gold. Everyone trusted the USA to maintain the value of its own currency with something. Most hoped that it was the gold at Fort Knox, but some economists say that it didn’t really matter, because the US was such a dynamic and growing economy, with a history of predictable inflation. And therefore, it had a high degree of trust.

But as we approach the ’70s, trust probably accounted for more dollar purchasing power than gold. In 1971, under Richard Nixon, the US terminated convertibility of the dollar to gold, even for foreign banks. By 1973, the US decoupled its currency from gold altogether, and in 1974, Americans could, once again, legally buy gold in any form.

So, what backs the dollar today? In academic jargon, it is a fiat currency.* To economists, it is backed by the full faith and credit of the US government. But in reality, this just means that the US can print or borrow more money to pay past debts. In truth, it is backed by something, but that something is no more than what backs a Bitcoin: It’s value is based on the confidence of the person accepting or saving the coin that it will be accepted in the future by someone else—and at a rate they can believe in today.

But wait! Though both the US dollar and Bitcoin are fiat money—backed only by the perception of buyers and sellers, in fact, Bitcoin has the distinct edge…

Why Bitcoin?

Why is the long term value of a Rembrandt painting unlikely to tank? To retain value, any asset must meet two criteria: Limited availability and precious to behold (I use art as a metaphor—preciousness can be anything valued by a pool of perspective owners). Bitcoin is a limited commodity by pedigree and it is precious because of a vast trust-matrix built on a foundation of mathematics. When a two-sided market develops around something with a provably limited supply, trust becomes more durable than decree.

Bitcoin is the future of currency because it has the edge in all areas: it can be more certainly trusted, it offers an advantage to saving, it is a stateless exchange medium and requires no backing. This isn’t to say it is not backed… In fact, it is backed by solid mathematical principles that are open to peer review.

In the long run, the dollar is a weaker and more risky currency than Bitcoin. It has no natural cap and is subject to counterfeiters and manipulation by the people who authorize its printing. A wallet or bank cannot easily be provably “backed up” and its value inflates rather than deflates with adoption. Although armchair economists who focus on protectionism, exceptionalism, or short term objectives may see some of these things as benefits, they are all serious deficiencies.

Advantage: Bitcoin

Ellery Davies is editor of awildduck.com. He is a frequent contributor
to The Wall Street Journal, Yahoo News, CNet and PC World.

Past Posts about Bitcoin

* Resources

9 thoughts on “Is the US dollar backed by more than Bitcoin?

  1. I’d be interested in hearing your thoughts on the value of bitcoins should quantum computing prove fruitful. I’m certainly no expert in this area, but my understanding is that this computing model makes generate and test type problems more efficient. Should that be the case, will the mathematical underpinning of bitcoins still hold water?

    • Hi Paul. As always, I really enjoy your questions and observations. They are filled with insight and an opportunity to clarify my arguments. And so, I wish to try a new approach in responding to your question above. This is my Take Two.

      Today, about 11 million Bitcoins have been mined (revealed) out of a total universe of 21 million coins. That’s not a theoretical cap. It is an evident fact. The underlying polynomial equation has this clearly understood number of valid solutions.

      Now, let’s assume that someone comes up with a perfect computer today. It can calculate instantly or test every possible combination of variables.*

      The new computer does not invalidate Bitcoin mathematics. It simply hastens the day that all coins are in circulation. It would make a few people very rich (like discovering an uncontested shipwreck filled with gold doubloons). But, it certainly won’t destabilize the Bitcoin model.

      Throughout history, there have been discoveries of unfathomable wealth: The New World, oil under Arabia, diamonds in South Africa. None of these discoveries has destabilized an incumbent monetary system. Traditional currencies are destabilized by easy credit, inflation, corruption, or the failure of an underlying security. These are properties that fall within the realm of governments. They are properties to which Bitcoin is brilliantly immune.

      I believe that the mysterious architect of Bitcoin designed a slow release of coins for several reasons. That decision was inspired, but none of these reasons are required any longer:

      • To give pundits and the public time to adjust to the idea that currency needn’t have controlled growth and that deflation is not a necessary component of economic expansion.
      • To demonstrate that the designer was not hording all of the coins. After all, ownership and transactions are anonymous, but if someone already had a wallet filled with undisclosed coins, they would be invalidated when other users demonstrated that solutions to the equation have been discovered.
      • For a currency to be accepted, anyone accepting it must believe that someone else wants what they are saving. The effort to mine outstanding coins is intensely competitive. It helped to raise enthusiasm and awareness at a time when there was little proof that others coveted the solution to a math problem.

      But knowing that they will all be discovered (probably at around the year 2040), leads most investors to simply consider a global market as if they were already in savings accounts with the potential to be circulated at any time.

      * Of course, a perfect computer would render every form of modern encryption useless, but I don’t think that your question relates to that theoretical conundrum.

  2. An excellent question, Paul! If I understand you correctly, you want to know how Bitcoin might be affected by a sudden, disruptive boost to computing efficiency.

    As an aside to our readers, new Bitcoins can be mined (or more accurately, “discovered”) by solving a complex mathematical equation. Thousands of individuals around the world do this in an effort to effectively print money for themselves. From a macroeconomic viewpoint, this how Bitcoin allows the total money supply to gradually grow — at least during it’s infancy.

    In short, it would push us to the money-supply cap and make a few individuals rich. Neither event would have any more effect than a few western settlers discovering a rich vein of gold in the California mountains.

    Regarding growth in the money supply, there are two significant differences between Bitcoin and US currency. Although both are advantages for Bitcoin, I claim that the first difference is not critical to its adoption and eventual success. It is only this first difference that is affected by a disruptive change in computing power:

    1. The Bitcoin protocol is designed in such a way that new coins are created at a fixed rate. Advantage: This makes Bitcoin mining a very competitive business.
    2. Bitcoins are created at a decreasing and predictable rate. The number of new Bitcoins created each year is automatically halved over time until Bitcoin issuance halts completely with a total of 21 million coins in existence.

    Because Bitcoin has a cap of 21 million ‘B’, investors assume that all 21 million coins will eventually be mined. This mitigates the disruption of a computing speed breakthrough. Just as with gold, I may not be the one to find a vein in my backyard, but unlike gold, I know how much is out there and I know that no one will discover a way to make more.

    Incidentally, one could argue that a slightly disruptive boost in computing power has already occurred when it was discovered that the CUDA video processor within high end PCs is more efficient in running the sieve that searches for Bitcoins. Of course, this was an early development in the history of crowd-source mining, so it is difficult to measure the effect on the overall rate mining all Bitcoins.

    If the theoretical supply of Bitcoins had no limit, then a disruptive boost to computer speed—or simply the fear of it—would render the currency untrustworthy. For this reason, small nation-states that mint their own currency are more likely to guarantee convertibility to gold, rather than seek trust as a fiat currency.

    * From the Bitcoin FAQ: How is the currency supply capped?

  3. The articles are all interesting, Rob. But let’s put the key points in context…

    • Bitcoin is used for illicit or illegal activities

    So is cash. Does this mean that cash should be outlawed, so that the government can trace every transaction back to the source without gumshoe detective work?

    I recall reading that Columbian cartel drug smugglers prefer Fruit of the Loom underwear. Perhaps we should raid the underwear factory.

    • A major exchange changes course; Mt. Gox will verify user identities.

    This doesn’t surprise me. Mt. Gox has a history of poor management. Their growth, self promotion, and fundamental implementation process were all bungled. They must struggle to convey a perception of legitimacy—separate from the currency. Going ‘legit’ is quite probably their only option to build trust and stay in front of the competition.

    I was a very early adopter of PayPal. In the early days, shortly after X.com acquired Confinity, you could transfer money to anyone with only a temporary email address. The recipient could redeem or spend real money without ever identifying himself. In effect, each user created a Tor-like layer that guaranteed the anonymity of past transactions. The founder, Peter Thiel, argued that PayPal is not a bank because funds are undisbursed and kept in commercial interest-bearing checking accounts.

    But, as PayPal sought to grow in trust and adoption, the business model relented (some say that PayPal relented under pressure from he IRS, which has reason to fear any anonymous cash transaction medium. PayPal required cash recipients to create an account, and made then added buyer and seller protections that pushed most users to further identify them selves.

    Incidentally, the use of Bitcoin does not require a bank, a government or an exchange. It is almost completely peer-2-peer. (The continuous, peer-verification of all transactions makes it a crowd-backed trust medium, rather than a pure p2p model). Individual transactions have a reasonable degree of anonymity, but due to information stored in the bit chain, they are not guaranteed to be completely anonymous.

    PayPal History

    • Hi Rob. You asked:
      > If the govt regulates Bitcoin, won’t that take the anonymity out of it?

      Not at all! Any government that makes announcements and edicts about Bitcoin serves only to legitimize it. Anonnymity is an inherent feature of every transaction. That is, transactions needn’t involve a bank, government, credit card processor, etc. Therefore, it is impossible to regulate Bitcoin. An attempt to regulate is more absurd than a government banning alcohol (America tried to do this by amending the constitution) – or banning sex (this even occurred in concentration camps, and in fact, it was a form of currency).

      But, for a moment, let’s take “anarchy” out of the equation: Bitcoin is not about anonymity. That’s simply an inherent property of transactions, just as it is with cash. Rather, Bitcoin is a perfect currency because there is no potential for abuse. Governments cannot inflate it, ban it, or even impose an exchange fee. In fact, Bitcoins will always go up in value in the long term, not only because demand is rising, but because there will never be more than 21 million BC. Period. There is no mint. No one can print more dollars. And Bitcoin is frictionless specifically because it does not require a bank, broker, or government.

      Now, back to the issue of regulation and anonymity…

      The only way to skim transactions would be to tax it like any other method of income. Of course, tax laws apply to all income or sales without specifying the currency. It even applies to barters. But taxing Bitcoin transactions is very difficult, because unlike all other means of transaction, buyers and sellers can easily choose to leave absolutely no trail. Even if one person snitches and turns over data, there is still no evidence of that any transaction occurred.

      Ever since the car was invented, millions of individuals have purchased tax free goods out of state. In the past 15 years, they continue to do so from online resellers. If you live in a state with sales tax, you are still required to send the equivalent local tax to your state government, and yet no one does this unless the are audited. Governments have been completely unsuccessful at collecting a legally mandated tax! Why? Because voluntary compliance is so easily evaded. But even these transactions have credit card records. With Bitcoin, there are no records at all. If you purchase something physical, then the government would have to go after UPS and the post office to figure out what was purchased and from whom it was sent.

      Prescient economists have predicted this from the time of the ancient Chinese and Greeks. Governments have feared it. Mark my words, Rob: There will continue to be dramatic swings in the value of Bitcoin. Perhaps even some 90% drops in the short term. But even at US $1,000/coin, there is only a max theoretical market cap of $21B USD. In the coming years, more and more populations will move their mainstream transactions to Bitcoin. Eventually, entire governments will acknowledge Bitcoin and even shift to it for official business (this was effectively acknowledged in the US Senate last week!!).

      Do you suppose that the world economy requires more than $21B in monetary liquidity? Of course it does! In a nutshell, that’s why Bitcoin is far from its natural level. Very far!

  4. A real “currency” needs stability. Stability can only be achieved with the backing of a credible institution. Current valuation of Bitcoin act more like the stock market than money.

  5. Hello, AppToday. Welcome to AWildDuck.

    I enjoy responding to Bitcoin skeptics. Not only does it increase my consulting income, it will certainly leave me with the glow of vindication as some fairly simple economic principles lead to adoption and stability.

    Your brief statement has three sentences:

    a) A real “currency” needs stability

    Certainly, Bitcoin is volatile in this, its infancy. Governments cannot stop it, but their efforts to suppress convertibility contribute to critical delays in the movement of incumbent money needed for exchange (dollars, Euros, Yuan must be moved into bank accounts or exchanges). This is a temporary issue. I would guess that it will occur for about two more years. How can I be confident of this?…

    As more consumers accept Bitcoin as a defacto chit for exchanging goods and services, there will be less need to exchange currencies. Gradually, consumers will allow their money to accrue in Bitcoin savings accounts. Effectively, it becomes a currency rather than an investment. Additionally, as trusted and efficient exchanges open in unrestricted geographies, the delays that stifle speculation and arbitrage will evaporate. Contrary to popular misconception, unfettered speculation and arbitrage stabilize a commodity.

    b) You said “Stability can only be achieved with the backing of a credible institution.”

    Perhaps—in the early years—it needs a stable exchange But it certainly doesn’t need anything more stable or trustworthy than math.

    Not only does Bitcoin have the indisputable trust of mathematics, it also has a provable supply cap. That’s not the case with dollars, Euros or Yuan. Governments and banks continuously manipulate currency, raid underlying assets, extend easy credit, enact bail-outs, and use liquidity or regulation as a political tool. More to the point, they keep printing money under the theory that a growing economy benefits from an ever increasing market cap.* That is, it makes spending more lucrative than saving because goods often depreciate less than money.

    c) Finally, you said: “Current valuation of Bitcoin act more like the stock market than money”

    Yes, exactly! As sure as I am about the long term viability of Bitcoin (Eventually, it will become a trusted world currency—perhaps the only one), it is currently hampered by regulation, inefficiency, and trading delays. As it becomes more widely accepted in trade, it will transition from a speculative equity into a currency. This will result in two things. And those who appreciate these things will be grateful that they understood the economics before Bitcoin became mainstream:

    • volatility will abate
    • value will rise indefinitely

    Anyone who saves will make a very real profit. Bitcoins deflate–because the money supply is capped)

    _____________
    * I used the phrase “market cap”. I would have used the phrase “growing money supply”. But for a supply to grow, you only need to divide a coin into smaller units.

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