Eric Posner on Bitcoin in The New Republic

Bitcoin's Bandwagon Has Never Been More Crowded
Eric Posner
The New Republic
December 3, 2013

Bitcoin broke $1,000 last week after Fed chief Ben Bernanke told Congress that virtual currencies “may have long-term promise.” Bitcoin is, of course, the most famous virtual currency. People can use bitcoins—which are just strings of numbers—to buy goods and services by transferring them electronically across the Internet. Enthusiasm about bitcoin has soared with its price, but the theories as to why are as speculative as the currency itself. Many critics see a bubble based on thegreater fool theory that if I pay something for a worthless asset I can make profits by reselling it at a higher price to someone more foolish than I am. Other former skeptics, like Business Insider's Joe Weisenthal, are coming around. To cut through the confusion, one needs to see that there are two different theories as to how bitcoins work—a wrong theory which is driving the excitement, and a banal theory which may leave a marginal place for bitcoin in the financial system.

The exciting, wrong theory is that bitcoin will become a self-sustaining currency that replaces fiat currencies like the dollar, yen, and euro. People will prefer bitcoins to regular currencies because those currencies are controlled by central banks, and hence ultimately governments, which from time to time find it irresistible to use inflation to finance wars, bridges-to-nowhere, and other foolish projects. Because the supply of bitcoins is limited, there is no inflation risk. The price of bitcoins has taken flight because investors believe that people will eventually see the advantages of virtual currencies and scramble to acquire them for their virtual piggy banks.

The problem with the argument is that the money supply needs to be flexible so that the government can address economic ups and downs. Bitcoin’s supply is fixed by algorithms that require increasingly immense computer power to mine new coins. The various experiments with currencies that are fixed to something out of the control of a government (gold and foreign currencies) have always ended in tears, usually when an economy enters recession and the government finds itself unable to devalue the currency in order to stimulate exports or domestic investment. In the unlikely event that bitcoin ever threatens the dollar, the U.S. government would shut it down. And if somehow bitcoin nonetheless thwarted efforts by the government to control it, it would surely be a victim of its own success, as other virtual currencies would flood the market, resulting in a volatile situation in which exchange rate risk—a problem faced by exporters and importers—would exist at home as well. Indeed, at least 30 virtual currencies have already entered the market. 

Faculty: 
Eric Posner

Comments

Agree and disagree

It is true that bitcoins have no intrinsic value, in the numismatic sense, in other words, value in any realm outside of being used as a medium of exchange.

However, while some tangible commodities do have intrinsic value, that value is generally much less than its trading price. Consider for example that gold, if it were not used as an inflation-proof store of value, but rather only for its industrial uses, would certainly not be worth what it is today, since the industrial requirements for gold are far smaller than the available supply thereof.

While historically intrinsic value, as well as other attributes like divisibility, fungibility, scarcity, durability, helped establish certain commodities as mediums of exchange, it is certainly not a prerequisite. While bitcoins lack 'intrinsic value' in this sense, they make up for it in spades by possessing the other qualities necessary to make it a good medium of exchange, equal to or better than commodity money.

Another way to think about this is to consider the value of bitcoin the global network, rather than each bitcoin in isolation. The value of an individual telephone is derived from the network it is connected to. If there was no phone network, a telephone would be useless. Similarly the value of an individual bitcoin derives from the global network of bitcoin-enabled merchants, exchanges, wallets, etc... Just like a phone is necessary to transmit vocal information through the network, a bitcoin is necessary to transmit economic information through the network.

Value is ultimately determined by what people are willing to trade for - by supply and demand.