The virtual currency bitcoin is gradually taking over the role of gold as a capital conservation tool. Bitcoin is a decentralized, digital currency that is transferred person-to-person, business-to-person or business-to-business, without going through a bank clearinghouse, as must be done with traditional currency transactions. After the Second World War, a system similar to a gold standard, which is sometimes described as a “gold exchange standard,” was established by the Bretton Woods Agreements. Under this system, many countries fixed the exchange rate of their currencies relative to the U.S. dollar and central banks could exchange dollar holdings into gold at the official exchange rate of $35 per ounce. The Bretton Woods Agreement was abolished in 1971 and a “fiat money” policy was introduced globally.
Fiat money is currency that a government has declared to be the legal tender of its country but which is not backed by a physical commodity, such as gold. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material (gold or silver) of which the money is made (i.e., backed). Historically, most currencies are based on physical commodities such as gold or silver but fiat money is based solely “on faith,” that is, faith in the market. Fiat is the Latin word for “it shall be.”
Though major central banks own gold and silver, the currency they issue is not “backed by gold or silver,” i.e., it cannot be converted into gold or silver upon demand. In the October 2013 newsletter we wrote about a new type of money or payment method, commonly referred to as cryptocurrency (http://eepurl.com/G7k). Cryptocurrency, digital money, or alternative currency is money that exists only in the digital realm; there are no physical coins or paper notes. Similar to the case with fiat money, the cryptocurrencies do not have any intrinsic value; their value is determined by supply and demand. There are various cryptocurrencies, with bitcoin being the most well-known of them.
The bitcoin is devaluation-proof. When central banks or states print and issue new money in excess of what the economy is actually producing, the supply overwhelms demand and the currency’s value (i.e., purchasing power) falls accordingly. Currently there are various countries with sizable discrepancy between their currencies official exchange rate and the street-value on black-markets, with the prominent current example of Venezuela. Some governments deliberately devalue their currency. There are various reasons why the central bank of a country might choose to devalue its currency but the most common reason is to make the nation’s exports cheaper and thereby stimulate economic growth. For example, the intentional devaluation of the yuan is a common complaint made against the Chinese government by other countries.
For the bitcoin to be used as a capital conservation tool, it must have a value. The value of the bitcoin is mainly based upon two reasons:
1. The supply is limited. The design of bitcoin is such that it limits the total number of bitcoins that can be produced to 21 million. (It goes beyond the scope of this article to explain the technicalities that limit the production to a maximum of 21 million bitcoins worldwide).
2. Bitcoin does not belong to a state or country, which renders it beyond the control of governments or central banks and it cannot be devalued at will by them.
The use of bitcoins is gaining momentum because it is an effective means to preserve the value of capital. After overcoming some initial start-up problems in its early development, bitcoin has enjoyed increasing success since its introduction in 2009; instead of losing purchasing power, as is the case with many currencies, the value of bitcoins has steadily grown.
In addition to steady growth and independence from central banks, bitcoin carries the additional advantages of universal recognition around the world and, being a digital currency, it can easily be sent and received around the globe instantly. The use of bitcoins is highly advantageous when compared to the use of gold and silver as capital or value conservation tools.
Governments typically restrict alternative currencies to protect their monopoly on money issuance. In many countries, residents must use the government-sanctioned currency or face prosecution, resulting in fines or even imprisonment. In the U.S., the government has declared bitcoin is a commodity (i.e. property) rather than a currency. Some nations have banned the use of bitcoin, presumably out of recognition that it is an alternative currency outside their control.
However, technically it is very difficult for a country to prevent or stop its citizens from using bitcoin because it exists virtually in a network that is scattered around the globe—a network that can be accessed by anyone with a web browser. So even when there are restrictions about using bitcoins within a country, bitcoin users can still make international purchases.
The intent of the developers of cryptocurrencies was to design internationally recognized and used digital currencies that were in keeping with the original intended purpose of the world wide web—to promote the transfer of knowledge and foster greater creativity and innovation in business worldwide. Bitcoin and other digital currencies are designed to take purchasing power out of the hands of government and to put it into the hands of the individual.
