Economist Brad DeLong poses a great question about Bitcoin:
Underpinning the value of gold is that if all else fails you can use it to make pretty things. Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year (yes, I know).
Placing a ceiling on the value of gold is mining technology, and the prospect that if its price gets out of whack for long on the upside a great deal more of it will be created. Placing a ceiling on the value of the dollar is the Federal Reserve’s role as actual dollar source, and its commitment not to allow deflation to happen.
Placing a ceiling on the value of bitcoins is computer technology and the form of the hash function… until the limit of 21 million bitcoins is reached. Placing a floor on the value of bitcoins is… what, exactly?
Bitcoin bulls will usually respond with something like “cryptography” or “technology” or something like that, but these aren’t really satisfying answers.
Paul Krugman explains why:
I have had and am continuing to have a dialogue with smart technologists who are very high on BitCoin — but when I try to get them to explain to me why BitCoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem. And I haven’t been able to get my correspondents to recognize that these are different questions.
There’s a good case to be made that Bitcoin is impressive technology for payments, but why a Bitcoin itself should be something of value is not easily answered. This isn’t damning to Bitcoin but it is problematic, and those with a big belief in the durability of the digital currency (or other digital currencies) should try to think it through. One way to think about it is not that the value of a Bitcoin has value per se, but that the network of Bitcoin speculators (people willing to trade them) provide a service of value to people who want to use Bitcoins as a product.
In other words, there’s a set of people who want to use Bitcoins for transactions (like people who want to get money out of China) and they rely on the set of people that is willing to take risk and swap Bitcoins for real currency and those two groups are distinct and symbiotic. That’s kind of the conclusion I worked towards in a post earlier this month. That’s still not 100% satisfying though, in part because there’s nothing guaranteeing that people will stay interested in trading Bitcoins (that’s not the case with real currency… by law there are people that have to hold US dollars).