Bitcoin is not money

Until I spoke on a panel on technology at a recent event in London I did not appreciate the passions evoked by Bitcoin.

For many libertarians Bitcoin, along with other digital currencies, provides a way to exercise freedom by allowing users to circumvent the bureaucratic power of governments and central banks. It does this by enabling individuals to transfer money directly to others without using the state-backed monetary system.

Many critics, in contrast, dismiss the possibility of money that exists independently of government. They were quick to gloat in February this year when Mt. Gox, the world’s largest Bitcoin exchange, collapsed into bankruptcy with the disappearance of many millions of dollars. They also cheered when the secretive founder of the currency was apparently identified in a magazine report.

For those still unsure about the basics of Bitcoin there are many primers on the internet (including by such illustrious bodies as the Federal Reserve Bank of Chicago). Essentially it is a virtual currency that was launched in 2009 to allow the transfer of funds outside of traditional channels. Although it has been used for illegal purposes – as of course has conventional money – it can also be a convenient means for making legitimate transactions.

But if Bitcoin is so simple, at least in principle, it begs the question of why it has created such a stir. Surely it should just be a topic for tech nerds?

To examine this quandary it should first be recognised that even conventional money is in some ways peculiar. It is not immediately apparent why anyone should be willing to exchange goods or services for bank notes – essentially just bits of paper.

In the days when paper money was backed by a physical commodity, such as gold or silver, it might make sense. But with fiat money, where all that underpins it is a government promise, it is harder to understand.

From this perspective it should start to become clear that both the supporters and critics of Bitcoin have a point. But both are also one-sided in their criticisms.

It is true, as many libertarians contend, that central banks have often debased their currencies by pursuing loose monetary policies for many years. Official institutions have played a key role in the creation of financial bubbles and they are also partly to blame for the subsequent fall-out when they burst.

However, Bitcoin’s critics are right when they say that real money needs state backing. There are indeed considerable problems with fiat money but the support of government institutions is far from meaningless. It provides official recognition that money represents a share in real economic activity.

To resolve this debate it is necessary to recall that money has more than one function. It is both a medium of exchange and a store of value.

Bitcoin can play the former role as it provides a high tech way to transfer funds. For this reason there is no reason why it cannot work as a sophisticated payments system.

But it is not a store of value. To the extent it holds wealth it is only with reference to conventional currencies such as the dollar, euro or yen. It embodies no value of its own as it is not underpinned by even an implicit guarantee from a national state.

For that reason it should not be considered money in the true sense.

This blog post first appeared today on Fundweb.