The excitement over Bitcoin is hard to miss. Countless articles in the popular press have brought the new investment device to the forefront, and the stories of 10X returns over the past year have enticed untold thousands to spend their hard-earned money on the mysterious electronic “coin.” As exciting as that is, we wonder how closely Bitcoin matches the expectations of an actual currency. Yes, the number of ways you can spend Bitcoins grows everyday, but if Bitcoins are ever really to be considered a new type of money then it will have to meet a few other tests.
For those of you who remember anything from basic economics classes, you may recall that money serves three functions: 1) it is a store of value over time, 2) it is a medium of exchange – it is used in financial transactions and 3) it is a unit of account – it used to measure the value of goods. Let’s see how Bitcoin measures up to these three tasks today.
Store of Value. For people to have faith in a currency it must be a dependable way to store value over time. Most of us think this means the currency should not lose value (and that’s true), but the opposite is also true: it shouldn’t be prone to dramatic increases in value, either. The truth is that volatility (a measure of risk) is influenced by changes in prices, be they positive or negative. In the case of Bitcoin, the recent run-up in prices has shown Bitcoin to be volatile, indeed. What’s the big deal if price jumps up dramatically – who doesn’t want a big increase in the value of something? Imagine for a moment that you want to sell something valuable and want to accept Bitcoins as payment. And what if that valuable item involves a relatively long sales cycle. What price do you set? If you pick 1000 bitcoins today and the sale takes 60 days to complete, will your buyer still want to pay you 1000 Bitcoins if the value of those Bitcoins jumps 5X from the time you started the sales process (like Bitcoins have the past 60 days)? Not many of us want to watch the price we are asked to pay multiply by five times during our negotiations. Despite/due to the run-up in Bitcoin prices, Bitcoin fails the first test of a true currency.
Medium of Exchange. Without money people resort to bartering services & goods. If I wish to eat beef and have only chickens, I need to offer a cow-owning friend enough chickens to get him to give me some of his beef. Sometimes that works, but often it is cumbersome and inefficient. If you own a cow and want to buy a chicken, it is hard to give your chicken-owning friend just part of your cow (without some harm coming to your cow). The problem is even easier to see when we introduce very different types of goods. If you have chickens and want to buy bookkeeping services, what is the correct price? How about if your bookkeeper just got a flock of chickens the day before and doesn’t want any more chickens? Money is the great go-between, allowing people to transact disparate goods & services among themselves easily & fairly. Bitcoin does accomplish this task to a large degree. You can buy a wide range of items from vendors who will take Bitcoins as payment, so you can sell your chickens for Bitcoins and then turn around and buy bookkeeping services with them. The list of vendors accepting Bitcoin payments is growing rapidly, too, so Bitcoin’s ability to function as a medium of exchange is improving, too. A note of caution: if the number of vendors accepting Bitcoins is growing as a result of the run-up in Bitcoin prices, then those merchants may be interested in selling you things just to get their hands on your Bitcoins with the intent of making money on further price Bitcoin price appreciation. If true, the ability to use Bitcoin as a medium of exchange may be artificially inflated. Time will tell if the variety of things you can purchase with your Bitcoins drops in the event the value of Bitcoins plummets 50% in a few weeks.
Unit of Account. This concept gets at the uses of money as an informational tool (rather than the transactional functions described above). If I tell you something is worth $500 you probably have a good idea of the value of that item without mentally converting that item into a number of chickens. When a company reports profits at the end of a quarter, we can interpret the information easily and can compare it to previous quarters primarily because the currency used meets these unit of account functions, whether the currency is US dollars, Euros, Yen, Krona, etc. Bitcoins don’t have that same level of functionality in our society just yet. That’s not to say that they couldn’t develop that characteristic over time, but today Bitcoins fail this test when looked at on a broad scale.
So, where does this leave Bitcoins as a new type of money? We look at the three standard functions of money discussed above and are not compelled to bestow true currency status just yet. We find Bitcoins a fascinating phenomenon and an interesting way to speculate, but we wouldn’t be inclined to invest in Bitcoins nor use them as a currency. To be sure, some will (and others already have) make a great deal of profit from Bitcoins, but it will be due to the speculative nature of Bitcoins and not because Bitcoins are a new form of money. By all means, enjoy the ride and watch how this plays itself out over the coming months & years, but don’t expect us to using Bitcoins for transactions or an allocation to client portfolios for quite a while.