Bitcoins, Cash and Gold

December 15, 2013

There’s a lot of buzz about Bitcoin and its significance lately. At the time of writing the MtGox price per is around $900 after briefly going above $1000 last month. I’m no economist (or investor – I sold most of mine way too early!) but it seems like the issue here has to do with relative demand for different financial instruments, specifically stores of value and mediums of exchange.

What is called a “store of value” I would describe as a kind of hedge, a financial instrument used to offset the risk associated with some investment. In this sense stores of value are hedges against losses on investment of time spent building wealth. The investor uses them to handle the risk of that wealth losing purchasing power, due to inflation or sociopolitics or whatever. The most famous store of value in history is elemental gold, which is scarce, shiny and useful (and therefore valuable) because of geology and physics and chemistry. This means that no human institution is required for gold to be in demand, and so nations still stockpile massive amounts in places like Fort Knox as a hedge against market disruption. Some citizens have been converting their own wealth into gold, especially since the value of dollars was decoupled from the stockpile in Fort Knox.

More recently, US dollars have served reasonably well as a hedge against instability elsewhere in the world. During the depression in the 1930s, people who trusted banks to store their wealth ended up regretting that decision, and those who kept cash in mattresses and walls made out comparatively well. Since then a culture of stockpiling cash has arisen, and historically the US dollar has been the favorite for its perceived stability. While this store of value provides a great deal of liquidity and quite reasonable portability, it can only be as reliable as the institution of the United States, and because the FDIC guarantees bank deposits there is not much reason to trust paper dollars as a better store of value than a standard US bank account.

Perhaps for this reason, Bitcoin has grown from a cryptography experiment into the hot new digital alternative to gold. Like gold it relies on mathematics and computer science rather than the authority of a government, but unlike gold it requires the existence of an information network like the Internet, and leverages that technology to enable much higher liquidity. In the long-term view it seems to function as a hedge against the marginalization of existing institutions and material goods caused by Internet and new technology.

I’m focusing on stores of value with medium to high liquidity, but there are certainly other options. Collectible goods like art and vintage instruments are popular, as is real estate. The value of these investments is necessarily non-zero (at the very least they can be used to build a fire) and determined by market demand. Still, no investment is risk-free and every one of these examples could lose value dramatically in the right situation. America recently went through a boom-bust cycle in real estate and many investors went bankrupt. Wealthy Chinese have been pouring their wealth into real estate for decades, the result being a market where not enough people can afford the hugely inflated housing prices and the bottom could fall out at any time. A non-trivial amount of that wealth is now moving into Bitcoin, which is probably the dominant cause of the recent spike.

In the case of cash, the primary risk is that the government will destabilize and/or the Fed will “ease” all the value out of those mattress dollars. As that risk was discovered commodities rose in value, most notably gold. It is still unclear exactly how much of the trend is due to devaluation of the currency and how much is due to speculation and fear.

In the case of gold, the practical applications might prove less useful than the price can justify, which would adversely affect its market value. In the extreme case, mass-produced alchemic gold could even end its reign as the definitive precious metal. That seems far-fetched right now, but I can’t honestly say it is entirely outside the realm of possibility. The technology to manufacture diamonds is orders of magnitude less sophisticated, but it did not exist a century ago.

In the case of Bitcoin, the most threatening eventuality is that the Internet goes dark and the blockchain ends. This might be even less likely, but many of the gold investors are also stockpiling guns and food so they are evidently thinking along those lines. If SHA-256 is broken the implications on digital security and the Bitcoin economy would be devastating as well. A less threatening situation might involve the lack of adoption by legitimate businesses and/or banning by governments. This would push the Bitcoin market further into illegal territory, but where there is money there will be money laundering so it wouldn’t necessarily shut down the market.

In summary, the best way to store value is never known and can only be determined in retrospect. It might involve more than one method, since bitcoins can function as a traditional hedge for dollars and vice-versa. Personally, most of my (modest) capital is stored in manufactured goods, with a bit of old-fashioned mutual funds and a tiny slice of other investments. If I sold these assets tomorrow they would raise much less value than the equivalent amount invested into gold bullion (or bitcoins), but I hope that won’t be necessary. Not having to provide for a family at the moment is convenient.

However, by far the most valuable things I have acquired are my skills. It seems like a decent market position to be in these days, but of course there is still the risk of being paralyzed in a car crash. I recently bought a new set of tires to mitigate the risk, so we’ll see how that works out.

BTC donations: 1LF6NC8wC8s3E77QSFqCJY3BMhSVuH4JEV

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