After last week’s volatility, many are questioning the stability and longevity of the Internet’s latest e-trading currency, Bitcoin. To understand whether or not the bubble was a “fluke” or whether it can be part and parcel for the money exchange, we first have to understand how Bitcoin actually works.
Most equate Bitcoins (the site’s currency) in terms of U.S. Dollar value. This is the simplest way, but it’s not accurate. The Dollar fluctuates just like any other major currency, with things like inflation, deflation, economic standing versus other major currencies, etc. changing the intrinsic value (how much it is really worth, in real world goods) constantly. For some economists, gold is the standard of currency for comparison since gold does not increase or decrease in its inherent value, only in value versus other currency measures. Back in the day, twenty U.S. Dollars would buy one ounce of pure gold. Today, the it’s around the $1,500 mark. That’s fluctuation in value for the Dollar, not gold, since the same ounce of gold buys roughly the same amount of goods or services in terms of labor or materials cost.
Bitcoin is not really based on gold either. Like the USD, it’s value is based on what those people using it believe it to be worth. Bitcoins are relatively constant in their general value per coin, but not as constant as gold. The way Bitcoin works is simple: each coin is worth as much as someone else will give for it and there are a finite number of Bitcoins available globally. That means it’s very flexible versus other currencies, which issue on demand, and thus can be seen as volatile.
The bubble and crash Bitcoin had was largely because of speculation. When “investors” – those using Bitcoins against another currency – bought into it in order to make a profit in that base currency did so, they raised the value of Bitcoin. Doing this raised the amount, versus a given currency, that each Bitcoin was worth. As this happened, more and more investors noticed and jumped on the bandwagon hoping for big rewards. After this had happened for a while, someone cashed out a large amount of coins for another currency. This showed in the Bitcoin system as a spike in selling, which triggered speculators to assume that Bitcoins were about to crash. They in turn sold theirs, hoping to get out while the gettin’ was good. The landslide was not unlike the bank runs of the 1930s and Bitcoin lost more than half its value (against other currencies).
The fact is, Bitcoin cannot be measured against other currencies well because, like gold or another relatively stable medium of exchange, it does not fluctuate in actual value, only in perceived value. This is the inherent weakness of most faith currencies (e.g. nearly all central bank issued currencies), which are based on the factors given above and are not generally stable in value. The misconception most people make is that their currency of choice (be it USD, Franks, Yen, or whatever) is the “base” upon which they measure all other choices.
Of course, unlike gold, silver, or platinum, Bitcoins do not have an inherent value outside of their use as a trading medium and they cannot be physically held and bartered with. In this sense, it’s no better than Dollars or Yen. Turns out, some prominent economists agree with me.