The true nature of money and why the bitcoin is a pyramid scheme.

Great article by the St Louis Fed on bitcoins. The key question, which remains unanswered, is whether bitcoins have intrinsic value.

The answer is a resounding No!  While computing work does go into solving the crypto-puzzles required for the issuance of new bitcoins, work alone, while a required condition, is not sufficient.  The other side of the coin, pardon my pun, is utility.  The source of intrinsic value is work that creates utility.  For example, a bridge to nowhere in Alaska has no intrinsic value because nobody is using it despite the tremendous amount of work and resources that went into its construction.  Regardless of how difficult the crypto-puzzle is and how much computing resources went into its solution, the fact remains that the puzzle itself serves no useful purpose.  If it did serve an actual purpose, such as solving a math problem that has real-life application, the value of the bitcoin would be inextricably linked to such application and would not be subject to huge swings in value.

The fact of the matter is that bitcoins are a type of fiduciary money.  Fiduciary money has no intrinsic value.  Instead, its value is based on trust.  In other words, holders of bitcoins hope that there will be others who will want those bitcoins more than they do, which is the very definition of a pyramid scheme.  Trust is a human emotion that can fluctuate wildly, which in-turn explains why bitcoins have suffered such dramatic moves in value.  Trust is also a very fickle commodity, which is easy to lose especially if it rests on pyramid foundations.  As soon as the supply of new investors eager to take a chance on the bitcoin is exhausted, the value of the bitcoins will collapse.

Bitcoins were designed to mimic very closely the "virtues" of another type of fiduciary money.  Back in the day when gold was used as money, it had no intrinsic value, either.  Prospectors dug holes in the ground to mine gold, but despite such tremendous effort, gold had no utility other than its limited use as jewelry.  A simple thought experiment illustrates the futility of using gold as money.

Imagine a two-person economy where John is a farmer who wants to save for retirement and Paul is a gold prospector who travels the world in search for gold.  John sells food to Paul in exchange for gold.  After two years John starts to get a bit anxious and has a little talk with Paul.  "I work very hard cultivating the land while you vacation around the world.  When are you going to start farming your land?"  Paul, of course, disagrees:  "This is no vacation.  Do you know how much hard work goes into mining gold?"  At this point, John begins to realize that his stash of gold is useless because Paul is under no obligation to accept it back as payment for food.  John's first two years of supposed savings are a complete waste, which prompts the following outburst:  "I don't want your gold, Paul!  What I really want is to be in a position to buy food from you when I am old and feeble and can no longer work the land."

This story can easily be applied to bitcoins.  Simply replace prospecting for gold with solving crypto-puzzles, but the moral remains the same.  Now imagine that John and Paul make a different arrangement.  John agrees to lend Paul food for two years and Paul agrees to pay it back when John retires.  Everything else in the story will stay the same - John will work hard while Paul travels the world; however, John has now secured the first two years of his retirement.

Let's ponder for a moment the true nature of money.  The source of intrinsic value is work that creates utility.  When people engage in trade they attempt to exchange equivalent amounts of intrinsic value.  This presents a problem for fiduciary money since it has no intrinsic value of its own.  Instead, the fiat money in use today represents an obligation not unlike the lending arrangement that John and Paul entered into after gold failed to facilitate their exchange.

We, as citizens, have the obligation to pay taxes.  The government borrows against our tax obligation.  Government borrowing is the source of fiat money.  Banks take the fiat money and use it as reserves against their deposit liabilities, which enables them to go out and lend to businesses and consumers.  In effect, banks create money by substituting their deposit liabilities for the debt liabilities of borrowers.  In either case, the dollar bills, the bank checks, the web-pay transactions, every single form of money we use today represents someone's debt obligation.  Think of it this way - without debt there would be no money, there would be no trade or economy to speak of.  The modern way of life will simply cease!

Modern money is not a perfect system by any means.  There are many problems and possible improvements, which could be the subject of another post.  However, it is far better than having to fret that you are at the bottom of the pyramid and there is no one else coming behind you to take your bitcoins.