Friday, December 6, 2013

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.


  1. I buy your argument that bitcoins have no intrinsic value, but the argument that money does have intrinsic value is specious. The only reason that a dollar bill is worth anything is that there are people who will accept it in exchange for goods and services. Should people quit accepting dollar bills, dollar bills would become useless.

    Saying that the dollar is backed by the U.S. Government doesn't give it intrinsic value. If you hold a dollar bill, it means that the government (in this case the Federal Reserve) owes you a dollar. But if you send them that dollar bill saying "here's the evidence that you owe me a dollar -- pay up!" they'll just send you back a dollar bill. There is no physical dollar that you can change your bills into. Intrinsically, there's no such thing as a dollar. Nobody has ever seen, touched or felt one. All you have is these pieces of paper saying that the Fed owes you a dollar.

    In short, no fiat money has intrinsic value. It's value comes only from other peoples' willingness to accept it.

    1. Great comment! The US dollar represents borrowing by the Federal Government which is backed by our obligation as citizens to pay taxes. Let me see if I can demonstrate my point with a simple thought experiment. Suppose there is a government that provides for the safety and security of its citizens by requiring them to join the national guard for one month out of the year. Such requirement is basically equivalent to 8.33% tax on the annual labor capacity of each citizen. Now suppose the community authorizes the government to build a road. Rather than requiring each citizens to put up an extra month of work, the government decides to make this a voluntary program where for each day worked on the road, a citizen will be given a labor certificate that can be redeemed for 1.25 days of national guard duty. A merchant would gladly sell goods in exchange for labor certificates, because she can use them to satisfy her labor tax to the government. The merchant can now use the extra month to grow her business and make more profit. That alternative use of resources is the source of the labor certificates intrinsic value.

      The US dollar works just like the labor certificate in the story. The Treasury cannot print money directly. Instead, it has to borrow and pay interest. Money is actually printed when the Fed buys back the Treasury bonds from the public. This mechanism ensures that the government always pays interest for its borrowings. When you present a dollar bill to the government, you are asking for reprieve from your obligation to pay taxes such as property tax, income taxes, sales taxes, etc. The government is required to accept that dollar bill even if it is worthless. Think of it this way, if the dollar indeed becomes worthless then our tax obligation will disappear. We will simply pay taxes with worthless dollars while keeping real assets and resources to ourselves.

      To conclude, the problem with fiat money is not that it has no intrinsic value. The risk with fiat money is that it is based on borrowing, and it is as good as the credit of the borrower - in this case the government. A government with bad credit destroys the value of its currency, which in-turn inflicts permanent damage to the economic well-being of its citizens.

  2. Bitcoin is not a currency, but a collectible and as such can function as a store of value.

    Similar to Kula armshell

    or Yap stones.