Wednesday, December 4, 2013

The Myth of Gold's "Intrinsic Value"

I had a conversation about Bitcoin with a friend, and the inevitable comparison with gold came up.  I asked, "Why does gold have value?"

She replied, "Because people will pay money for it."

I asked, "Why will people pay money for it?"

She said, "Because it has value."

I asked, "So why does it have value?"

She said, "Because people... will... um..."  She frowned for a bit.

The thing is, the idea that gold has some kind of intrinsic value is so deeply embedded into world culture that no one seems to question it.  But it's worth examining.

Gold as Money

There are a number of properties that make something useful as money:
  1. Scarcity.
  2. Permanence. If something will physically degrade over time, it's not useful as money.  The metals used for coins don't corrode.
  3. Divisibility.  If you can't divide money into units small enough to be trivial, you're right back at one of the problems with barter.
  4. Fungibility.  Any given unit should be tradable for another same-size unit.  Currencies like USD do this better than gold, as gold has varying purity, and testing for purity is non-trivial.
  5. Identifiability. It should be easy to recognize a unit of money for what it is.
  6. Transportability.  It should be easy to transport non-trivial amounts of the money.
  7. Uselessness.  If a money is useful for purposes other than monetary, industrial demand can violate its purpose or confuse its value.  The copper in a pre-1982 US penny is worth more than a penny; the only reason people don't buy pennies and melt 'em down for copper is because it's illegal.  And even though it's actually worth more than a penny, most people will only assign a penny's value to it.
Gold hits all of these points soundly, including the last, as its actual uses in electronics and dentistry are fairly new relative to the long history of "gold as money."  Its use in jewelry derives solely from the fact that it represents a conspicuous display of wealth.  Gold is actually rather weak in divisibility, because it's difficult to work with in trivial amounts.  (Hence silver and copper coins; however, copper has become so useful that no one uses it for coins anymore-- modern pennies are 97.5% zinc. Factoid: copper is more conductive than gold.  Gold is used for connectors because gold doesn't tarnish.)

Intrinsic Value

I've seen a number of authors/pundits explain that unlike Bitcoin, gold has "intrinsic value," and because Bitcoin doesn't, it has no real value.  Part of the problem is that there are lots of definitions for this term, but they all seem to boil down to literally: the value that innately exists in the subject of discussion.  But what exactly is that intrinsic property of gold that gives it value?  When I started asking this question on forums, I got many variations of these answers:

  • Bitcoins are just like tulips.

Except tulips fail at the aforementioned attributes 2, 3, 4, 6, and others would also include 7.  (I personally don't care for tulips.)  And you can't magically transport tulips around the world in minutes.
  • Gold has intrinsic value because people will pay money for it, and that's why it has value.
This argument is a tautology, and is dismissible as such.
  • Gold's intrinsic value has been acquired over time as people have used it for money.
Something acquired over time is not "intrinsic" unless you redefine the word.  Bitcoin can also acquire this property over time in the same way.  As people accept it more, it becomes more accepted, so people accept it more.  The network effect.
  • Gold's intrinsic value is the cost of mining it.  After all, the price of gold is very close to the cost of mining it.
I believe that this is actually backward.  One of the fundamental properties of a money is that it's scarce, and therefore difficult to find/create new units of it.  Mining gold will happen so long as the cost doesn't exceed the market price / perceived value.  If the market price of gold were half of what it currently is, then all mining that cost more than that would be suspended.  It bears noting that there are sources of gold that cost more than the current marginal mining cost to pursue (e.g. seawater), but those sources won't be pursued until the value perception (and therefore price) of gold exceeds those costs.  If production of "new" gold ceases because the price of gold is less than the cost of any source of mining it, demand for what remains will presumably increase until the price exceeds the marginal cost of once again mining "new" gold, and mining will resume.

Some people try to peg Bitcoin "mining" as a source of "intrinsic value" for the currency, as there are costs in hardware and electricity to produce Bitcoin.  But the fact that mining currently produces Bitcoin is unrelated to what someone is willing to pay for the unit.  In fact, the same amount of Bitcoin will be produced no matter how much additional cost is expended.  (The difficulty of "finding a block", which is the goal of every miner, automatically adjusts to keep the block creation rate at about one block every ten minutes.)  However, like mining for gold, the amount of Bitcoin mining performed will find an equilibrium to the cost of mining it in electricity, hardware, and administration.  For this reason fewer and fewer miners use GPUs-- the only ones that still do either have subsidized electricity or don't care that the value of the Bitcoin mined is less than the cost of electricity spent to acquire it.

Money is a Useful Illusion

The "price of gold" is, from one moment to the next, defined as the market price of gold.  And by market, we mean "whatever someone is willing to pay for it."  If we ignore for a moment the emergent industrial uses of gold, we're back to the fact that for most of its history, gold was useless as anything but money, but because it was so useful at being money (because of all of the properties outlined above), it was therefore used as money.  People accepted gold in exchange for goods and services because they expected that others would exchange their goods and services for gold.  Soon enough, lots of people started to recognize gold as a useful barter intermediary, and that network effect plus its utility at being money made it the universal store of wealth.

But if you're starving, and your neighbor is starving, no amount of gold will buy his loaf of bread.

It turns out the reason gold has value as money is only because it's so darn useful as money.  "Shiny" doesn't hurt, but your significant other won't be impressed by an iron pyrite ring.

In the end, the intrinsic value of gold is the same as the intrinsic value of Bitcoin: it's very useful for lubricating trade.  (That being said, Bitcoin has a long way to go before it enjoys the same network effect and recognition that gold has.)

Usefulness has its own intrinsic value.  If you don't believe me, ask your employer why they pay you.

Saturday, March 30, 2013

Economists on Bitcoin (FUD, Part Two)

Saw this article whose author is puzzled/confused about the value of Bitcoin as a currency.

Why do people concentrate solely on the currency itself?  Bitcoin would be absolutely not worth mentioning as more than a curiosity in encryption if not for its backing network.

The true value brought by Bitcoin is not in some imaginary inherent value in the private key that can unlock a transaction, it's in the network backing that transaction.  I don't believe in the value of a given Bitcoin per se, but I do have a lot of confidence in the long-term value of a Bitcoin in its corresponding eponymous network.

In short, neither the Bicoin currency nor the Bitcoin network have any particular value separately, but together they break new ground.

People who have their attention focused solely on the monetary aspects are understandably confused.  It's like wondering why people think television breaks ground when the audio quality is no better than radio.

Unlike that author, my comments section is open.

Friday, March 22, 2013

Bitcoin Elevator Description

"Bitcoin is a global person-to-person digital currency that works on the Internet.  It allows transfers of any amount from anyone, to anyone, at any time, near-instantly, with negligible fees, and no third-party (government or bank or corporation) control.  Bitcoin is like digital cash: transactions can not be reversed, as there is no central authority to adjudicate disputes.  The Bitcoin network has been working since 2009 and is just starting to get mainstream attention."

Q: If there's no government backing it, why does it have value?

A: Its inherent value is in its ability to store and transfer value from anywhere to anywhere with negligible fees and no borders.  (You can transfer funds now via international wire transfer, but the red tape can be exhausting, the exchange rates frustrating, and wire is just not suitable for smaller/personal transactions.)  While gold has some inherent value for industrial applications, 90%++ of its value comes from the fact that it's (a) scarce, (b) easily recognizable, (c) highly divisible, and (d) very transportable, all of which are important features of money.  Bitcoin has all of these features, but takes "very transportable" to a place never previously imagined.  If you think there's no inherent value in "usefulness", I'd invite you to ask your employer why they pay you.

It's worth noting that USD and other fiat currencies don't really have anything backing them, either.  The "gold standard" went away long ago, and the only inherent value left is the emotional value that we assign to it, which is our belief that it will probably still be worth most of its value tomorrow.  It's also important to note that because of the enforced scarcity of Bitcoin, Bitcoin will tend to hold value over time (like gold), instead of leeching value away over time (like fiat currencies, which can be printed at will.)

Q: What if the government shuts it down?

A: There's no central place to "shut it down".  The gov't would have about as much luck as the music industry did shutting down Bittorrent.  That being said, the US Govt has acknowledged virtual currencies and (so far) simply wants businesses that convert Bitcoin to USD and back to implement money laundering controls just like any other business that converts currencies.  If you're not moving more than $10k at a time, you probably don't care.

Q: How does it work?

A: The database of all Bitcoin transactions ever completed is shared by all of the participants of the Bitcoin network.  A group of people known as "Bitcoin miners" continuously audit the transactions and bundle them into "blocks" that are protected by cryptography so that Bitcoin transactions can't be reversed, and coins can't be spent twice on the network.  (Your Bitcoin always exists on the network, but the secret, private keys that allow you to unlock your coins and spend them are kept by you: either on your computer or phone, or backed up on a flash drive or piece of paper.  How safe your Bitcoin is varies directly with how well you protect those keys.)

Q: Is it safe?

A: Relative to what? Recent events in Cyprus show us that banks are not safe.  And even if they were, governments can step in and seize your money arbitrarily, and if done without cause, a lengthy court battle will be required to release your funds.  Even if they don't take your money outright, the government will leech away the value of those stored funds over time, via inflation.

Any funds you have in Bitcoin are controlled only by you, but the burden of securing those funds falls on you, too.  One should be especially cautious of leaving Bitcoin keys on a computer that's used for general browsing, or shared with family members or friends.  For the especially cautious, solutions exist for keeping your private keys entirely offline, where you have to "sneakernet" transactions from the offline computer to the online one in order to complete a payment.  As with all things, there's a tradeoff between security and usability.

Also, because Bitcoin only has a market value, if that market loses confidence in the value of Bitcoin its real value will go down.  It's a fairly new currency, and if you plan on using it as a long-term store of value, it should be considered (at this time) a high risk investment.

Q: What can I use it for?

A: While Bitcoin is still in its infancy, new point-of-sale merchants are springing up every day that accept Bitcoin.  Some online merchants already do, and services are available that will accept Bitcoin and buy on your behalf just about anything available online.

Q: If there is no central authority, then how does it work?

A: There's no central authority, but there's a central specification that anyone that wants to participate in the Bitcoin network Must follow.  Any transactions or blocks that do not follow the specification to the letter will be ignored by the rest of the network.

In order for that specification to change, almost all Bitcoin miners must agree to it and implement the change.  (The ones that don't may wind up with a "hard fork" blockchain of their own, but they'll quickly find that situation untenable.)

 (Are there any other questions I should add here?)

Monday, September 12, 2011

Bitcoin FUD

First, let me say that not all Fear, Uncertainty, and Doubt (FUD) is unwarranted, though I recognize that the acronym "FUD" does imply that.

There was a response to blog post called "Krugman’s Bitcoin Error" that asked a couple of very important questions about Bitcoin, and I was rather too long winded in my response for a simple reply, so I decided to instead post my thoughts here. The two questions asked by "beeemtee" were as follows:

Q: Why would anybody spend a coin that’s destined to increase in value until his/her regular income comes in bitcoin form?

A: I could as easily ask: "Why would anyone buy a computer when you know that next week, a newer, faster model will be available at the same price?" The computer industry has had price deflation in its products since day 0, and somehow people keep buying them, despite this obvious drawback. A equally (in)valid argument would be: why would you accept payment for goods or services in the form of a currency that will be worth less tomorrow, the next day, and every day after that? We're so used to inflating currencies that it's hard to imagine money just simply holding its value from one month to the next.

Q: Why would anybody want to make his/her life or business depend on a currency whose price is highly unpredictable?

A: If I had a business, for now I'd accept Bitcoin at a somewhat unfavorable exchange rate, then cash it out every night. Once (ok, *if*) suppliers start accepting Bitcoin, I think we can assume that by then a good portion of the Bitcoin<->fiat volatility would have died down, and I'd hold enough Bitcoin back for payment to those suppliers. (If I were a supplier at this point, I'd prefer Bitcoin to credit card transactions due to the lack of fees/chargebacks, and prefer Bitcoin to checks due to the lack of worry about bounced checks.)

Once the volatility subsides (which would be a natural by-product of an actual economy transacting business in Bitcoin), it will be a far more attractive currency. The hardest part right now is finding early adopters. I'm not figuring on Bitcoin being a force of nature this year or next, but looking 2-5 years down the road.

Another common question is something to the effect of, Q: "How can Bitcoin have any value when it doesn't exist in a useful form the real world, like gold, or is backed by force of arms, like fiat currency?"

A: The value of Bitcoin *is* its utility in facilitating no-recipient-cost, nearly-instant, and permanent transactions. Usefulness has its own value. If you don't believe me, ask your employer.

The biggest risk, as I see it, is that Bitcoin spits right in the face of the people who control the money right now, and I expect them to react badly when they see their money hose kinked [or even potentially kinked] by Bitcoin. They'll throw matresses full of cash at all of the corrupt (or just easily persuaded) politicians they can find (remember: Bitcoin doesn't have a lobby), and try to find some way to kill it. Online gambling was effectively killed in the US by a law that made it illegal to transfer money outside the US "for purposes of gambling"; a similar law that made it illegal to transfer money to buy Bitcoin (using whatever language they'd need to [a] not name Bitcoin specifically, and [b] not cut off online gaming currencies like Eve Online's ISK or World of Warcraft's gold), or even just a conflation of Bitcoin and "online gambling", would have a very chilling effect on US adoption. I realize that Bitcoin is an international currency, and US laws only apply in the US, but I also realize that as long as it's currency non-grata in the US, its utility (and therefore value) will be markedly constrained.

Tuesday, July 5, 2011

How Bitcoin Works: A Technical Discussion

There's a lot of layman speak around for how Bitcoin (aka BTC) and Bitcoin "mining" works, but little that covers it without glossing over the details. So here's a guided tour of some of the gory details.

(The Bitcoin Wiki has most of this information, but it doesn't offer anything like a guided tour, which is what this attempts to be.)


1. Public Key Cryptography. If you use the same password to encrypt something as you used to decrypt something, this is called "Symmetric-Key Encryption". With "Public Key Encryption", two different passwords are created; anything encrypted with one can be decrypted by the other. In practice, one is selected to be your "private" key, and kept secret; the other is designated a "public" key and broadcasted to the world.

2. Hash. Hashing functions are computer algorithms designed to take any arbitrary input of any length and produce a numeric derivative of that input. Hashes are repeatable; for the same input, you will always get the same hash. Cryptographically strong hash functions (or "one-way hashes") go a step further: A change of just one bit on the input (no matter the length) is expected to change around 50% of the output bits; also, it's expected that it's near-impossible to take any given hash and produce a string that would have created it. (That last property isn't important for Bitcoin, but is important for things like digital signatures.) Bitcoin uses SHA-256, which produces a 256bit hash of anything input to it.

3. Digital Signatures. If you take a hash of a document, then encrypt that hash with your private key, you've created a digital signature. If you attach that digital signature to the document, then anyone with your public key can create their own hash of that document, decrypt your hash using your public key, and compare. If the hashes match, then (a) that document must have come from you, and (b) must not have been altered. (Otherwise the decrypted hash wouldn't match the generated hash.)

4. Wallets and Accounts. These are constructs created by the Bitcoin clients that really have nothing to do with how Bitcoin actually works, except insofar as wallet accounts have one or more Addresses.

5. Addresses. Bitcoin addresses are really public keys. [Strictly speaking, they're hashes of public keys.  Thanks to niko for that clarification.] You can send BTC to someone (in a Transaction) at their Address, and everyone on the network can see that you did so, but only the holder of the address's private key (which is stored in their Wallet) can actually spend the BTC awarded to you by that transaction.

6. Transactions. BTC doesn't exist at addresses; BTC only exists in transactions. Any time you spend BTC, you are (completely) draining one or more "input transactions" and sending that BTC to one or more "output addresses." Note that the inputs are transactions, and the outputs are addresses. You can't partially spend ("redeem") an input transaction; if there's BTC left over, you send the "change" back to yourself at an address you own (typically created just for that transaction.) Transactions are finalized when they're included in Blocks. Including a Transaction Fee helps ensure a miner will include you in their Block. You prove that you're allowed to spend the input transaction(s) by digitally signing the transaction(s) you're spending.  (And by "you", I mean your Bitcoin client software.  This all happens without you having to worry about it.)

Mining and Blocks.

1. Miners are Bitcoin's professional auditors.  The point of Bitcoin Mining is to create Blocks of transactions (that haven't yet been included in a block.) At the time of this writing, the creator of a Block is awarded 25BTC, but this will decrease over time. The block creator is also awarded any Transaction Fees attached to transactions included in the block. Eventually, new blocks will stop creating BTC altogether, and miners will be rewarded solely through transaction fees.  The blocks are in a sequence known as the "block chain."  Sometimes two miners will create a block at the same time, which is known as a "block chain split" or "fork."  Whichever side of the split grows faster quickly becomes the "winner" and becomes the official transaction ledger for Bitcoin going forward.

[If you've wondered what a "51% attack" is, it's a mostly-theoretical attack where someone controlling more than half of the hashing power of the network could spend Bitcoin, then create a fork that spends the same transactions a different way.  They force the network to accept their reality by growing their chain faster than the "real" one, so their original transaction would be unspent.  Presumably, after the actor has received whatever product or service they'd bought with the original transaction that they've just unspent/reallocated.]

2. Difficulty. Mining consists of attempting to find a hash of: the previous block, the current set of un-blocked transactions, a transaction indicating where the block reward+fees should be paid to, and a nonce ("nonce" = "number used once"). Since any change to the nonce will very randomly change the resulting hash, Mining involves trying (literally!) trillions of different nonce values in order to find a hash that's numerically below the current difficulty number, thereby "solving" the block. In theory, the first hash you try could solve the current block; but in practice it generally takes many, many, many, many tries. Note that every hash has an equal chance of solving a block; so while there's an average time to solve a block, there's theoretically no limit to the amount of time it might take to solve a block. Fortunately we have the Law of Large Numbers working on our side.

3. Invalid Blocks. The block chain that represents the entire history of all transactions in the Bitcoin network is linear; there can be no [permanent] branches. If two miners solve a block at about the same time, a branch occurs, and miners may begin building on either of the two. Whichever block chain grows faster becomes the "valid" block chain for the network, and the blocks in the "losing" chain become invalid. This is why there's a 100-block maturation time before block rewards and transaction fees may be spent; it's insurance against those BTC becoming invalid in the meantime.

4. Pools. Because solving blocks is so ridiculously hard, you can share the work with others by joining a Pool. When you join a pool, you work alongside many other miners to attempt to solve the pool's current block. The block you're attempting to create includes the transaction that distributes both the block reward  and the block's accumulated transaction fees. "Shares" are hashes that are numerically below a much lesser difficulty level than the block difficulty; the pool can easily verify that your "share" hash is valid for the block (though otherwise useless); this proves that you've been working on that pool's block, and (through share quantity) gives a reasonably accurate depiction of how much work you've been contributing. (Note: because the pool's block-in-progress includes the transaction that pays the pool, someone can't take their "winning" hash and steal the block reward from the pool unfairly.)

Discussions about the viability of Bitcoin for any particular purpose are political, not technical, and are outside the scope of this document.

 Other Resources.

The Bitcoin Wiki:
A more conversational description of mining: