Back in late 2010 I heard about Bitcoin and foolishly laughed it off as ridiculous. Now I wish I'd understood it better. Bitcoin is a fascinating economic experiment, which has challenged our conventional idea of what a currency is.
A currency is liquid trust. Look at a one dollar bill, it states 'In God We Trust'. The intrinsic value of paper notes or numbers in a bank is little or nothing. The only reason a currency has any value is because of the trust we place in it and usually it is backed by a government, which promise us it is worth something. Coins and notes are really just bearer bonds. For example the British 10 pound note says 'I promise to pay the bearer on demand the sum of 10 pounds'.
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In this respect Bitcoins are no different from a paper currency. Without the trust of others they would be worthless. Gold is different since it does have some commercial application. However most demand for gold also comes from the trust people place in it as a medium for exchange. So in this respect gold is similar to Bitcoin and other currencies, its value is also determined by trust. Without this trust it would just be a shiny lump of metal.
The most important element of trust in any currency is that supply is limited. For a currency to have any value or use we have to trust that it will not be easily reproduced.
- We trust that notes and coins cannot be forged.
- We trust governments to control the money supply and not print huge amounts of it.
In my mind four elements make up a currency
- Limited supply
- A stable unchanging form
- Arguably stability in value so the currency can be trusted as a means of exchange
Now of course not everyone trusts the so-called fiat (government backed) currencies. Some advocate a gold standard whereby a currency is tied to gold (an asset which has a very stable supply)
Without this stable underlying asset there is always the risk that a government will print more money thereby increasing the supply and devaluing the currency. This is exactly what has happened in recent years with quantitative easing causing the value of gold to increase relative to the world's major currencies.
Gold Price in US Dollars data by YCharts
Bitcoin versus Gold
There has been some speculation that Bitcoin is starting to replace gold as a safe haven asset. See Are Bitcoins Killing the Price of Gold? So is Bitcoin really any different from gold?
Both currencies have limited supply beyond the control of any government or any individual. This stable supply makes them very viable as a currency. The total supply of Bitcoins will never exceed 21 million (current supply is just under 11 million and all Bitcoins are expected to have been mined by 2040). It gets progressively harder to mine more Bitcoins as the supply grows. Therefore the rate of inflation is always slowing. The supply of gold is limited to what is in the earth's crust. The current supply of gold grows by about 3% a year.
Another important aspect of any currency is accessibility. A currency can't be so rare (e.g. moon rock) that no one has access to it. There is enough gold that billions of people can own it. It is also malleable making it relatively easy to break down and redistribute. The same is true of Bitcoins. Whilst the total supply of Bitcoins is limited to 21 million, Bitcoins can theoretically be divided a limitless number of times. i.e. you can own 0.00000001 Bitcoin so everyone could own them.
Gold is proven. Many people have tried to recreate gold over the years and unsurprisingly always failed since it is impossible.
Gold is tangible whilst Bitcoins are not. Gold is a hedge against the end of the world. Even after a nuclear Armageddon the gold under your bed will still be worth something to someone else.
It is now possible to hold physical Bitcoins but even these need to ultimately be uploaded into a computer and are therefore linked to the online system. Unlike gold they don't pass the nuclear Armageddon test.
An advantage to Bitcoins over gold is that they are much easier and cheaper to transfer and store.
One of the criticisms of Bitcoins is that it could never be used as a serious medium of exchange given the extreme price volatility. This reminds me of the damage caused by hyper inflation. If businesses are constantly having to re-price everything they waste a huge amount of resources to the point where the currency is useless.
Whilst this is true you could probably level a similar criticism at gold. Gold is very rarely actually used as a medium of exchange because it is less practical than conventional currencies. Bitcoin may ultimately have an advantage over gold in this regard since as more businesses sign on it becomes easier to convert Bitcoins into goods and services. At some point the price may become more stable. Price volatility is an issue but in my opinion there are bigger concerns.
Bitcoins Weaknesses versus gold
Bitcoin could be hacked. Although this would be difficult it would be technically possible by altering Bitcoin's code. It has been suggested this might be done through a routine update. As Bitcoin becomes more successful and valuable it will attract ever more attention from hackers. Even if the chances of a hack are miniscule they still detract hugely from Bitcoin's credibility. Even a tiny chance of compromise kills Bitcoin's status as a safe-haven asset.
Bitcoin exchanges have already proven themselves vulnerable. The main Bitcoin exchange, Mt. Gox and others have already been attacked, which has caused the price of Bitcoins to crash in the past. An attack a couple of days ago on instawallet has caused many to lose their coins. These attacks are more akin to a bank robbery than actually compromising or altering the currency. Nevertheless these incidents have been prevalent and damage Bitcoin's image.
Government intervention is a huge risk. In many countries there are laws against creating new currencies. For example the United States constitution states:
Congress has the concurrent power to restrain the circulation of money which is not issued under its own authority in order to protect and preserve the constitutional currency for the benefit of all citizens of the nation.
Governments have already shown how nervous and keen they are to stamp down on and regulate the internet. The U.S. government has already shown it is prepared to take action. It shutdown poker sites operating in the U.S. in 2011. If Bitcoin ever took off and threatened other currencies it's difficult to imagine that governments would not do something. Politically it would probably even be popular as many people might perceive Bitcoin as a threat. The hacking attacks on Bitcoin exchanges and the increasing use by drug dealers would offer easy justification.
Of course Bitcoin enthusiasts argue that banning Bitcoins would make them even more popular and valuable. Maybe banning them would be fine for drug dealers but honest citizens aren't going to want to risk getting arrested for owning Bitcoins. Initially at least there would be a rush for the exits and the price would crash. In this scenario Bitcoin's openness might actually work against it. Gold can still always be hidden under a bed.
We should remember that the private or corporate ownership of gold was banned in the United States in 1933 by Franklin D. Roosevelt. It was not until 1974 that it was allowed again.
You might also argue that the government might just as easily ban gold ownership again. Given the widespread acceptance and ownership of gold I think today this would probably be politically impossible as well as impractical. Bitcoin has a much higher chance of getting banned.
Bitcoin's greatest weakness (which most people haven't properly considered) is that it can be copied. Bitcoin itself acknowledges the danger.
A much more distinct and real threat to the Bitcoin use is the development of other, superior virtual currencies, which could supplant Bitcoin and render it obsolete and valueless.
If Bitcoin does become an incredible success others will set up their own currencies in exactly the same fashion. Just as in any market, new entrants will emerge where super-normal profits are being made. Bitcoin's barriers to entry aren't impervious.
Initially other currencies might not be as widely recognised or as accepted as Bitcoin. However with enough resources behind them they definitely could be. As Bitcoin itself says,
It would certainly be in keeping with internet history for a similar system built from the same principles to supersede and cast Bitcoin into obsolescence, after time had revealed its major shortcomings.
Bitcoin's own supply may be limited but it cannot control the potential of other competitors. This in my view destroys Bitcoin's value and credibility as a safe-haven asset. If there are 10,000 Bitcoin clones in existence who's to say which is best.
Again this is where gold shows its value because it has proved itself over centuries. Gold itself has competitors in the form of silver, platinum and others but has always proved itself as the most viable.
For all the ingenuity of Bitcoin it lacks the same safety and certainty of gold. There is too much to worry about with Bitcoin. Most of the major issues; the potential for copycats, government intervention, intangibility and hacking will never go away. Therefore gold will always be the better safe-haven asset and should always have a much higher value than Bitcoins. In reality there is no comparison. Bitcoin seems to lack everything you actually want in a safe haven, namely certainty. Bitcoin's are highly speculative, risky and unproven. Those rushing into Bitcoin in the wake of the Cypriot banking crisis should be wary.
Today taking a rough price of $50 per gram of gold and $140 to one BTC. A Bitcoin is currently worth 2.8g of gold. I would prefer to own the gold.
This article is not a recommendation to buy gold. I am only arguing that Bitcoins could never replace gold as a safe-haven asset.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.