Great post by Robert David Graham explaining the recent surge in bitcoin popularity.
Bitcoin is an increasingly popular electronic currency, used both for legitimate and illegal transactions. Economists haven’t taken a serious look at bitcoin yet, so I thought I’d take a stab at it. In particular, I’m going to look at the “intrinsic value” of bitcoin, answering the question whether the recent rapid rise in price (to $240 at the time of writing this) is justified.
Bitcoin vs. Money
There have been many un-serious looks at BitCoin. Take, for example, this 2011 blogpost by Nobel-prize winning economist Paul Krugman, where he compares bitcoin to the gold standard. He’s completely wrong.
The mistake economists make is assuming that bitcoin works like real money. It doesn’t. While bitcoin is designed as a “medium of exchange”, it doesn’t serve the other traditional functions of money, such as a “store of value”, “unit of account”, or “measure of value”.
In recent months, the price of bitcoins has skyrocketed. In classic economics, this means that the bitcoin economy has experienced massive “deflation”. Likewise, when the bitcoin bubble bursts and the price goes down, the bitcoin economy will experience hyper “inflation”.
But this inflation/deflation has no effect. Prices aren’t denominated in bitcoins, but in some hard currency like dollars or euros. Buyers exchange their dollars for bitcoins, give the bitcoins to the seller, who then immediately changes them back to euros. The entire process takes about 30 minutes. The only requirement is that the exchange rate for bitcoins not fluctuate wildly during this half-hour window. When analyzing bitcoin, we have to toss out this idea that it is a “measure of value” and the related ideas of inflation/deflation.