What is Money?

A few months ago, I had a conversation with another parent at my son’s school. The gentleman was an enthusiast for Bitcoin, a type of crypto-currency. I had a strong impression his interest was more than theoretical. He exhibited the sort of nervous energy characteristic of speculators hoping a large bet comes good.

Bitcoin’s origins remain obscure. In February, an energetic Newsweek reporter “outed” an unemployed electrical engineer, claiming him to be the source of the computer code that underlies Bitcoin. It appears that identification was wrong, and a lawsuit likely to follow.

Bitcoins create both benefits and problems on multiple levels. One obvious benefit is having access to a virtually untraceable form of buying power, outside the supervision of governments. This has appeal to terrorists, organized crime figures, folks with privacy concerns, and those who fear any government, including our own. (No, I’m not suggesting that Tea Party members are terrorists. I’ve never known any terrorist who walked around with a copy of the U. S. Constitution in his pocket.)

Bitcoin also has appeal for those not members of Al-Qaeda or the Russian Mafia. It is not fiat currency. The algorithm that creates new Bitcoins is designed to strictly limit the number in circulation, in theory preventing the inflation that gradually erodes the purchasing power of paper money in most countries. (Quickly, if you live in Venezuela or Argentina.)

Ironically, the anonymity of Bitcoins, and the lack of regulatory oversight, creates unanticipated risks. In February Mt. Gox in Japan, the largest trading exchange and depository for Bitcoins, sought Japan’s version of bankruptcy protection. Initial reports suggested the firm’s customers might have lost almost $500 million. At the time it went dark, Mt. Gox handled 70% of the world’s traffic in Bitcoins.

Another problem with Bitcoin as money is taxation. The Internal Revenue Service has determined that ‘spending’ a Bitcoin is a capital transaction. If the value is more than you paid, the result is a taxable capital gain.

The very name Bitcoin suggests the intention to create money, also reflected in the term ‘cyber-currency.’ So is Bitcoin money? In more general terms, what is money, and what do we want it to do for us?

The classic purpose of money is to be a medium of exchange. Instead of trading your two sheep for my ten chickens (which would require that you want chickens, and that I have some), you can sell me your sheep, receive cash, and spend that cash on other things you want, including goods that I do not possess. So far, so simple.

An ideal currency would be easy to use, widely accepted, and capable of being used to purchase goods anywhere in the world. By these measures, the U. S. dollar gets high marks. Perfect money should also be a stable store of value. If a sandwich cost $2 in 1980, you should be able to buy that same sandwich for that same $2 in 2014. By that measure, the U. S. dollar falls short. Inflation since 1980 has reduced the dollar’s purchasing power by 84%. (Still much better than the Zimbabwean dollar, which was abandoned in 2009 when inflation hit an annual rate of 6.5 quindecillion novemdecillion percent. You know you are in monetary trouble when you have to use words to save zeroes.)

The appeal of Bitcoin in part reflects dissatisfaction with the money otherwise available to us. The most significant defect of fiat currency like the U. S. dollar is its failure to preserve real purchasing power. Might Bitcoins have avoided that 84% loss in buying power?

Bitcoins weren’t around in 1980, but gold was. Anyone who bought gold in 1980, at the prior inflation-adjusted high, and held through the end of the 20th century, lost 69% of their nominal dollar value and over 90% of real value. Meanwhile, they missed out on a 2,427% bull market in U. S. common stocks.

Buying any asset at a time of euphoria usually works out poorly. How about if you bought gold when it was out of favor? If you had invested $10,000 in gold back in 1968 (illegal at that time in the U.S.), you’d have acquired 286 shiny ounces. Today, 46 years later, you would own the same 286 ounces of the yellow metal. In fiat dollars, the value of your holdings would have grown to $357,000; in real dollars, to $55,000.

So gold can be a successful or unsuccessful speculation, depending on price and sentiment, just like Beanie Babies, baseball cards, or penny stocks. But gold is not useful as money, because it does not reliably preserve real purchasing power, even if held for decades. If you had enough gold to buy a cheesesteak in 1980, by 1999 you might have been able to afford a pack of gum.

Does this mean we must ignore the erosion of wealth caused by long-term inflation? Certainly not. Warren Buffett believes that inflation will gradually confiscate the value of dollars over time. Thus far, he agrees with the goldbugs. But he believes the best hedge against inevitable long-term inflation lies in ownership of growing businesses, not shiny yellow metal. If you invested $10,000 fiat dollars in Warren Buffett’s Berkshire Hathaway in 1968, by the end of last year your shares were worth over $58 million. (Still fiat dollars.)

Would you really be happier to have assets worth $357,000, instead of $58 million, simply because what you held was not a fiat currency?

Saying you want only want physical currency is kind of like saying we should only permit live, not recorded music. Unfortunately, you cannot operate a modern international economy with physical metal, any more than you can carry around fifty symphonies and two thousand popular songs in the form of vinyl LPs. You need those countless trillions of ones and zeroes flying around the world over fiber-optics and copper wire to make the banking system work, just as you need digital data to make your iPod function.

Money is a medium of exchange, useful as a mechanism to make commerce work, hopefully with value that is not ephemeral. It is never an investment. Gold is lousy money in any modern economy, and is never a sensible long-term investment. In fact, gold is not an investment at all, since it produces no economic return. It is, always and forever, simply a speculation on future sentiment. Likewise, Bitcoins are no substitute for actual money, and have no intrinsic economic value. They may retain scarcity value, or they may not. What they most resemble is a kind of Ponzi scheme, since early “miners” of Bitcoins (presumably, those who created the underlying computer code) got lots of them dirt cheap, while later miners extract few coins at great effort.

Bill Gross had a recent comment on this whole issue of money. Conceptually, he suggests we think of all liquidity, including money, simply as diverse forms of credit. I’m not sure this entirely works. With borrowed money, there are two known parties, at least initially. Though once you add in credit-default swaps and securitization, maybe it is no longer possible to differentiate paper assets from real.

An aside — the night I met that other parent, Bitcoin was trading at over $1,000. Yesterday’s close was under $500, a more than 50% loss. Ouch.