Watching Bitcoin, Dogecoin, Etc…

Underpinning the value of gold is that if all else fails you can use it to make pretty things. Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year (yes, I know).

Placing a ceiling on the value of gold is mining technology, and the prospect that if its price gets out of whack for long on the upside a great deal more of it will be created. Placing a ceiling on the value of the dollar is the Federal Reserve’s role as actual dollar source, and its commitment not to allow deflation to happen.

Placing a ceiling on the value of bitcoins is computer technology and the form of the hash function… until the limit of 21 million bitcoins is reached. Placing a floor on the value of bitcoins is… what, exactly?

At the moment, it’s only a $10 billion bubble–or, if you are going to convince me that it is not a bubble, you are going to have to find me a market player willing to become a bitcoin sink…

Timothy B. Lee has smart things to say:

Timothy B. Lee: Dogecoins and Litecoins and Peercoins oh my: What you need to know about Bitcoin alternatives: “Dogecoin is a joke. Though weirdly it’s a joke that, at least on paper, is worth millions of dollars….

The founders of Dogecoin took the source code of another Bitcoin variant called Litecoin, made some further tweaks, and rebranded it as ‘Dogecoin’. That’s a reference to the canine variant of lolcats, an Internet meme where a grammatically challenged dog makes excited statements. Dogecoin has been around for less than a month. In that time, the value of all dogecoins in existence has skyrockted from zero to more than $8 million…. Bitcoin’s pseudonymous creator, Satoshi Nakamoto, did an amazing job of building a payment network that is secure, scalable and useful. But he wasn’t perfect; he made some design decisions that might not look so great in retrospect. The problem is that thanks to Bitcoin’s decentralized design, it’s not easy to change the core Bitcoin protocol. Hence, if you have an idea for an improved version of Bitcoin, it’s easier to start your own virtual currency….

Most of the altcoins have focused on improving mining, the process the Bitcoin network uses to process transactions. In the Bitcoin mining process, hundreds of computers race to solve a repetitive math problem. The winner of the race gets to add a ‘block’ to the Bitcoin network’s global transaction register, and to award itself 25 bitcoins (roughly $20,000) for its trouble…. One problem is that the mathematical formula at the core of the Bitcoin mining process, called a hash function, can be performed much more efficiently by expensive, custom-designed computers than with an ordinary PC. As a result, mining has become an increasingly specialized activity, with people spending thousands of dollars on chips whose only function is to mine Bitcoins…. It’s no longer cost-efficient to mine Bitcoins with an ordinary PC–the electricity consumed is worth more than the bitcoins produced…. A Bitcoin alternative called Litecoin replaces Bitcoin’s hash-based mining process with an alternative that’s harder to accelerate with dedicated hardware…. As this is being written, the value of all Litecoins is more than $500 million….

The second Bitcoin flaw is the… mining process is a computational arms race…. The Bitcoin principle that miners with more computing power earn more Bitcoins is known as ‘proof of work’. Several Bitcoin alternatives use an alternative principle called ‘proof of stake’, where miners with the most virtual cash earn the most. That approach eliminates the incentive to spend ever-larger sums of money on mining hardware, which is good for the environment….

All bitcoins in circulation are worth around $10 billion. Its nearest rival, Litecoin, has a total market value of around $500 million. The other virtual currencies are worth much less…

UPDATE:

Okay. Suppose that you’re on the island of Yap and it is the late 18th century…

You want to get richer. You can either work on Yap doing something useful, or catamaran over to Palau where the limestone is, carve a big piece of limestone into a disk, catamaran it back, and use it as money. If the value of stone money is too low, it won’t be worth anyone’s while to catamaran over to Palau. Thus the stone money supply will stop growing if the price dips. As long as the relative desire to use stone money does not shrink faster than per-capita income on Yap plus the population of Yap grows, the value of stone money on Yap will be determined by its cost of production–that is, the cost of catamaraning it over to Palau, carving the limestone disk, and bringing it back…

We can see this at work come the late 19th century. Europeans show up with steel tools that make it a lot easier to carve limestone disks on Palau. Thus there is a huge boom in the limestone disk-carving stone money-mining industry. And the value of stone money on Yap Falls as the money supply grows…

Now suppose that you were on the Internet and it is the early 21st century…

You want to get richer. You can either work doing something useful, or you can set up a botnet to mine BitCoins, or you can fork the code behind BitCoin and set up your own slightly-tweaked virtual cryptographic money network. Setting up a new, alternative network is really cheap. Thus unless BitCoin going can somehow successfully differentiate itself from the latecomers who are about to emerge, the money supply of BitCoin-like things is infinite because the cost of production of them is infinitesimal.

How can BitCoin successfully keep itself differentiated from the latecomer copiers?

1. By asserting, over and over again, simply that it was first. And this might work. But I am skeptical.

2. By stressing that it has a trustworthy track record of being a safe store of value–and thus appealing to a history that the latecomers do not have. This works until someday, for some reason, demand for BitCoins falls. Then supply and demand drives the value down. BitCoin is then no longer differentiated as a safe store of value. Then the people who were holding BitCoin because they thought it was a safe store of value dump it, its price falls even more, and so it becomes even more questionable as safe store of value. And the downward spiral continues.

Note that in these respects–unless it can successfully and permanently differentiate itself from other virtual cryptographic money networks–BitCoin is like fiat money, and unlike 18th and 19th century Yap stone money, in that its cost of production is zero.

So how do actual fiat moneys maintain their value? Well, they don’t always do so–cough Zimbabwe, cough Weimar Germany. When they do so, it is because a government (a) accepts its money in payment of taxes, thus giving people a reason to hold it, (b) doesn’t want the financial chaos that hyperinflation would generate, and so (c) sets its central bank the mission of being a currency sink–of maintaining the value of the currency by buying it back and burning it up if necessary. Thus I tend to be a “chartalist”: commodity moneys can maintain their value via their cost of production, but fiat moneys maintain their value when some very large too-big-to-fail entity backs them.

In my view, BitCoin’s chances would be a lot better if there were some large and durable entity that promised to be a BitCoin sink if necessary. If, say, Google Cayman Islands were to start GoogleCoin, and announce that it would always stand ready to buy back GoogleCoins at a fixed real value, it could make a (small) fortune and, I think, eliminate BitCoin’s business in a month…