Gold and Bitcoins

In the mid-nineteenth century, the US state of California was a fairly quiet place, mostly made up of natives. Then suddenly people turned up from all over. In two years, the population of San Francisco ballooned to twenty-five times its former size.

People from all over the world risked a dangerous ocean voyage to get there. They either sailed around the tip of South America, or camped along a cholera-infested route from coast-to-coast along the California Trail.

The massive influx of settlers changed the state of California forever …

Why all the fuss and bother? The answer is that something highly scarce and therefore valuable was found in riverbeds and streams: it was of course the Gold Rush of 1849.

At first, anybody could turn up (assuming you could get there) and pan for gold, tax free. It was a free-for-all.

Panning for Gold

There really isn’t much gold in the world: all the gold ever extracted would only fill 82 cubic feet.

Gold mining is not exactly a walk in the park. First you have to find some. According to the colourfully-titled Hard Rock Miner’s Handbook, “it takes 25,000 claims staked, to find 500 [sites] worth diamond-drilling to find one mine”.

Then you have to dig your mine - up to 4km underground - which is unbearably hot and subject to “major seismic events”.  Once you cart your ore back to the surface, the extraction process involves a dangerous cocktail of cyanide, sulphuric acid and mercury.

You could certainly say that gold is scarce, both in terms of quantity and extraction costs.

All this is worthwhile though, because once you’ve got it, gold is fantastically durable to the elements. Glowing nuggets of it can theoretically be found lying about in their natural state.

This durability means that 24 carat (pure) gold is fairly uniform stuff, so is highly fungible (easily traded like-for-like). It is also incredibly dense, so a small volume of it conveniently represents a high value.

These properties make gold a highly suitable symbol of value. If you could embody the value of human endeavour into a coin, it would be a gold one.

A quantity of gold could also be said to be a “proof of work”. It is a proof of work because it is relatively easy to prove that a certain amount of work was done to extract it. Therefore the value it represents can be easily established.

Bitcoin

Another proof of work is a solution to a difficult mathematical problem. The Bitcoin system of “digital currency” relies on this fact. A Bitcoin is “mined” by means of a computationally-intensive search for solutions. A solution (or ‘block’) yields a number of Bitcoins. These Bitcoins are demonstrably unique, and can be cryptographically linked to their owner. They can then be traded for goods, services or even exchanged for another currency.

A Bitcoin block could be likened to a nugget of gold in economic terms. It’s fungible, easy to verify and relatively difficult to “mine”. Therefore it’s much like a commodity, assuming there continues to be a demand.

With the current hype surrounding Bitcoin, there certainly is a demand. The price for a Bitcoin on the digital exchanges has risen many times over this month: a bubble, no doubt.

However Bitcoin is not just for speculators: a number of online retailers accept Bitcoins in exchange for goods and services. Why? Several quoted advantages of Bitcoins are that they are (currently) anonymous and therefore (currently) tax-free. Some of the more sensationalist articles claim Bitcoins are “dangerous” and that governments will have to ban them (how?).

Gold Rush Over

However, the Gold Rush is already over for Bitcoin. It is no longer a “free” commodity, like gold was during the Californian Gold Rush of 1849. Ordinary CPUs are no longer capable of generating Bitcoins in a reasonable timescale: the FAQ quotes a period of ‘years’. Now, only massively-parallel hardware such as GPUs can possibly mine for them (whether they can do so profitably is another matter). Over time, the yield of Bitcoin extraction will wane, until no more can be produced.

Only 21,000,000 Bitcoins can ever be produced by the year 2140, with a restriction to allow only one block to be generated every 10 minutes. Those who got in early essentially have all the Bitcoins already. Assuming demand keeps up, the price for Bitcoins can only rise as the supply drops. Therefore, it could be the case that many of the early-adopters are now holding out to sell later on.

Ordinary currency exchanges won’t sell you Bitcoins. However there are a number of independent Bitcoin exchanges which will (if you can trust them). With all the hype and speculation, these exchanges are highly volatile (like any real currency admittedly).

The only way to get in on the market now is to either buy at a high price, or wait for prices to go down (implying confidence for Bitcoin has also dropped, effectively making it worth less).

Another way to join the market is to sell your own goods or services for Bitcoins. Of course you’d be limited to customers who are already in the market. But these customers are going to want to hold onto their increasingly scarce Bitcoins.

The Bitcoin Market

Modern currencies are backed by a government fiat: a law that says everybody must accept it. Therefore, if you have some of the currency you are reassured of its value.

Of course, Bitcoin is not a fiat currency. So, some argue that the Bitcoin currency “is not backed by anything”. The organisers challenge this criticism by saying it’s backed by the goods and services sold by merchants that accept it. This small cohort of merchants tend to be internet services or online gaming companies.

Some small web retailers are accepting Bitcoins in exchange for material goods. These retailers appear to be quirky individualists, perhaps revealing the cross-section of those who are holding out for Bitcoin.

To be fair, Bitcoin was always intended to be an online-only currency. You can’t exactly print them out to pay for your lunch. By nature they are a peer-to-peer concept, relying on a circle of cryptographic trust.

But as the price rockets and people wonder what’s going to happen next, is confidence going to go up? As a retailer, I’d hesitate to accept Bitcoins, because I’m not convinced the next person will want them. The Bitcoin market seems quite closed and quirky, and too small and narrow to hedge against big movements.

If Bitcoin survives, it will become a sealed market, where only a few can afford to buy them (due to their scarcity and deflationary nature). Those few will buy and sell goods and services from each other. Nobody else will be able to get in because no more can be mined, and the barrier to entry will be too high.