Digital Currency II

This post retracts a key point in the previous post and collects several relevant tidbits.

Retraction:  the Frequenter retracts the claim that a rise of bitcoin could plausibly hurt the dollar.  The Federal Reserve has the tools to contract the supply of the dollar.  If the dollar becomes less valuable (at least domestically) for any reason, including a bitcoin craze, the Fed will most likely contract the money supply enough to avoid inflation.

Tidbits:

1. The need for economy of scale in bitcoin mining may mean that an extremely small number of players will end up collecting the vast majority of new bitcoins.
2. If bitcoins were to take over a large fraction of commerce, wealth inequality would take on a whole new meaning.
3. The "experts" seem to have trouble agreeing on exactly how to value the bitcoin:  high, low, high, low.  The current valuation remains well below the peak, and it's looking mighty frothy.
4. The Assassination Market is one of the most flamboyant illustrations of the bitcoin's potential as the currency of choice for the dark underworld of web-based crime.  How hard must it be for the secret government agencies to resist using such a market to destabilize its worst enemies?
5. This sloppy rant by a brilliant young reinventer of the internets is perhaps the second most likely scenario for how the bitcoin will disappear (the most likely being that it goes poof spontaneously, or due to animal spirits).

Digital currency and the future of money

It is easy not to care about the precise meaning of money.  We all have a basic idea of how to use money, how to spend and save.  The problem, however, is that we could be on the verge of a big shake around.  The recent emergence of digital currencies, particularly bitcoin, may have historical importance comparable to that of genetic engineering, climate change, pretzels, democracy, or nuclear power, take your pick.

Money is a notoriously tricky concept, and my brief history of money is all too brief.  Money is anything that carries out the functions of money.  These include common-sense things like being easy to store, being easy to exchange, and retaining value.  Perfect money does not exist.  Gold coins, an early form of money, did pretty well.  But gold would be even better, as money, if you didn't have to worry about people paying you with coins that are not pure gold. The ordinary cash dollar (USD) is excellent money for the day-to-day, but tends to lose value over time due to inflation.  Also, if you're traveling internationally, USD can be a hassle to exchange in countries that use ther currencies.

Gold and USD are only examples of a large number of materials, currencies, and other bits of paper that are traded as money.  Adding to this long list, we now have digital currencies to think about. 

Bitcoin, introduced in 2009, is the most successful digital currency to date, recently trading at around $1000 USD per coin.  About 12 million bitcoins exist, for a total market capitalization of about $12 billion.  If the anonymous creator of bitcoin were to be hording a million coins, he or she could now be the world's first digital currency billionaire.

Bitcoins are created by "mining," a process that requires significant effort to understand.  By design, the number of bitcoins can never exceed 21 million.  Like gold, and unlike tulip bulbs, bitcoins are unlikely to suffer large losses in value that are driven by growth in supply.

The appearance of the bitcoin (or one of its competitors) raises a perplexing set of related questions:

1. What will the bitcoin be worth a week/month/year/decade from now? 
2. How might the rise of bitcoin affect the value of the dollar?

We begin with question 1.  Anyone who can answer this consistently can quickly get rich by trading on the bitcoin's wild swings.  The best we can do may be to put some vague upper and lower bounds on the future price of a bitcoin.  For the lower bound, let's say zero.  For an upper bound, I turn to this nifty little calculator, explained here.  Adjusting all of the sliders to their maximum positions, I get a maximum long-term bitcoin value of about $600k USD, or about 600 times the current valuation. 

But, turning to question 2, the $600k figure quoted above is on the scale of the present purchasing power of USD.  If bitcoin were to reach such heights as to replace government-backed currencies in most large transactions, the purchasing power of USD could also fall, making price of bitcoins, denominated in USD, nominally orders of magnitude higher than $600k.

Thus, the question of how much to "invest" in bitcoin is not exactly analogous to how much you should invest in Apple stock.  If you decline to buy stock in Apple, and subsequently the price of Apple spikes upward, you may have been left behind, but at least you still have the USD in your savings account, and the value of that USD is not hurt by the success of Apple.  On the other hand, if you choose not to buy bitcoins, and bitcoin subsequently becomes the dominant currency of the world, you not only miss the chance to get rich, but your USD savings also lose most of their value.

The Frequenter is genuinely perplexed, so take this advice at your own peril.  As a hedge against getting left behind, it might be a good idea to spend about 0.2% percent of your savings on bitcoins.  For this purpose, savings include checking account balances and retirement funds, but not your physical possessions, which have intrinsic value.  Then, in the extreme case, i.e., if bitcoin were to rise in purchasing power by a factor of 600, you'll come out slightly ahead, assuming you manage to buy in before the price spikes well beyond $1000 per coin.