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Tuesday, March 12, 2013

Bitcoin and Gold

I must admit to a certain philosophical attraction to the concept of a digital currency. What does Bitcoin have in common with Gold or fiat currencies? What are the differences? Will Bitcoin, or some future digital currency replace gold?  Let’s take a look at three forms of currency or money:
1) Fiat currencies like the $US, the European €, the Japanese ¥, etc.
2) Gold (and Silver)
3) Digital Currencies such as Bitcoin

High recognition/acceptance
Long History
High acceptance of notes
Widely available electronic substitutes and transfer mechanisms.
Centrally controlled

High Recognition
Long History
Limited supply
No central control
No central point of failure
Lower acceptance than Fiat
Storage risk and cost
Requires electronic substitutes to facilitate transactions
Software fraud
Technology failure
Encryption flaw
Gov’t sanction
Easy to transfer
Easy to store
Limited supply
No central control
No central point of failure
Anonymous transfers
Irreversible transactions

Low recognition
Short history, unproven
No physical medium
Anonymous transfer-gov’t concern
Lost Bitcoins unrecoverable
Point of sale delays, storage insecurity
Irreversible transactions
Difficult to establish value
Bitcoin Exchanges are unregulated

Gold and silver have thousands of years of history. Gold-backed currencies then evolved and were around since at least the Roman times interspersed with periodic returns to Gold and Silver after early debasement schemes such as clipping of gold coins or adulterating with copper caused currency collapses. Then came almost totally fiat currencies of the type we have today. They have been around in their recent manifestations for several decades backed by the full guarantee of the state! While some fiat currencies look increasingly shaky the major currencies have, with some exceptions, survived in spite of progressive debasement over the decades with very few near total collapses requiring re-establishment of the currency.
Bitcoin, on the other hand is still very, very new. It had its beginnings in 2008 and got traction largely because its design solved a number of problems that early virtual currencies failed to address. The anonymity with which transfers can be done, its lack of central control, its inability to be debased and its electronic/virtual nature are strong suits. But there are some drawbacks not the least of which is its newness. It is untested relative to the countless trials by fire for gold and silver and fiat. It is not tangible like the paper dollar or a coin. It can easily take 10 minutes or more to verify the authenticity of a Bitcoin. This would be problematic in point of sale transactions at stores, for example. But the real problem for new entrants to the currency game is government. Government relies on central control for taxation and revenue. Governments also detest things that they can’t control, sometimes for legitimate reasons such as crime control but often because it is the nature of governments to meddle in people’s affairs. This to me is the biggest challenge and risk for Bitcoin and subsequent iterations. Will government even tolerate, never mind, endorse such a new currency? I doubt it.
But forgetting government for a moment and taking a lesson from history, most, if not all successful currencies were initially launched by being backed by gold and silver. This is simply because a tangible starting point for value is usually needed for mass adoption. Once confidence in a currency is earned, the backing is typically gradually removed to permit unfettered debasement. Thus, down the road, an interesting approach would be to combine Gold, the “barbarous relic” with a virtual currency such as Bitcoin to produce a gold-backed Bitcoin which would also add the missing physical exchange mechanism. Gold wouldn’t be used for most transactions, though. It would be like your savings account. Bitcoin would be your checking account. Now the government could confiscate the gold and outlaw the Bitcoin - Back to square one! Seriously, though, for digital currencies such as Bitcoin to come out of the shadows will require wide public, merchant and government acceptance, as well as a solution to the delays inherent in verifying authenticity of a Bitcoin transaction. Some accommodation to Government demands for traceability (reduced anonymity) will likely also be a needed compromise.
UPDATE April 7, 2013: Example of Bitcoin Storage security issues: