Although cryptocurrency has become a household topic in 2017, what most households don’t understand is — why does cryptocurrency, such as Bitcoin, have any value? (Many actually think crypto has no value at all. But when you ask them why, they couldn’t answer because they have never really thought it through.)
In order to answer this question, we have to ask another fundamental one — where did currency come from?
In the early state of society, the value of a good or service was determined by the amount of labor required to produce it, and then the need for exchange of goods and services bred currency. For example, Bob spent a year to raise a cow and it took Alice the similar amount of labor to raise three lambs. Alice wants to buy cow so she exchanged Bob’s cow with three lambs. However, using livestock as a medium of exchange (barter) was very inconvenient so some people started to use gold instead. When gold was widely accepted as the medium of exchange, it became a currency. You may wonder, did gold come out of thin air and was abruptly assigned a value? Of courses not. Some people spent a lot of time and resources to mine gold so there was labor behind supporting its value. (The situation is more complicated under modern economy where owners of capital are compensated by profit, but we can skip it for now).
If you believe in this theory, then bitcoin has value. Simply put, some people are spending time and resources to build a transaction system, and get compensated with bitcoin. Just like gold miners expend resources to dig gold. So, rather than coming out of nothing, bitcoin is produced by labor through the blockchain building process.
I know another question comes to you mind — why do we have to use cryptocurrency instead of dollar? Cryptocurrency cannot gain value just because it requires labor to produce it. You can spend time and resources to produce something that is of no value at all, a stone spear for instance, because it is useful to no one. You are absolutely correct based on the subjective theory of value — value of a good is determined by our desire for it. However, you will also realize that cryptocurrency has value because it has great use cases and it is better than dollar as a medium of exchange.
Gold and silver are considered as commodity money since they have intrinsic value. Dollar during time of gold standard has intrinsic value too because one dollar was pegged to 1.61 grams of gold. Therefore, governments could not issue as many dollars as they want because gold is limited. However, gold standard doesn’t exist anymore. What we use today are fiat currencies which are intrinsically valueless. They are used as medium of exchange purely because of government decree. Is this something you should worry about? Yes. We trust dollar for now because we trust US governments’ creditability, the economic health of the country and the stability of dollar’s purchase power. If these conditions no longer held (like Zimbabwe or the U.S. during financial crisis), fiat currencies can depreciate rapidly.
Unlike gold or dollar bills, cryptocurrency are not tangible, making some people feel unsecure. However, they are actually more secured than fiat currencies once you understand the mechanism behind.
Cryptocurrency have several advantages over fiat currencies. 1) They usually are capped in quantity (e.g., there are at maximum 21 million bitcoins). Similar to gold standard system, it prevents hyper-inflation due to excessive issue of currencies. 2) Cryptocurrency cannot be forged because it is secured by cryptography. 3) The transactions costs are lower because no middlemen, like banks, are required any more. In the extreme, even if all governments and banks collapsed, cryptocurrency, living in blockchain, can last forever.
Currency is just a collective agreement. If enough people reach a consensus, what they agree upon becomes unimportant. We can use different languages to describe the same object; similarly, the choice of medium of exchange is flexible too. It can be livestock, cowrie, gold, note or simply a code. It took thousands of years to transition from barter to coinage, 400 years to transition from coinage to paper money and 50 years to transition from paper money to plastic card. This time, it may take only 15–20 years to make cryptocurrency widely accepted.
You can choose to change or to be changed. Please get prepared.
(P.S., on a different note, it is still a debatable topic whether Bitcoin is a currency or commodity. Satoshi’s original purpose was to create a digital currency but it looks more like a commodity based on the reaction of the market. We will cover this topic in the next post.)