When we talk about money, we tend to treat the bills in our wallets and the numbers in our accounts like a grandmother might treat a new iPhone: Why ask how it works when it works so well?
It’s why those in the know may be a bit confused by all the questions most people have about Bitcoin, the volatile digital currency that is now as ubiquitous as it is misunderstood. Chief among these questions is the most basic: How does it work?
Bitcoin largely works like the U.S. dollar. A central force stymies how much money is in the market and this certain level of scarcity retains its value. In the case of the dollar, it’s the Federal Reserve and the U.S. Treasury that decide how many dollar notes are allowed into the ether, which currently stands at roughly $1.2 trillion. With Bitcoin, however, the controlling figure is not a bank but an algorithm.
There are 21 million Bitcoin in existence. There will (if the currency’s creator/s Satoshi Nakamoto is to be trusted) always be 21 million Bitcoin. The reason you can still go out and buy Bitcoin today is the way it is “mined.” Without getting too bogged down in the technical details, you can earn Bitcoin by allotting a computer to help find the “address” of Bitcoin; the money isn’t so much being created by computers as it is being “found.” The more processing power you have (your graphics card is especially important), the more equations you can solve, the more Bitcoin you can locate and retrieve. Only 11 million Bitcoin have been found and it gets harder and harder to find them everyday.
But why? Why bother hunting for Bitcoin at all? Isn’t it just made-up Internet points?
And here’s where economists tend to shrug: the money you use everyday is much like Bitcoin. We agree the U.S. dollar has value and accept it as payment for all debts public or private. Bitcoin likewise has value because merchants—from the mundane to the scandalous—are accepting it as payment. So if you believe it has value, it has value.
If that sounds ridiculous, that’s because it is. But it’s also the way the world economy works.
But Bitcoin—after crashing then recovering then bringing down the nation of Cyprus then recovering again—suddenly finds itself not so alone in this brave new world of digital monies. 2013 saw the rise of Bitcoin’s two major competitors, Litecoin and Ripples. Both use a similar method of mining and keeping the number of Litecoins and Ripples minimized. The end of 2013 saw the unlikely rise of Dogecoin and 2014 has already brought us Coinye (a cryptocurrency named after Kanye West that hopes to find niche markets) and the Ron Paul Coin, a coin devoted to that lovable, libertarian imp.
OK, so first we just get to “decide” what has value, and now you want me to believe digital coins named after memes and rappers are the future of commerce! That’s ridiculous!
And it is!
But it’s also how the world economy works!
So if money has value because we accept that it has value to us as individuals and merchants, what happens if/when some of us decide a different kind of money has value instead? What happens when we want to use Bitcoin to pay bills and Dogecoin to wager bets and Coinye to by new music?
Then we have something that looks an awful lot like a market. Monopolizing a market effects currencies differently than it does businesses. If a cable company has a monopoly, it gives them full control of their own pricing without the worry of competitors. If Bitcoin has a monopoly, it becomes a bit useless. It can’t raise it’s own value because that would mean destroying some Bitcoin, possibly causing a “run” by miners. It can’t create more Bitcoin because that will only devalue the currency that’s left over. In fact, due to the very nature of how Bitcoin is earned, most people will be priced out of earning it at all sooner rather than later.
And here is where competition actually helps Bitcoin. In the early days, Bitcoin miners could be any script-kiddie with half a brain and an economics textbook. Now, mining Bitcoin requires some significant processing power. The more Bitcoin that is mined overall, the more power needed to reach the remaining Bitcoin. While devoting entire machines to this process may be a reputable investment for some, most people would rather stick with working for a living thank you very much. The more people leave Bitcoin as an operation, the less valuable it becomes.
But if entirely different cryptocurrencies arise with lower exchange rates and easier costs of entry, miners can begin to behave less like prospectors and more like traders. So mining Bitcoin isn’t working out for you? Try mining FedoraCoin, which you can slowly trade into the Deutsche eMark, then Earthcoin, then maybe you can turn those coins into the equipment necessary to locate Bitcoin and Litecoin. Smaller currencies get a chance to grow (maybe even take over the larger currencies) while new players get a vehicle to mine the big currencies. Without the benefit (or hamperance) of geography and politics, the only thing that stops any digital currency is simply how popular it can make itself.
Don’t get me wrong: the whole thing is still really, really ridiculous. And even Bitcoin is not the safest place to hedge your savings (no market this volatile ever is). All that stands between Bitcoin and obscurity is a strong-enough DDoS attack. But if this is the strange, new world of magical interweb money we choose to live in, let’s dance in the glory of its variety. Even Dogecoin points to a future whereby you can actively affect how far a dollar goes.
Illustration by Jason Reed