Bitcoin versus the Dollar
You can’t hold a bitcoin in your hand, but you can spend one. Bitcoins are digital representations of value, a fiat currency based on cryptography—the use of encryption to store and transfer value securely. Transactions using bitcoins are decentralized in that they are validated and certified through a network of users rather than one central administrative site.
Though bitcoin has attracted a lot of attention, bitcoins are not widely accepted as a method of payment at most retailers, so the transaction volume associated with bitcoin is only a fraction of that of other forms of payment. Since its inception, daily transaction volume has varied from days with no transactions to over 100,000 transactions on November 28, 2013. The median number of transactions per day is 6,461, a tiny level of activity compared to credit cards and US currency. In 2011, for example, 20 billion credit card transactions were processed, according to one report, while fewer than 2 million Bitcoin transactions were confirmed during the same time period.
The price of one bitcoin in terms of the US dollar has varied from five cents to over $1,000 since its creation in 2009. As of July 2014, the price is around $650 per bitcoin. Bitcoin trades simultaneously for different prices on different exchanges, and the price is highly volatile.
This volatility is greater than that of the US dollar; another way to put it is that bitcoin prices are subject to high rates of inflation and deflation, whereas the Federal Reserve monitors the inflation rate in the United States and can adjust monetary policy to prevent hyperinflation or deflation. This allows the holder of a US dollar to have confidence that the value of his or her money will not be subject to great losses, an assurance bitcoin holders do not have.
Another way to note the changing value of bitcoin is to look at what it will buy. The average monthly price of a gallon of gasoline in US dollars since 2011 has varied $0.69. In bitcoin, it has varied 1.17326 bitcoin—$734.37 in terms of the current exchange rate. One practical problem for merchants posting prices in bitcoin is that they must quote prices out to several decimal places, whereas prices in most other currencies are rounded to two. So for instance, if bitcoins were used to purchase a gallon of unleaded gasoline in June 2014, the price would have been 0.005994 bitcoin.
While the supply of US dollars is adjusted by actions of the Federal Reserve in the market for bank reserves, the supply of bitcoin increases as users of the system, or “miners,” confirm transactions; this will continue until the total supply reaches 21 million bitcoin.
Another difference between dollars and bitcoins is the way they are produced. Bitcoins are created when people validate transactions by solving a difficult math problem—a process known as bitcoin “mining.” The economic cost of producing bitcoins, the rate of seigniorage, is tied to the rigor of a mathematical problem, and each miner devotes computational power to confirming transactions and solving the problem. Once transactions are confirmed, the miner who confirmed the transaction receives bitcoin as a reward, that is, compensation for his or her work. In comparison, for dollars, the Federal Reserve determines the amount of high-powered money that is produced (currency plus bank reserves), which ultimately determines the total number of dollars in the world. Even ignoring bank accounts, there are a lot more dollars around than bitcoins: The current supply of bitcoin is nearly 13 million, whereas there are 34.5 billion US currency notes in circulation; or nearly 2,700 bills for each bitcoin.
In terms of value, the differences are also large. As of January 2014, the amount of bitcoins in circulation valued in US dollars was around 9.3 billion; by comparison the total value of all US currency is nearly $1.2 trillion, or nearly 130 times the value of all bitcoins (and we’re not counting bank accounts in this either). Once the entire supply of 21 million bitcoins has been mined, their value (at the current exchange rate) will be barely over 1 percent of the value of US dollars (even assuming no growth in US currency). So bitcoins, despite their high profile and relatively high value, still make up only a small portion of the value of US currency. And as a fraction of all payments in the world, it is even less.
It’s perhaps too early to assess the future of bitcoin, but in terms of number of transactions, total value, and even price stability, it is not currently a major competitor of the US dollar.