Much has been made about the meteoric rise of bitcoin. Bitcoin’s move up to what some consider bubble-like levels has inspired the creation of hundreds of other cryptocurrencies as well as interest in the blockchain that makes virtual money possible and valuable.
Aside from buying bitcoin itself, investors look to buy companies such as International Business Machines Corp. (NYSE:IBM) or the Bitcoin Investment Trust (OTCMKTS:GBTC) to invest in this market. However, the focus on bitcoin or virtual currency in the general sense may be too narrow. The more important question remains the effects of virtual currency on the world economy, and how investors can profit.
The Real Definition of Money
To know how virtual currencies affect our thoughts on money, we first have to understand the definition of money. When most people are asked to define money, they will typically respond with examples of legal tender—dollar, yen, euro, etc. or possibly a precious metal such as gold or silver.
However, at the core, money functions as a medium of exchange. This money holds its value simply because the market at large believes in its value. For example, forever stamps serve as money in prison because they have the desired attributes needed to be money. The stamps are easily carried and stored.
They also retain a fixed value, the cost of mailing a 1 oz. letter. In the outside world, money held its value through the gold standard for much of history. This measure guaranteed a fixed amount of gold per unit of legal tender.
Between the 1930s and 1971, the U.S. government guaranteed 1/35 of an oz. of gold for every dollar in circulation. Today, every currency in the world is backed purely by confidence in the sovereign.
The “full faith and credit of the United States government” now supports the value of the U.S. dollar. However, the dollar gradually loses value under this system and analysts figure in an inflation rate on all long-term loans and savings plans.
Cryptocurrency Changes Assumptions
Virtual currencies turn this assumption on its head. The blockchain fixes the eventual maximum amount of a cryptocurrency in circulation at 21 million bitcoins. It engenders belief in the value by keeping only a limited amount of a given currency in existence. Due to increased demand and a fixed supply, blockchain has given the world something that has not existed for decades—money that goes up in value.
This creates profound ramifications for the economy, and not all boost the economy. One might think about the programmer who paid a 10,000 bitcoin priced for two pizzas from Papa John’s Int’l Inc. (NASDAQ:PZZA) back in 2010. The increase in value since that time creates a great deal of reluctance to spend bitcoin.
The same would go for borrowing. A loan of bitcoin to pay for the pizza could have brought a different kind of pain. Having to pay back 10,000 bitcoin could have led to his bankruptcy, even at “non-bubble” values.
Government Currencies now Have Competition
Further, sovereign currencies now have a competitor in virtual currencies. The winner between the two depends on whether “full faith and credit” inspires more or less confidence than the integrity of a blockchain. Huge disparities exist on both sides. A possible result entails blockchain winning out over the local currency in countries such as Venezuela or Zimbabwe.
However, hackers could undermine confidence in virtual currency to the point that government currencies still win out in the United States or Japan.
The implications could become nothing less than one of the greatest paradigm shifts in world economic history. Third World assets once left for dead could become investable. Even First World currencies could face challenges to the confidence that retains their value. Some currencies might have to return to the gold standard to stabilize their values.
The possible effects of virtual currency on the world economy remain both infinite and unknown. Investors need to prepare for opportunities to appear and disappear in surprising places.
Final Thoughts on Virtual Currency
The implications of virtual currency reach well beyond a possible cryptocurrency bubble. The rise of blockchain creates currency outside of government control. It brings to the world a form of money that can move either up or down in value.
This brings less stability in the sense that changing values may depress spending and borrowing. It could also create political and economic chaos anywhere it challenges confidence in legal tender.
However, virtual currency could bring stability in a different sense. Assets previously left off investor watch lists could become good investments, especially in countries with weak currencies. Governments could also respond by solidifying the value of their money.
Whatever changes come about, when looking at virtual currencies, investors should place their focus on possible opportunities, not bubbles.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks or cryptocurrencies.