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The Puzzle of Bitcoins and Cryptocurrencies

Something stored on the internet gives you buying power

All of us are aware of bitcoins and other types of cryptocurrency. It may sound extremely strange that something stored on the internet gives you buying power. This something is not information about your bank account, and this something looks quite irrelevant to actual money. Even more confusing is the fact that anyone can generate bitcoins for his/her own use just by running a computer program. This all makes us feel like Alice in Lewis Carroll’s Adventures in Wonderland. People use cryptocurrency to buy real things including cars and other expensive items. People can exchange bitcoins into actual American dollars, and the exchange rate is actually quite high in favor of the bitcoins. As of the beginning of March 2020, one bitcoin can be exchanged for eight and a half thousand dollars. This means that you would pay eight and a half thousand actual real dollars and get one bitcoin, which does not physically exist. There are no physical bitcoins in our real world. Bitcoins exist in the virtual world of computers and the internet. Thus, what is this? Is it a scam? Or maybe, a computer game? Let’s try to understand what cryptocurrency actually is. We start with the history of money. Money was first introduced as a universal media for exchange in contrast to the barter, when people closed the exchange chain by finding matching goods or services. The universal media made exchanges a much easier action. Note that money didn’t always have a high commodity value. Some tribes used seashells or other physical objects as money, not always gold or silver. Other roles of money such as a store of wealth, unit of an account, and liquidity, appeared almost automatically with money. Note that money is only a good media for exchange if all participants want the money. As soon as the participants of the exchange no longer want the money, the money loses its ability to be a media for exchange.

Thus, money is an abstraction of the real goods and services, which everybody wants not for consumption but for the purpose of exchange. Paper money was introduced as another level of abstraction over commodity money. Paper money is easier to produce and for this reason paper money has a strong tendency for inflation. Most Americans no longer use cash for all transactions, but prefer credit cards or electronic methods of payment. When you use a plastic card, for some reason the seller hands you real goods or renders real services. Just for showing a plastic card. The trick is not in showing a plastic card, it is that the plastic card represents available cash value in your possession. Are you following the allegory? Plastic cards and electronic transactions are a medium to exchange money. It is another level of abstraction. Cryptocurrency is yet another level of abstraction in the monetary system. The first cryptocurrency, Bitcoin, was introduced on January 3, 2009 on the internet in the form of an open source software by Satoshi Nakamoto. Nobody knows whether this is a real person or a fictitious name of a person or a group of people. The idea of Bitcoins is to make transactions trackable. A new block of information is created for any new transaction. The block contains all information current and past about this transaction. All blocks form a blockchain. Generating a new block requires running a computer algorithm. The Bitcoin software performs such a task, and for their efforts the users who run those algorithms are granted a certain amount of bitcoins. The number of potentially generated bitcoins is limited and the size of blocks are growing with the number of transactions. This is one reason, but not the only reason, why the cost of one bitcoin is so high. Thus, cryptocurrency in general and Bitcoins in particular are not a scam but the next level of abstraction in the world of money. It is hard to say what will happen to Bitcoins or any other cryptocurrency in the near future. However, it is clear that cryptocurrencies occupy their own space in the monetary system.

-Professor Sergey Aityan


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