Economics 101

Joe Huffman commented on why he doesn’t trust Bitcoin in the current environment and in that post he made one statement that drew my attention:

What if people start losing their faith? Doesn’t the value of Bitcoin decrease exponentially with this loss of faith?

One of the commenters hit on the subject that crossed my mind:

Second observation: all currencies, digital or otherwise, are entirely faith-based. They differ only in the number and fervency of the believers.

But I wanted to expound on that a little bit.

I’m not trying to insult anyone’s intelligence here, but there are a lot of people out there who really don’t grok basic economics. Even some who do insist that the principles don’t apply in some situations. Heck, the entire premise of Keynesian economics is that big governments can just ignore all those common sense rules that your grandpa taught you because if you’re “too big to fail” they don’t apply.

Until they do. Dramatically. Cue the Venezuela reference.

At any rate, back to the subject at hand:

The value of anything is what other people will trade you for it. At the most basic level, people trade because they value something that they have less than they value the item they wish to trade for.

If I grow pigs, and have a bunch of them but what I really need right now is a new pair of overalls, I might be willing to trade a pig or two for a nice pair of overalls. I value the overalls more than I value the pigs (right now) because I have more pigs than I need.
If you make overalls but really, really love bacon, it’s very possible that you might value the pigs higher than the overalls and a mutually beneficial trade can be arranged. In free trade we both win, because we both end up trading something of relatively lower value to us, for something of relatively higher value to us. Plus, depending on what it is we’re trading for, our productivity may be improved causing us to have even more of a surplus of our products enabling more trade and adding more and more value to the overall community. That’s how wealth is “created”…but that’s another discussion.

Currency is nothing more than a proxy for the goods and services to be traded. What if I have an excess of pigs, and you have an excess of overalls, but you HATE bacon and don’t want my pigs? I could try to find someone who does eat bacon to trade with and hope they have something that you might want, but that could get pretty complicated pretty quickly. The glazier likes bacon but you don’t need a window either;  maybe the bricklayer needs a window, and you could use a new fireplace so I trade my pig to the glazier for a window, trade the window to the bricklayer in return for the bricklayer to build you a fireplace so I can get my overalls. Whew. You know what would make this a lot easier? If we had some universal thing that we could all trade with each other for anything. We’ll call it “currency”. I can sell my pigs for however much of this “currency” I can convince someone to pay and, when I’ve sold enough pigs and collected enough “currency” I can trade it to you for a pair of overalls and then you can trade the “currency” for whatever it is you need. That would make things much simpler wouldn’t it?

So…who decides how much of this “currency” we should trade in return for products and services? Well…we all do. If I am a skilled worker who is paid for my labor, I know how much effort I put into earning the amount of currency my employer paid me. How much I’m willing to pay for some other product or service is going to be based on how much value I place on my own labor. If you want me to purchase your goods or services, you’re going to have to negotiate a price wherein I’m satisfied that I’m getting at least as much value from you as I put into earning the currency. Then we get into competition and the free market but again, that’s a discussion for another time.

I know I’m putting this stuff into very simplistic terms and I’m not trying to insult anyone’s intelligence. What I’m trying to do is explain that, even as complicated as things can get when you get a bunch of “financial experts involved” at its basic level this stuff really is this simple.

What it boils down to is that generally people will trade for one (or more) of three reasons: The item they are trading for is of more practical value (by being consumed or used) to them than the item they’re trading away; They have confidence that the item they are trading for is going to increase in value over time more than what they’re trading and thereby increase their wealth; They have confidence that the item they are trading for will at least maintain its value over time and will prove more durable than what they traded for it, thereby preserving their wealth for the future.

When currency is used as a proxy for the traded goods and services, it has no inherent value in and of itself. Currency of any type is only as valuable as the goods and services it can be traded for. If suppliers of goods and services lose faith in the currency and stop accepting it in trade (or will only accept huge amounts of it) it becomes worthless.

That’s just as true for Dollars, Yuan, Euros, Gold, Silver, etc as it is for Bitcoin.

Some would argue that Gold and Silver have intrinsic value that makes them immune from such forces but I strongly disagree. Gold and Silver do have practical uses and when put to such purposes, their value is wrapped up in the practical uses to which they are put. The value of those metals is propped up to a certain level by the value of those practical purposes, but as a currency, their value is primarily based upon the value that others assign to it with respect to the goods and products they produce.

If those producers refuse to accept Gold and Silver in payment for their goods and services (or demand huge amounts of it) then the value of Gold and Silver drops to the level that can be supported solely by their practical uses…which may still be significant, but is likely much less than their potential value as a currency…a result of greatly reduced demand.

Anyway, that’s just a very long way for me to say “yea, that commenter is right”. Hopefully someone, someday reading this post will get something out of it.

By the way, if you’re interested in basic economics, there is a great resource from a world-renowned but completely unpretentious economist named Thomas Sowell that I highly recommend.

Buy Thomas Sowell-Basic Economics at Amazon

I get no kickback or other compensation for you using that link so if you find it somewhere else cheaper, knock yourself out…in fact if you find it somewhere cheaper online, feel free to post the link in the comments so others can save money too.

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