A question that has fascinated me for the longest time is understanding where money gets its value from. Why is the R100 in your bank account worth R100? Bill Gates is worth about US$85 billion – what does it even mean to be worth that much? Understanding where money gets its value from is key to understanding Bitcoin.
The answers to the above questions all boil down to one thing – trust. Virtually all currencies in the world have value because governments say so. Governments pass laws that allow certain institutions – usually their Reserve Banks – to issue money. Through law – governments make it a crime to not accept that country’s money as ‘legal tender’. The country’s citizens, on the other hand, trust that the money will have the value that the government says it has. This is the concept of ‘fiat currencies’ – fiat being Latin for ‘Let it become’.
In return for the trust given by its citizens, the government, through its Reserve Bank, has to manage money responsibly. Issuing too much or too little money can have negative effects on the economy. In essence, governments have to carefully manage the amount of money in circulation to ensure that the economy does well.
How about Bitcoin?
Now, Bitcoin is not issued by any government so where does its value come from? There have been many debates about this. In addition to meeting the requirements to be a currency, it gets its value from the people that use it – like normal currencies. If enough people agree that Bitcoin has the value that it says it has then that’s it! As more people adopt Bitcoin, its value will increase.
The amount of Bitcoin, however, is not regulated by any government so how is its value preserved? The answer lies in the mathematics behind Bitcoin. Bitcoins are created at a constant and reducing rate. The number of Bitcoins that will be in existence next year is known in advance. The total number of Bitcoins that will ever be created is limited to 21 million. This scarcity helps preserve the value of Bitcoin over time.
Understanding how the value of money arises will help you assess whether the value of Bitcoin will go up or down. It is important to consider the potential gains and the potential losses you could face with Bitcoin. These will be covered in articles 3 and 4 of the Bitcoin series.
Have you read: Bitcoin – the absolute introduction?