Economics textbooks say that the three main functions of money are 1) a unit of account (a measurement of value); 2) a medium of exchange; and 3) a store of value.
As I wrote earlier, only the first two functions are really unique to money. Lots and lots of things serve as a store of value and are better stores of value than money, so although it is a function of money, it is a distant third place function. There is an inherent tension between this function and the second function because whenever something gets used as a store of value, it stops being used as a medium of exchange. Just like you can’t have your cake and eat it too, you can’t store your money and exchange it too. Bitcoin is more like gold than money because both are primarily bought as a store of value rather than as a medium of exchange and this is one reason why Gold and bitcoin both have very volatile value. If the value of gold and bitcoin didn’t change, speculators would have no interest in holding them as a store of value except if they expected that an economic disaster would cause everything else to drop in value. Speculators capriciously speculate about future values and that drives the price volatility of goods that are primarily used as a store of value. In fact, the more that something comes to be seen as primarily a store of value rather than as something that is valued for its intrinsic usefulness, the more volatile its price becomes. For example, housing bubbles are not caused by people who just want an economical place to live long run, but by speculators who see housing as a growing store of value and are hoping to resell at a profit in the near future. Although bitcoin proponents like to tout its rising value as a success, that appreciation causes a major problem for bitcoin as a medium of exchange.
In contrast, a modern fiat money almost never goes up in value, so the main reason people hold it is as a medium of exchange. Central banks actively manage the value of every successful modern money to keep it reliably predictable and one way they try to prevent money from being used as a store of value is by engineering a little inflation which steadily reduces the long-run value of money. Inflation gives speculators an incentive to buy other things (like stocks, bonds, money-market shares, gold or bitcoin) as stores of value rather than money. It is the “animal spirits” of speculators that cause most price volatility in financial markets and by making money a bad long-run bet for speculators, central banks make their job easier to reduce the volatility of the value of money. Because money is held as a medium of exchange, there is little speculation about how much it should be worth and so its value does not change unpredictably which makes it more useful as both a unit of account and a medium of exchange.
Nobody uses bitcoin (nor gold) as a unit of account (for measuring value) because the units jump around much more capriciously than the value of money. According to Mark Williams, as of 2014, bitcoin had volatility seven times greater than gold, eight times greater than the S&P 500, and 18 times greater than the U.S. dollar. Even the Bitcoin Foundation sets its employee’s salaries in dollars rather than in bitcoins. Because bitcoin (and gold) are bad units of account, they are rarely used as a medium of exchange except by criminals. Bitcoin has a major advantage for criminal exchanges because it is untraceable by any police, but for everyone else, the transactions costs due to high price volatility outweighs any other advantage of bitcoin.
The block chain technology that bitcoin is built on could offer a more efficient way of making payments, but prices will always be quoted in dollars (the unit of account) because dollars have more stable value. And as long as dollars are used as the unit of account, they will also be used as the de-facto medium of exchange too. For this reason bitcoin will never replace money as a unit of account nor as a medium of exchange, but the technology does have some advantages for reducing transactions costs. That could be the real legacy of bitcoin. Some of the technologies of bitcoin could be adopted by the banking system or a payment provider like PayPal to reduce transactions costs and replace our antiquated money
transfer system, but the new system will still exchange dollars rather than bitcoins.
Once everyone realizes this, the value of bitcoin will collapse. The main reason people are excited about bitcoin is on the theory that it could eventually become our standard money, but it cannot beat central-bank money as a medium of exchange, and at some point this fact will inevitably enter the consciousness of the speculators that determine the price of bitcoin which will then collapse to near zero. Speculators base their hopes for bitcoin on the theory that its technology is more efficient at reducing transactions costs, but eventually the banking system will adopt those technologies and then bitcoin will cease to even have a theoretical advantage. At that point the only advantage bitcoin will still have is its usefulness for avoiding detection by those who are evading taxes, profiting from crime, and funding terrorism, so the long-run future value of bitcoin will depend upon the heath of the only arena where it is already being used as a preferred medium of exchange, the black-market economy.
Once the speculators abandon bitcoin and it becomes just a reserve of terrorists and criminals, the police will shut down the companies that exchange bitcoin for money which will make bitcoin virtually worthless for criminals too because they mainly rely upon money for most transactions and only use bitcoin for illegal transactions.
Bitcoin’s value will fall to zero once people realize its failure as a medium of exchange because it has absolutely no other source of value. All stores of value must have some underlying value. Fiat money (like the dollar) is truly useful because it really does minimize transactions costs as a medium of exchange which give it its underlying value. If there were something else that was better at facilitating exchange transactions (like bitcoin), we would use it instead of dollars and the dollar would become worthless because it has no other fundamental source of value. Commodity monies like gold and silver can rise and fall in value, but they cannot fall to zero (and did not fall to zero when fiat money replaced them for transactions) because they are inherently useful for other things besides facilitating transactions. They are used for industrial production and for making beautiful things like the shiny gold plating that Donald Trump likes to surround himself with. Neither bitcoin nor fiat money have any other value if they aren’t the cheapest medium of exchange in some market. However, fiat money cannot fall completely to zero value as long as the government requires that everyone pay taxes using government-issued fiat money. Almost a quarter of US income is paid in taxes each year, so that requires a lot of dollars and prevents the value of dollars from falling to zero even if they weren’t the best kind of money for every other transaction.
A fiat money like the US dollar is cheaper to use than bitcoin as a medium of exchange because 1) its value is more stable because it is actively managed by the central bank which makes it a better unit of account; 2) it is cheaper to use for paying taxes because the government requires it for paying taxes so Americans have to have the ability to pay in dollars; 3) the fact that everyone uses dollars creates a kind of economy of scale called a network effect which makes dollars more convenient to use simply because all other Americans are already using them; 4) bitcoin is structurally prone to deflation which would contribute to recessions if it were adopted for an entire economy. That fact will prevent any large economy from adopting it. Bitcoin has some other technological advantages, but they are small and don’t outweigh the advantages of the dollar. Plus, the dollar system could copy the technological advances if they were truly important.
So far bitcoin speculators have been hoping that bitcoin’s technological advantages will eventually prove to be so much better than the dollar as a medium of exchange that everyone will someday want bitcoins for conducting all their daily business (except paying taxes presumably). But it is more likely is that the dollar system will eventually adopt some of bitcoin’s technologies and wipe out what little advantages bitcoin currently has for exchanges. Plus, because bitcoin’s main advantage for exchange has been its ability to fund illegal activities, it will probably eventually be used to fund a major terrorist act and that will motivate large governments to clamp down on the exchanges that connect the bitcoin network to the global financial network. That could be the sudden end of bitcoin except as a historical curiosity.
I hope that doesn’t happen because bitcoin is that it provides a backstop alternative for the fiat monies of the world. Every fiat money is always in peril of being managed badly and that has dire consequences for the people who depend upon it such as in the Zimbabwe hyperinflation. But if a fiat money ever becomes a worse option than bitcoin, then people can switch. Bitcoin provides competition for the world’s fiat currencies. So far that hasn’t panned out except in a few niche areas, but it is nice to have it as a possibility. For example, in Zimbabwe’s case, people have been mostly using the fiat currencies of other nations, most commonly, the US dollar rather than bitcoin. There is simply no major economy where bitcoin has replaced fiat currencies as the main medium of exchange except in some networks in the criminal underworld.