Bitcoin and the digital currency craze appears to be gaining more and more traction. But we have to ask ourselves why this is occurring? After all, Bitcoin isn’t backed by men with guns, the government’s ability to tax, the banking system’s depth or really anything. Bitcoin is the purest form of a decentralized medium of exchange that presently exists. But what makes Bitcoin so interesting is why anyone cares about it at all. And the reason for this is grounded in some work by a great economist at UC Berkely named Hal Varian.
Hal Varian has spent a good deal of time trying to figure out why a fiat money has any value at all. He has been intrigued by the idea that while fiat money is supposedly backed by legal tender laws and men with guns, it can also always be rejected by its users. So, if people can reject a currency even if it’s backed by a government then surely something else must be a powerful driver of its acceptance. Varian coined the concept of the “network effect”. In essence, we accept money because we know it will be accepted by others as a medium of exchange.
Varian has used an interesting example to prove his point. When the first Iraq war ended UN sanctions forced Saddam Hussein to create new currency to finance his spending. He called these notes “Saddam Dinars” and required the exchange of all outstanding currency for these new notes. But the old notes continued to trade. Over time, Hussein printed so much of the new currency that the old Iraqi Dinar surged in value relative to the new Saddam Dinars. The old Iraqi Dinars became the dominant form of money as Saddam Dinars hyperinflated themselves away.
Boring story? Not in the least! The fact that the old notes even traded at all is curious. After all, they were no longer backed by a government force. They were only good due to social convention and the network effect. And that’s what I find most interesting about Bitcoin. It is most backed by the network effect and social convention. Of course, there’s more to Bitcoin than pure belief, but to a monetary nerd like myself, I find this concept of the network effect and the viability of money to be of particular interest….