Dollars have value to person A because he's confident person B,
to whom he's in debt, values dollars. Person B values dollars
because he's confident person C values dollars. And so the chain
of confidence goes on until everyone uses dollars.
This network effect is so strong that the majority of the world
trade is in dollars. A Russian is likely to pay a Chinese in dollars.
The dollar's near-monopoly would last indefinitely if the
currency were better designed. Unfortunately (or fortunately?)
the amount of dollars inflate and, consequently, the value of each
unit declines. It is likely that an opposite chain reaction will
occur during the next financial crisis. Reduced value of the
dollar leads to loss of confidence which in turn reduces the value
even more, and so on.
When the dollar fails new currencies will compete for the
monopoly position. The big favorite is gold. Everyone on this
planet knows about gold and everyone is confident that gold is
immune to inflation.
People tend to like gold because of its intrinsic value. It's a nice
word that few know the meaning of. The reality of gold is that
most of its value comes from the network effect – just like with
dollars. Only a tiny portion of the world's gold supply goes to
industry or jewelry. Palladium, a related metal, is ten times more
scarce than gold but its price is less than that of gold. Palladium
is mainly priced for its use in industry and jewelry. If gold were
priced the same way it is likely it'd had to drop to less than a
tenth of today's price for the gold supply to be absorbed for its
“intrinsic” purposes.
Bitcoin too owes its value to the network effect. I see two main
reasons for buying bitcoins. It can be used to transfer value
today or it can be a storage of wealth for the future. For the latter
purpose you need confidence in that others will continue to
value it, just as you'd need confidence in others if you'd store
your wealth in dollars or gold.
