Like other fiat currencies, Bitcoin is a network-backed currency: It derives all its value from the network effect — also known as Metcalfe’s Law. (Monetary economists call this the hot potato effect.)

Many people think that Bitcoin is flawed as a currency because it is not backed by something beyond itself. They are wrong. Bitcoin is flawed as a currency, but it is flawed because of its fixed supply, inherent in the protocol. Contrary to what many Bitcoin proponents argue, fixed supply is not a desirable characteristic of money because it would make monetary policy impossible. And remember, monetary policy is very important because it solves the problem of price stickiness and money illusion. In particular, bad monetary policy causes recessions (and disastrous monetary policy causes depressions).

Thus any currency that does not allow for monetary policy is inferior to the current model and is not likely to be mass adopted in the long-run — unless, of course, it finds some other solution to money illusion. But so far, I have not heard of any solution to money illusion other than monetary policy. To become widespread, Bitcoin needs a central bank that can adjust the money supply to prevent recessions. (Actually, a central bank is not needed if money supply adjustments are built right into the protocol, which would be very interesting, but I digress.)

Now, this does not prevent Bitcoin from being a platform for currencies. I have discussed before that it is likely that central banks will create their own crypto-currencies, and the easiest way for them to do so is to simply fork the existing Bitcoin protocol. Central banks would then be able to change the supply of money by leveraging the network effect (read the post to get a full description of how).

And if Bitcoin is forked to create official central bank money, bitcoins mined today will still have value in the future. But that value will be determined by central banks in the future, and means that today’s value comes from Bitcoin being a platform, not Bitcoin being money.