|>>|| No. 3518
A currency is just a unit of exchange, used as an intermediary in trading. Currency emerged as a more efficient alternative to barter. Without currency, if I'm a sheep farmer and want some new shoes, I've got to find a cobbler who wants a shitload of mutton. With currency, I just need to find someone who wants mutton and the cobbler just needs to find someone who need shoes.
Precious metals have been used as currency for a long time, because they have intrinsic traits that make them a useful unit of exchange for primitive peoples. They're inherently scarce, durable and portable and can be proved to be authentic fairly easily. Coinage was a good way of providing a consistent and trusted weight of metal, in a quantity that was convenient to exchange. The ridges on the edge of a ten pence piece are a throwback to this - coins were originally ridged to prevent people from shaving off the edges of gold and silver coins for profit.
If there's no functioning currency, people will simply use whatever is suitable. When the German economy collapsed between the wars, people took to trading in cigarettes. Rolling tobacco used to be the currency of British prisons, but they switched over to phone cards when smoking became less popular. In many US prisons, they use pre-packaged snack cakes.
The first paper money were gold and silver certificates, written out by pawnbrokers. People found it convenient to store their metal with a pawnbroker and give someone the pawnbroker's slip. Eventually, government took over that role, guaranteeing bank notes against a store of silver. The pound sterling was once literally that - a pound weight of sterling silver.
Many governments realised that they could print more banknotes than they had metal to back it, which was of course highly profitable for the government. The problem with that is that as you print more money, the money in circulation falls in value due to simple supply and demand. If there's more money in circulation but the same amount of stuff to buy with it, the value of money will fall. We call this process "inflation" and it's why things always get more expensive over time.
Inflation is very useful to a government for several reasons. Governments are heavily indebted, but if the value of a pound falls, it's effectively cheaper to pay off your debts. Inflation also encourages people to spend money rather than hoard it, which is good for the economy. Too much inflation can be risky and discourage investment, so most governments aim for inflation of a few percent per year.
Eventually, governments abandoned their store of precious metals entirely, creating what we call a "fiat currency" - a currency with no direct material value that is backed purely by confidence in the government that prints it. Fiat currency is a win-win for all sorts of dismally nerdy reasons, but it comes with a big risk attached. A government has complete reign in manipulating that currency and a collapse in confidence in the government can lead to a collapse in the value of that currency. A common vicious cycle is that a government with severe debts prints more money to pay their debts, which reduces the value of their money, which means they need to print more of it. This is hyperinflation, which happened in Germany in 1923, Hungary in 1946, Zimbabwe in 2008 and many other places and times. This is extremely destructive, because people lose confidence in the value of money and spend it as soon as possible.
Bitcoin is currently experiencing the opposite, hyperdeflation. The value of bitcoin is increasing at an exponential rate, because supply is very limited but demand is increasing rapidly. The more Bitcoin increases in value, the more people who want to buy it, on the expectation that they'll make a big profit. The key problem is the opposite to that of hyperinflation - nobody with Bitcoins wants to spend them, because they expect them to increase in value.
The problem for Bitcoin is that a currency is only worth what people will exchange it for. Nearly all of the current value of a Bitcoin is the expectation that, in the future, lots of people will want to exchange things for them. As it stands, transactions where Bitcoins are exchanged for goods or services represent only a tiny fraction of all Bitcoin transactions. The sum value of all the goods in the Bitcoin economy and all of the non-Bitcoin currency held by Bitcoin bureaux de change is vastly less than the nominal value of all Bitcoin in circulation. The entire value of a Bitcoin is the expectation that Bitcoins will be valuable in future, which is an extremely fragile state of affairs.