Several economists such as Paul Krugman have noted that what gives a currency such as the US dollar its intrinsic value is the backing by a government.
Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year
I don’t think that’s accurate. Government doesn’t give a currency value. A government can tax all it wants, but if there is unlimited currency to go around, it will never be worth anything. A government can force everyone to use dollars, but if they are unlimited, why do you need to work to get them? What makes dollars valuable is not that you pay your taxes in them (as Krugman states), but that there is a very limited amount to go around.
I was once running a social gaming site called Xuqa. We had a points system called Peanuts. Peanuts were free and abundant. They were used to play free games on the site such as Poker, Backgammon etc. You could get more just by logging in and clicking a button. We figured people wanted them to play games, and so we gave out almost unlimited quantities daily.
As a business operation however, Xuqa was running out of money. Forced by commercial realities, I decided to make Peanuts scarce. We stopped giving them away for free. You could not longer get them just by logging into the site. The only way you could get them now was by pulling out your credit card and paying.
And wow. I will never forget what happened.
I expected people to care even less about Peanuts now that you were required to pay for them. They were so much harder to get now.
But the opposite happened. As soon as they became scarce, they became valuable. Users started hoarding them. Saving them. They instantly exploded in value to several thousand times their earlier worth. Groups of people on the site started marauding and harassing each other for Peanuts (just like they do in the real world). There were fights. Some forum moderators started taking bribes in Peanuts for administrative favors, such as banning someone you didn’t like.
The craziest thing was that girls started reaching out to our engineers on their Xuqa profiles offering them sexual favors for Peanuts. “500 Peanuts for a cute pic”, or “10,000 Peanuts for a webcam nude show”, or “100k Peanuts for a real date”.
Most people however were just earning Peanuts the regular way – spending hours grinding away at games (the same way most people grind away at jobs). I felt like I was the Central Bank, the Federal Reserve. I could create more Peanuts just by adding a few zeroes in the database. I could make everyone instantly richer or poorer.
So I experimented. In order to boost daily site usage, we gave away some free peanuts to users. I thought this would make everyone happier – now they didn’t have to work as hard to get them. But it didn’t. The price of everything just went up: administrative perks, top 10 status lists, sexual favors, bribes etc.
The opposite was also true. When we increased our sinks from the system (% fees in games), people initially complained. But then the price of everything just decreased in proportion to the amount of Peanuts we removed, and a new equilibrium was reached.
It was this experience with Xuqa and Peanuts that taught me how central banks operate at a basic level. And it this same experience that tells me that Bitcoin derives a lot more of its value by being scarcer, and increasing in supply far slower, than things like the US dollar.