A bill is only worth as much as you decide it's worth. We both have to agree on a method of payment in order to fairly exchange goods. Bitcoin is a method of payment.
When someone sends you Bitcoins, your bitcoin software will decide whether they are fake or not. Since the entire transaction history is public, it can find all transactions to and from the person who is sending you coins, and see if they indeed have enough to pay you.
The problem is that, at first, nobody had coins. To get them into circulation a system was built: For finding a "proof of work" (just assume for now that it's something that takes a computer a certain amount of work to find), the program agrees that you earned an X amount of coins. It used to be 50 coins per proof of work, right now it's 25. It will get down to zero eventually and there will be 21 million coins in circulation. Never more.
A proof of work is easy to validate. It's like a big number is given, and you have to find its prime factors. It takes forever to search all possibilities, but once they're found, you can easily multiply them to check the validity.
So when you are sent coins, your Bitcoin program (called the bitcoin client) will check the transaction history for who found proof of works, how much they gained from it, and who sent coins to who. After this you know how much money someone has, and whether he can pay you.
It's up to your bitcoin client to use the same rules as everyone. You can decide that proof of works are worth much more or much less than everyone else agrees upon, but it will only prevent you from using the network. Most, ifnot all, other clients will reject your version of the truth.
I hope this cleared things up. It probably rose other questions, but most are asked before. Just google for it ;)
Thanks for your response. But my doubts are still there. From your response I understand that running a process on a computer would let you to 'emit' a limited amount of currency with a general cap of 21MM. I am not doubting of your words, just trying to make sense in my mind, but if that's true that means that earlier adopters can generate coins for free and hence easy money. If I have a big enough cluster of computers, I can then generate enough proof of work in a cheap manner. Is that true?
While there's a hard cap on coins, they are usable in increments as small a 1E-8.
As for mining... yes. Early adopters got 'free money' for buying into the system. Those with lots of computing power can more easily mine but, at present, in order to be cost effective, serious miners have had to move to custom designed hardware. It takes a serious investment and a large ongoing electrical bill to compete.
> that earlier adopters can generate coins for free
Never for free. For a much smaller cost, yes. It always required the computation or at least the effort to turn the the mining software on.
The thing in the start was that nobody believed in the currency, therefore bitcoins were practically free. After some time people started using & believing in bitcoin concept, and from there on the currency started gaining value. Same as with traditional stocks.
> If I have a big enough cluster of computers, I can then generate enough proof of work in a cheap manner. Is that true?
Yes and no. Yes, you can get money doing this, but many people are. Because of this, the difficulty has increased to a point where it's fairly hard to make money (you've got to consider the electricity costs, for example). GPUs are the minimum you need, many people use FPGAs. Recently released are the first custom ASIC chips designed solely to mine bitcoins, which will drive up the difficulty extremely sharply and push GPUs and FPGAs out of the market.
More or less free, yes, and some of the early adopters are likely still sitting on masses of them.
You can't generate a 'enough proof of work in a cheap manner' because the rate at which currency is handed out is fixed. You can only fight other people for the currency being generated by having more computers than them.
IMHO this puts BTC in the 'massive waste of electricity' camp.
I don't see much value in the proof-of-work concept attached to BTC, no. I know that the PoW is somehow bound up with the security and counterfeit-protection side of the whole system, is PoW mathematically necessary to this? If so then how much of it? Because if not then it's really doing work for the sake of it, to fight (ever harder) for a slice of the pie. The work done is lost to heat, not somehow forever bound to the bitcoin.
And really I rather like the idea of a central bank that is able to help stabilise currency by taking various actions, but then I'm not someone that gets upset at inflation 'stealing' value from my savings. Governments and central banks can help keep money and food prices relatively stable.
The privacy, yeah, good I guess. Low-fee... don't really care. The lack of any sort of chargeback facility makes the entire system very unattractive for someone who is not an online seller.
Yes, the computing resources are required to secure the block chain. How much? The network needs to have at least twice the computing power of an attacker to prevent that attacker from taking over the block chain.