It’s customary at the Passover seder for the youngest person in attendance to ask four questions about why the first night of Passover is different from all other nights. For some reason, at my seder a different question was raised as well: what are bitcoins all about? I guess everybody wants to know about bitcoins now. Well, how embarrassing is that? Not only do I not understand why bitcoins have spectacularly increased in value since their inception (though the current price of a bitcoin is less than half of what it was last December), I don’t even understand why the market price of a bitcoin is now, or ever has been, greater than zero.
Here’s a chart showing how the value of a bitcoin has soared over the past two years:
Why am I so perplexed about bitcoins?
The problem I have is that bitcoins can’t be used for anything except as a means of payment for something else. Bitcoins provide no real service distinct from being a means of payment. Think about it; if a bitcoin can’t be used for anything except to be given to someone else in exchange, that means that someday, someone is going to be stuck holding a bitcoin with no one left to give it to in exchange. When that happens, that stinky bitcoin won’t be worth a plum (or plugged) nickel, or a red cent. It will be as worthless as a three-dollar bill.
Now I grant you that that final moment of clarity might not happen for a long time – maybe not even for a very long time. But if anything is certain, it is certain that, sooner or later, such a moment must certainly come. But if it is certain that ultimately no one will accept a bitcoin in exchange, then it follows that no one forseeing that inevitable outcome would accept a bitcoin in exchange prior to that moment unless he or she is confident that there is some sucker out there who will accept in the interim. But since when does a theory of asset valuation premised on the existence of an unlimited supply of suckers count as an acceptable theory? Under the normal rationality assumptions that economists like to use, it is not possible to rationalize a positive price for a bitcoin at any point in its history.
So if, as the above chart so dramatically shows, bitcoins are in fact trading at a positive price, how does one avoid concluding that bitcoins are a massive bubble, a Ponzi scheme that must inevitably collapse, as soon as people realize where things are headed? To see just how massive a bubble bitcoins are, compare the above chart to this one constructed by Earl Thompson from actual prices in tulip contracts during the Dutch tulip mania of 1636-37. Compared to bitcoins, the tulips were barely more than a blip.
Now one could respond that if bitcoins are a bubble, then so is fiat currency. That is a pretty good response, and the positive value that we typically observe for most fiat currencies is far from unproblematic. But, as I have pointed out before on this blog (here and here), it is possible to account for the positive value of fiat currency by reference to its acceptability in discharging tax liabilities to the government. The acceptability of fiat currency in payment of taxes is a real service provided by fiat currency that is conceptually distinct from, though certainly facilitated by, its acceptability as payment in ordinary transactions. So, as long as one expects the government issuing fiat currency to remain in power and to be able to punish tax evasion, there is a rational basis for the positive value of a fiat currency. The backward induction argument that establishes the worthlessness of bitcoins does not apply to fiat currency.
Another possible explanation for the positive value of bitcoins is that they are very useful to those wanting to engage in illegal transactions on line, because, unlike other forms of electronic payment, payment via bitcoin is hard to trace. That is certainly a good reason for people to want to use bitcoins in certain kinds of transactions. However, the difficulty of tracing transactions via bitcoin is not an explanation of why bitcoins have a positive value in the first place, only an argument why, if they do have a positive value, the demand for them might be greater than it would have been if it were not for that advantage. Without an independent explanation for the positive value of a bitcoin, you can’t bootstrap a positive value for bitcoins by way of the difficulty of tracing bitcoin transactions.
So there you have it. As far as I can tell, the value of a bitcoin should be zero. But it’s obviously not zero,and though falling, the value of bitcoins is showing little sign of moving rapidly toward its apparent zero equilibrium value. There seem to be only a couple of ways of explaining this anomalous state of affairs. Either I have overlooked some material fact about bitcoins that might impart a positive value to them, or there is a problem with the theory of valuation that I am using. So I ask, in all sincerity, for enlightenment. Help me understand why bitcoins are not a bubble.
HT: Dana Dachman