Bitcoins have been on a wild ride these past several months. After the November 2013 crash which saw the value of bitcoins plummet from over $1000 a coin to less than $300 a coin in just over a year, bitcoins seem to stabilize in a fairly tight range between $250 and $350 until early November 2015 when the price started to climb gradually reaching $730 last July before a brief decline to less than $600 in August, when another sustained price rise commenced. The price rise accelerated in December, and bitcoin price broke the $1000 barrier early in January, reaching $1100 last week before plummeting to less than $800 (a loss of almost of a third in value). Bitcoins have again recovered, climbing back over $900, and now at about $890 as of this writing (11:22pm EST).
In earlier posts (e.g., here and here) I have suggested that bitcoins are a bubble phenomenon, because bitcoins have no fundamental value, their only use being a medium of exchange. Some people believe that all forms of paper or token money, unless associated with some sort of promise or expectation of convertibility into a real asset, are bubbles. The reason why privately issued inconvertible paper money is unlikely to have any value is that people would expect it eventually to have zero value in the future, inasmuch as no one would want to be stuck holding paper money when there is no one left to trade with. The rational expectation that the future value of paper money must go to zero implies, by the mathematical argument known as backward induction, that its value today must be zero. If its value today exceeds zero, then the violation of backward induction, must be termed as a bubble.
That at least is the theory. However, that theory of the worthlessness of paper money applies only to privately issued money, not to government issued money, because government issued money can be given a current value if the government accepts the paper money it issues as payment for tax liability. At peak periods when the public has a net liability to pay taxes to the government, the aggregate outstanding stock of money must have a real value at least as great as the net outstanding aggregate private-sector tax liability to the government.
So I was very interested today to read a post on NADAQ.com “Why Bitcoin Has Value” by David Perry, chief architect for BitcoinStore and author of the Bitcoin blog Coding in My Sleep. Perry deals intelligently with many of the issues that I have raised in my earlier posts, so it will be interesting to try to follow him as he tries to explain why Bitcoins really do have value.
To begin, we really need to understand why anything has value. Fans of post-apocalyptic fiction will often point out that in the end, the only things of real value are those that sustain and defend life. Perhaps they’re right on one level, but with the rise of civilized societies things got a bit more complex, because the things that sustain and defend those societies also gain a certain degree of value. It is in this context that all monies, Bitcoin included, gain their value. Since our societies rely heavily on trade and commerce, anything that facilitates the exchange of goods and services has some degree of value.
In case you missed it, there was a bit of a logical leap there. Things can be valuable either because we are willing to give up something in return for the services we derive from owning them or possessing them, or because we believe that we can exchange them to other people for things that we derive services from owning or possessing them. If something is valuable only because it facilitates trade, you run into the logical problem of backward induction. At some point, far into the future, there will be nobody left to trade with, so the medium of exchange won’t have any more value. Something like gold does have value today because it glitters and people are willing to give up something to be able to derive those glitter services. But a piece of paper? No glitter services from a piece of paper. Of course if the government prints the piece of paper, the piece of paper can serve as a get-out-of-jail card, which some people will be willing to pay a lot for. A bitcoin does not glitter and it won’t get you out of jail.
Imagine, for example, a pre-money marketplace where the barter system is king. Perhaps you’re a fisherman coming to market with the day’s catch and you’re looking to go home with some eggs. Unfortunately for you, the chicken farmer has no use for fish at the moment, so you need to arrange a complex series of exchanges to end up with something the egg seller actually wants. You’ll probably lose a percentage of your fish’s value with each trade, and you also must know the exchange rate of everything with respect to everything else. What a mess.
This is where money saves the day. By agreeing on one intermediate commodity, say, silver coins, two is the maximum number of exchanges anyone has to make. And there’s only one exchange rate for every other commodity that matters: its cost in silver coins.
In truth there is more complexity involved—some things, like your fish, would make very poor money indeed. Fish don’t stay good for very long, they’re not particularly divisible, and depending on the exchange rate, you might have to carry a truly absurd amount of them to make your day’s purchases.
On the other hand, silver coins have their inherent problems too, when traded on extremely large or extremely small scales. This is what is truly valuable about Bitcoin: It’s better money.
Again that same pesky old problem. Silver, like gold, provides services other than serving as money. It has a value independent of being a medium of exchange, so, at the margin, there are people out there who value it as much for its glitter or other real services as other people value it for its services as a medium of exchange. But the only series that a bitcoin provides is that someone out there expects somebody else to accept it in trade. Why makes that a sustainable value rather than a bubble? Just asking, but I’m still waiting for an answer.
It’s been a long time since those first “hard” monies were developed, and today we transact primarily with digital representations of paper currency. We imagine bank vaults filled with stacks of cash, but that’s almost never the case these days—most money exists merely as numbers in a database. There’s nothing wrong with this type of system, either; it works fantastically well in an age where physical presence during a transaction is not a given. The problem is that the system is aging and far too often plagued by incompetence or greed.
Every IT guy knows that from time to time you have to take a drastic step: throw the old system in the trash and build a new one from scratch. Old systems, such as our current monetary system, have been patched so many times they are no longer functioning as efficiently as they should.
We previously patched our problems with gold and silver by introducing paper banknotes. We patched further problems by removing the precious metal backing those banknotes, then patched them again and again to allow wire transfers, credit cards, debit cards, direct deposit and online billpay. All the cornerstones of modern life are just patches on this ancient system.
But what would you do if you had the chance to start over? What if you could make purely digital money based on modern technologies to solve modern needs? What if we didn’t need those dusty old systems or the people making absurd profits maintaining them? This is Bitcoin.
Am I missing something? Just what is the defect with the good old dollar that the Bitcoin is improving upon? This sounds like: “it’s better, cuz it’s newer.” That’s not an explanation; it’s just like saying: “it’s better, cuz I say it’s better.”
Bitcoin isn’t another patch, another layer of abstraction added on top of an aging and over-complex system. Bitcoin isn’t another bank or payment processor coming up with new ways to move old dollars. Bitcoin is instead a simple, elegant and modern replacement for the entire concept of money. It has value for exactly the same reason as the paper money in your wallet: It simplifies the exchange of goods and services, not in the antique setting of a barter system bazaar, but in the current setting of modern internet-enabled life.
“But that’s only why it’s useful,” I hear some of you saying. “Why does it actually have value?”
Yes! That’s exactly what I’m saying, and I’m still waiting for an answer.
The two-word answer is one most economists are familiar with: network effect. The network effect is a lovely piece of jargon that refers to the quite commonsense statement that networked products and services tend to have more value when more people use them. The most common example is the telephone. During its early days when few people had access to telephones their utility, and therefore their value, were minimal. Today practically everyone has a phone, so its utility and value is [sic] so high as to be unquestionable. In this way the value of Bitcoin is directly tied to the number of its users and the frequency of their use.
OK, I get that. Just one problem. The dollar has already internalized all those network effects. To get people to switch from dollars to bitcoins, bitcoins would have to offer transactions services that are spectacularly better than those provided by the dollar. What exactly are those spectacularly better transactions services that bitcoins are providing?
Of course Bitcoin’s value stemming from the network effect is not without its own unique difficulties. When the network is still relatively small, each new group’s entry or egress can create massive price fluctuations, resulting in huge profits for early adopters. Unfortunately, this makes Bitcoin look, on the surface, too good to be true—a bit like a Ponzi or pyramid scheme.
Ponzis and pyramids are distinct and different forms of fraud, but they share one thing in common: The first ones in make a lot of money while the last ones in foot the bill. Both feature initial “investors” being paid out directly from new investors’ money. The return is always too good to be true and the gains (for those who actually get gains) are exponential.
The huge increase in value (along with occasional huge drops in value) may be good for early investors, but they are fatal for an aspiring medium of exchange. What you want from a medium of exchange is not a rapidly increasing value, but a nearly (if not necessarily perfectly) stable value. There is no upper limit on the value of a bitcoin and no lower limit. So the bitcoin lacks any mechanism for ensure the stable value that is essential for a well-functioning medium of exchange.
Because Bitcoin’s value has risen so dramatically since its 2009 debut, it seems to fit this sort of a profile at first glance, but then so does every new technology. It’s just not normally the case that we get to invest in this sort of technology and profit as it’s adopted. Imagine being able to invest in the concept of email back in 1965 when some clever hacker at MIT found a way to use primitive multi-user computer systems to pass messages. It might have seemed like a silly waste then, but owning even a tiny percentage of the rights to email today would make one wealthy beyond imagining.
Technologies follow a known adoption curve, which tends to include a period of exponential rise. Bitcoin is no exception. Ponzis and pyramids both create value for their oldest investors by stealing from the new. There’s no economics involved—just theft.
Bitcoin creates value for the old investors and the new by splitting a finite currency supply more ways. That’s not trickery or theft, just good old-fashioned supply and demand at work—a basic and ancient economic principle applied to the world’s newest currency system.
The maximum number of bitcoins is bounded from above, meaning that if it ever did begin to internalize those network effects and the demand for bitcoins did rise, the increased demand would cause its value to skyrocket, which would undermine its suitability as a medium of exchange. The market capitalization of bitcoins hit an all-time high of $15 billion last week. The US monetary base is $3.5 trillion, which is about 230 times the market capitalization of bitcoins. I mean, get real. Bitcoins, by design, are incapable of ever becoming a widely adopted medium of exchange. So even if there were to be a collapse of the dollar — and that outcome may be beyond the capacity of even a Trump Presidency to achieve – it could not be the bitcoin that replaced it as the world’s dominant currency.