Paul Krugman set off a new firestorm this weekend with a post about Bitcoin that asked a fairly simple question: What gives a bitcoin its worth?
The post drew a ton of angry reaction from the internet and tech people for a couple of reasons.
One is that this question — why is a Bitcoin worth anything — is a difficult question to answer. The other is that the post is bizarrely titled “Bticoin Is Evil” even though the post doesn’t say that. But on the internet, people don’t read past the headline and so, outrage!
But back to the question of trying to establish an “intrinsic value” for Bitcoin. It’s not simple. The dollar has intrinsic value because you need dollars to pay taxes in the United States. The government accepts no other currency. So if you’re going to engage in any kind of commerce whatsoever, you need to use dollars. This creates real value for the currency. Gold has real value because it’s shiny and can be used for jewelry. Other commodities get their value from industrial purposes.
But what about Bitcoin? If you ask Bitcoin believers why a Bitcoin is worth anything at all, they will tell you about how amazing the technology is, and how it’s “programmable” and how cryptography and pseudoanonymity are so great. But none of these are very satisfying answers.
For one thing, these features mainly explain why Bitcoin as a payment platform are so intriguing. They don’t explain price. And as Krugman even notes in his original post, most of the techie Bitcoin bulls usually talk about Bitcoin as a platform (something that’s easy to defend), rather than Bitcoin as an asset that will go up or down.
Furthermore, if Bitcoin’s value were simply a function of all of the technological aspects, then there’s no reason that Bitcoin wouldn’t easily be supplanted by another crypto-currency that has better features (even the Bitcoin bulls will acknowledge that the technology could be better, particularly on the mining side and the confirmation time).
For example Litecoin, the second biggest player in the game advertises that if you transact in Litecoin you can faster confirmation times and that the whole system can handle more volume than Bitcoin.
So the usual arguments aren’t that compelling.
Now in the Bitcoin-sphere, there’s a lot of debate about what Bitcoin is. People go round and round in circles about whether Bitcoin is a currency or a commodity or a platform or a protocol or an equity or whatever. These squabbles frequently get semantic (what is a currency? Must it be a stable store of value?) and usually they suffer from an inclination to plug Bitcoin into a category where it never quite fits.
I think Bitcoin is a hybrid of three things with which we’re all pretty familiar: A currency, an equity, and a social network.
The currency part is pretty easy to understand. Someone is offering something for sale like a bike or a month’s rent, and they might give you a quote in dollars, yen and Bitcoin. Bitcoin basically acts like a currency then.
Bitcoin also has equity-like characteristics in that the value seems to grow as the whole Bitcoin ecosystem grows. The value of a Bitcoin is up about 50x this year, which is an insane swing for a currency, but if you think about it as equity in a hot startup, it’s not that preposterous when coming off of a low base. Bitcoins also have market cap (see: CoinMarketCap).
And most crucially, there’s a social networking element to it (this is something Antonis Polemitis has written on). Bitcoin is something that’s valued because lots of people use it. It’s not that different from Napster. Napster was gamechanging technology in terms of how people get music, but it only had value once it was used by a lot of people. Same with Facebook. The technology may not have been better than its predecessors, but it got a lot of people using it, and suddenly the platform became tremendously valuable.
Strong, robust network effects are crucial for making the whole thing work.
Let’s go through why…
Let’s say you’re a Chinese millionaire, and you’re looking to take a big hunk of your fortune out of the country. This is not a trivial problem. The Chinese government has strict controls about wiring money out of the banking system. One way to get money out is to give your money to something called a “junket operator.” That junket operator will give you a bunch of chips to go gamble with in Macau. Then after you’re done gambling you take your remaining chips, cash them out for the local Macau currency (the Pataca) and then deposit those Pataca in a bank in Macau where that money is not burdened by capital controls. But that’s difficult in part because you’re dealing with a shady junket operator which might have ties to the criminal underworld. Then you have to gamble and play a huge vig to the casino. And then there’s all the travel.
Another way you can get money out of the country is by buying a bunch of Rolex watches and putting them on all your wrists and ankles, and then flying out of the country and selling them to someone outside of China and then depositing that cash in a foreign bank. But like all luxury goods, the Rolexes are likely to lose a lot of value the second you take them out of the store. And do you really feel safe travelling with all those watches on you? It’s a dicey enterprise.
The hot new way to evade capital controls is to buy Bitcoin, and then slip them to another wallet connected to a bank account in some other country. Then sell the Bitcoin to a buyer and deposit that money in a bank somewhere. The government would have an extremely hard time tracking this down (which is why lately the government of China [and India!]) have grown more negative on Bitcoin. This is a low cost solution, but it’s not risk free. As we’ve seen Bitcoin is volatile, so you could experience a big price swing. But even if you can stomach the price swing, you have to be certain that there will be buyers for millions in Bitcoin on the other end of the transaction. This is only assured with big network effects.
Despite the technological similarity, our Chinese millionaire could not conduct the same transaction with Dogecoin. The value of all the Dogecoins in the world is just $US7 million, so if you wanted to move $US1 million, you’d need to suck up 1/7th of all the money in Dogecoin. It would be way too dicey.
Other crypto currencies have total “market caps” much less than $US1 million. So then you literally could not execute the transaction despite equivalent or in some cases superior technology associated with other coins.
Without the network effects, the technology is nothing. It’s just a theoretical amusement.
The question then becomes: Can the social network last? If it can, then the value can be maintained, or might grow by even a lot. But history is not on Bitcoin’s side on this question. For one thing, no social network seems to have much lasting power… especially not the first in a given category (Napster, MySpace, ICQ, etc).
This also doesn’t satisfy what gives Bitcoin a “floor” in value, but then an equity never has a floor. Equity can go to zero, but that doesn’t mean that in the meantime it’s not worth something.
Bringing it all back home: A lot of Bitcoin sceptics are willing to accept that there’s something technologically interesting going on here (Paul Krugman even posted a followup to his “evil” post talking about what kinds of problems the Bitcoin technology solves). But the economics of it are more tenuous. But if the network of people remains, Bitcoin may keep solving problems, like the problem of getting money out of a restrictive country.
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