I continue to struggle with the question of where cryptocurrency gets its value.
(Note: When I say “value”, I mean private value, as reflected in the price. Social value is a whole separate question, for a separate blogpost.)
To be fair, I also struggle a bit with the question of where gold and dollars get their value. So let’s consider some of the reasons various assets might be valuable, and ask which arguments apply to other assets.
1. Gold is valuable because you can use it to make jewelry and electronics. I have no doubt that this is true (which is not the same thing as saying that this is the only reason gold is valuable.)
2. Dollars are valuable because (at least if you are an American) you can use them to pay your taxes. One hears this all the time, and I plead guilty to parroting it from time to time in the past. But it’s stopped making any sense to me. Here’s why: Taxes are foreseeable. In order to pay my taxes on April 15, I don’t need to hold dollars on April 13, let alone in January, February or March. Instead, I either borrow from a home equity line or sell off some bonds on the morning of April 15, and hold the money until the government cashes my check a week or so later. That’s a pretty small contribution to the annual demand for money.
To put this another way, one billion people paying $100 tax bills does not create a demand for a stock of 100 billion dollars. Instead, it creates a demand for 100 billion dollars for about 2% of the year.
Notice then, that despite the superficial similarity, argument number 1 (for gold) and argument number 2 (for dollars) are crucially different, because in order to have gold jewelry or gold electronics, you’ve got to have gold pretty much permanently employed as jewelry or electronics, whereas in order to pay your taxes with dollars, you can hire your dollars on the spot market and then be rid of them.
3. Dollars are valuable because you can use them to make small unexpected purchases. Yes, this makes sense. I have a $20 bill in my pocket right now precisely in case I want to buy some ice cream on a whim. When I go to a street fair, I carry even more.
4. Dollars are valuable because you can use them to make large, planned, and (if you care about this) anonymous transactions. Presumably this is why a lot of dollars spend a lot of time in suitcases traveling back and forth between the United States and Colombia. I buy this one.
5. Crypto (e.g. Bitcoin) is valuable because you can use them to make large, planned, and (if you care about this) irreversible transactions. I buy this one, but as you’ll see below, I don’t think it can explain a high price for Bitcoins.
Now: How does all of this apply to understanding why people hold dollars, gold and crypto?
1. There is, I think, no good analogue of jewelry/electronics when it comes to Bitcoin (or for that matter when it comes to dollars). That’s one step toward understanding gold and zero steps toward understanding Bitcoin.
2. There is also no good analogue of paying taxes when it comes to Bitcoin. On the other hand, as noted above, I’ve stopped believing this explains much of anything anyway, so I’ll count this as zero steps toward understanding anything.
3. For small unexpected purchases, at least with current technology, dollars seem to clearly dominate Bitcoin, for a variety of reasons including (most crucially) the lack of transaction fees. So I’m going to count this as one step toward understanding dollars and zero steps toward understanding Bitcoin.
4,5. That leaves large, anonymous transactions, and/or transactions that you want to be irreversible. For this, I believe Bitcoins are often far better than dollars. But (you might say paradoxically), this very feature should make Bitcoins less valuable, not moreso. Here’s why: If I want to move a lot of wealth around the world using dollars, I need to hold a lot of dollars for a substantial period of time. If I and my trading partners want our transactions to stay anonymous, we might hold on to those dollars for a much longer time, rather than facing the trouble of re-acquiring them the next time we need them. But if I want to move a lot of wealth around the world using Bitcoin, I can (not with perfect ease, but a lot more easily than with dollars) acquire them moments before I want to transfer them, and be done with them. There’s no reason for me to tie up my wealth in a non-interest bearing asset before it’s absolutely necessary — and with Bitcoin, relative to dollars, it’s not absolutely necessary until quite late in the game.
So — and again, call this a paradox if you want to: The better Bitcoin serves its purposes, the less it should cost (in terms of dollars). If Bitcoin (or some other cryptocurrency) improves to the point where nobody has any reason to hold it for more than a second, its price will be close to zero. One reason dollars are worth as much as they are is that dollars are relatively clumsy, so to use them, you’ve got to hold them a while.
That, then, is one small step for dollars and zero steps for Bitcoin.
I am not saying there’s no reason Bitcoin should be valuable. I’m saying that whatever the reason might be, I don’t get it. And I’m pretty sure that most of the things you hear on this subject are just plain wrong.
There is another reason why Bitcoin is harder to understand than dollars, and that’s this: Dollars have just one price (basically the number of apples or haircuts you have to sell to acquire a dollar). Bitcoins have two prices — the number of dollars you need to buy a Bitcoin and the dollar value of the fees you pay every time you transact. Any argument that starts with “demand is high (or supply is limited) so the price should be high” is instantly suspect until one sorts out which of the two prices is being explained here, and why. But that’s a separate topic, which I already blogged on last week, so I’ll stop here and end with a question:
Can anyone give me a plausible reason (not necessarily a slam-dunk correct reason, just a plausible one) why cryptocurrency should have any value at all, except during the course of a speculative bubble?
Bitcoin is less anonymous than cash — all transactions are public, and published to all users, in realtime. You have to go to great lengths to make Bitcoin untraceable, and I’d assert that you simply can’t do it when it comes to large sums of money. In contrast, while cash has serial numbers, who’s keeping track?
Tim McCormack: Point taken. I should not have put so much emphasis on anonymity; Bitcoin is also good for big transactions that you want to be sure can’t be reversed. I am going to edit to correct this, which will make your comment less relevant, but I’m very grateful for it.
Dollars are also good for stored value. I can convert my wealth to $100 bills, hide them in a shoe box in my closet, and be confident that they will be valuable to me 5 years from now, even if there are disasters that make life difficult.
You are going to say that there are better investments. That’s right, but sometimes I may just want to retain the value I already have.
Bitcoin also serves as a means of stored value. Maybe too volatile for you, but it should be on your list of reasons for holding dollars or bitcoins.
If bitcoin were like artwork or other collectibles, having some inherent joy of ownership, increasing value would make some sense.
My guess: It’s greed. The cap on total number of bitcoins creates an expectation of increasing value. That expectation feeds increased interest and increased price, until all people susceptible to FOMO are invested. Then comes the crash.
Bitcoin is tulip bulbs.
Roger (#3):
Dollars are also good for stored value.
Not really, because dollars don’t earn interest. It’s very hard for me to see why anybody would use dollars to store value when they could hold bonds instead.
It seems that the explanation of why people hold dollars is that it has the lowest effective transaction and administrative cost of the available options. (eg a bond has a cost of inconvenience). Essentially your point 3 Steve, but expanded slightly. Even for longer term purchases, it’s easier for me to pay if I have dollars accessible by a card or whatever. I’m speculating, but if I could directly sell and spend my bonds from a debit card, I’d expect them to be held in larger quantities.
It seems to me that bitcoin’s non-speculative value, if it exists, would then also come from the convenience of managing balance and ease of exchange to other goods. But I don’t have a strong argument for this.
I think in both dollars and bitcoin, the usefulness requires them to have some non-zero value, but I’m not sure for both cases what primarily sets the specific observed price.
Ether is required to purchase a virtual commodity, “gas”, which is required to run programs on the Ethereum Virtual Machine (EVM). So Ether has value to the same degree that running smart contracts on the EVM has value.
I think of Bitcoin as analogous to fiat currency in that it has value because it has value to other people. I think of Ether as analogous to a currency backed by a commodity. In this case the commodity is EVM cpu-cycles.
Perhaps it could be used as a hedge against currency problems for a country. Perhaps at the beginning of the Venezuela crisis, it seemed apparent that inflation was on the rise. Someone could transfer their wealth to bitcoin as a hedge. It could work better than gold since it is harder to find/seize. It is also much easier to convert to bitcoin than most foreign currencies, especially if you want to deposit them.
I also think that there is a growing number of wealthy people who fear their governments, and see this as a check on government control.
Dr Landsberg
> Gold is valuable because you can use it to make jewelry and electronics.
If physical properties like density, strength etc aren’t critical, gold is the best thing for everything from door knobs to plumbing to plating steel (instead of chromium). This is the reason that its scarcity makes its price so high that uses are reserved to jewelry, electronics and store-of-value money.
Dollars are “invaluated” by legal tender laws because they MUST be accepted to repay debts.
Crypto is valuable because people will pay gold or dollars for them just as tulip bulb collectors once paid sky-high prices before the market collapsed. It remains to be seen if the advantages of crypto that you explain are sufficient to sustain its value.
Don’t be the last buyer in a Bigger-Fool market.
Regards,
Bill Drissel
The Colony, TX
At issue is the means/symbol used in a “clearing house” between “financial intermediaries”.
If Person A wants to transact with Person B, it is likely (as Coase predicted, to reduce costs) that they will use intermediaries.
The intermediaries have agreed to use “money” for matching up the balance at the end of the day. This is what is known as a “reserve currency”.
BTW, in Canada, there is no regulatory requirement for reserve requirements. Indeed, the monetary history of Canada and the US is a stark reminder that a) the countries are different and b) prior to 1935, Canada had no State central bank.
The properties something need to be useful as money are, according to some:
durability, portability, divisibility, uniformity, limited supply, and acceptability.
Not many physical things fulfill the physical requirements. That is why the regression theory is not proven by example, because for most of history almost any example of something with these properties will probably have a use value.
If we accept that bitcoin does have the “physical” requirements, the only thing possibly lacking is “acceptability.”
If it is acceptable, then there is no reason for it not to be used. How the value is arrived at I don’t know.
Bill, isn’t this question-begging? “Crypto is valuable because people will pay gold or dollars for them.” I feel like our host is asking *why* people are willing to give up other valuable things (e.g., gold, dollars) in exchange for bitcoin.
Yes, yes, in the end the answer is “they are valuable because people value them,” but there’s a deeper — or maybe shallower — question about whether valuing bitcoin highly might be a mistake, making reasonable assumptions about what people’s ultimate objectives are such as maximum consumption, minimum risk, etc.
My best guess is along the lines of Patrick #8 – in light of the rather poor history of government-managed currencies (including increasing concern over another inflationary episode brewing for the USD), Bitcoin (like gold but perhaps with some advantages) gets some value from fear the alternative will lose value. Certainly some inherent appeal for libertarian types.
I don’t want to hold dollars long term. I’d prefer real assets. However, I want to get paid in dollars, purchase in dollars, and view pricing for goods, services, and assets in dollars.
I don’t know about you, but I need to be constantly acquiring and holding a non-trivial amount of dollars in order to support my lifestyle. (It’s kind of a hassle really)
P.S. No difference between dollars in my bank account and dollars in my pocket, right? I’m thinking that both represent demand for dollars.
Sorry for my late response–I’m behind in my required reading (i.e., essential blogs like yours)…
Here are my attempts.
Attempt #1: Suppose Steve decides he wants to retire and move to Paradise Island. He plans to liquidate his assets including current real estate to purchase a dream place on the beach. He is not alone as many are contemplating and acting toward just such a move. At the same time current real estate owners on Paradise Island are looking to cash in on the land run by selling existing places including raw land. Unfortunately, many scamsters abound looking to take advantage of a key information asymmetry–namely, that it is extremely difficult to determine who actually holds title to actual land. Fortunately, there is one source (a cryptocurrency ledger) that can validate with complete certainty which of these are legitimate sellers and therefore legitimate potential transactions giving Steve (and all others) good title to any purchase. [Note: While this is an extreme case, adjusting for real-world frictions and the availability of alternative solutions simply lowers rather than extinguishes the value of the ledger.]
Attempt #2: Octan Corporation is a multinational firm with extensive interests throughout the globe. As such it has continual needs to transfer liquid assets (call it money) between subsidiary accounts and with arms-length third-parties all of which can be domiciled in different states and nations with custody at various third-party firms. In the current/old world this is costly in a number of respects: It has limited availability since banking systems are open only at certain times and days of the week, it is slow since the clearing process is built on old architecture with a cumbersome and time-intensive trust/verification procedure, and it is explicitly expense in fees as a result of these prior two reasons as well as the regulatorily-driven limited competition for these services. In the world of cryptocurrency these costs are substantially reduced. Literally Octan can send $1,000,000,000 across the world at 11:59 PM on a Saturday completing the transaction in 10 minutes for <1/100th of current wire costs in fees.
Attempt #3: Steve has many opinions and predictions about the world. Unfortunately, talk is cheap. Many dispute his contentions with vigor. However, Steve is actually very often correct. To his frustration Steve's detractors seem to vanish once the reality plays out in Steve's favor. And even if they are around for Steve to claim victory, they usually move the goalposts rarely admitting defeat. This among so many other facts like lack of liquid collateral or basic counterparty risk means ex ante bets are rarely able to be made. Fortunately, cryptocurrency allows trustless contracts to be written between these parties creating vast potential markets and submarkets for predictions and hedging.
Attempt #4: Steve loves using his credit and debit cards. He is a "points guy" who has the obsessive hobby of finding and exploiting all the various opportunities including arbitrages that exist for non-cash transaction rewards programs (e.g., frequent flyer miles bonuses, cash-back rewards, etc.). Steve is like all consumers, though, in that he doesn't like transactions fees. Fortunately for Steve, many of these fees for him are being cross-subsidized by naïve customers who are not maximizing their points if using credit/debit cards at all. The fees are transactions costs representing the true costs of validating and facilitating financial transactions. These add up to hundreds of billions of dollars annually. Fortunately, cryptocurrency offers the potential to cut these costs dramatically by creating "trustless" alternative clearing options. It is trustless in that the two or more parties to the transaction do not have to know each other as the network ledger validates the funds going from A to B are both good and compete (irreversible). [Note: While today transactions on various crypto networks like Bitcoin seem painfully slow (minutes or longer), there are options of subnetworks that can reduce these to seconds. Also in anticipation of a common objection, the price volatility risk can be eliminated by adding entry/exit transactions for both parties on both ends of the crypto exchange (e.g., dollars for Bitcoin for customer A, Bitcoin transfer from A to B, Bitcoin for dollars (or other) for seller B.).]