Why Is Bitcoin Worth Anything At All, Part II

In the first part of this long post, I’ve identified three instances where Bitcoin was used for transactions, namely: pizza, drugs, and ICOs. I’ve postulated that the transactional nature of Bitcoin doesn’t confer it any long-term value, but instead creates speculative bubbles due to long transaction periods, and the price inelasticity of demand for transactions.

In this second part, I’ll first outline why it’s nonsensical to fantasise about Bitcoin becoming a widespread currency in its current form, basically debunking Saifedean Ammous’ arguments inspired from the Austrian School of Economics. Then, I’ll consider its potential as a launchpad for new, innovative financial instruments - a feature that is indeed promising, although still a dream.

“Switching to Bitcoin will save the world” is nonsense

First, if you don’t really know what the Austrian School of Economics is all about, I suggest you see this video of Keynes vs. Hayek Rap Battle - it perfectly sums up the grudge Austrians (Hayek) hold against Keynesians. The Austrians think that central banks exacerbate the boom and bust cycles, because economic agents feel like the central bank has their backs, and so they become reckless and push the economic cycle into unsustainable excesses.

The Austrian school of thought received a lot of attention after the Great Depression, as everyone was looking for an easy answer to, and a scapegoat for, the nonsensical tragedy that the 1930s turned out to be, both economically, politically, and societally. Bitcoin maximalists love the Austrian School of Economics, of course, because it seems to plead in favour of a much simpler financial system, where central banks are gone, and the banks themselves are replaced with Bitcoin. No more fractional reserve banking, no more “money printing”, what a wonderful world that would be!

Switching to Bitcoin wouldn’t make the world a better place

Imagine for a second that all the world’s governments and bankers decide to switch to Bitcoin overnight. Supposedly, they would no longer be able to print money - i.e. borrow without limits whenever they need to pay their bills. According to Bitcoin maximalists, this would prevent governments from engaging in nefarious enterprises such as wars, because they wouldn’t be able to finance their plans by printing money, and the people would obviously refuse to finance such a bad, no-good thing.

Well, to know wether that’s true, look no further than the 19th century, when all currencies were backed by gold. Theoretically, money was in limited supply back then, just as it would be if we switched to Bitcoin. Remember how the 19th century was a period of peace and financial stability? No? Of course you don’t, because it wasn’t.

Money supply can’t be limited because people figured out credit three freaking thousands of years ago. Babylonians and Assyrians made loans to each other on the security of mortgages and advance deposits as early as 1300 BC. Even if the total supply of money were to be limited (because money is backed by gold, or because it’s Bitcoin), governments could still issue IOUs, with interest rates high enough to entice lenders into giving them some of that limited money. Or they could simply pay their soldiers directly with IOUs.

Switching to Bitcoin would simply replace inflation (soft defaults) with (hard) defaults

Of course, with a limited money supply, governments would routinely end up issuing too many IOUs, and would have to default on their debt.

Whoever took the time to read “This Time Is Different: Eight Centuries of Financial Folly” by Carmen Reinhart and Kenneth Rogoff knows that governments used to default extremely frequently before the advent of modern central banking. And if you think that a hard default is better than a soft default through inflation, well, read a book about the 19th century.

Valuing Bitcoin according to the money supply is stupid

Bitcoin maximalists dream of the day when Bitcoin replaces all the money in the world, because, supposedly, it will then be worth all the money in the world. Their simplistic train of thought is, we’ll need as much Bitcoins as there is money now, but we can’t have more Bitcoins, so Bitcoin’s price will have to go up, so that its market cap equals the global money supply.

This theory is extremely appealing to Bitcoin HODLers, because the global money supply currently stands at around $7.6 trillion, and to match that, Bitcoin’s price would need to go up to around $380,000. And that’s only considering the M1; if we were to take the broad global money supply, or M3, which stands at around $90 trillion, one Bitcoin could be worth as much as $4.5 million.

Unfortunately, that theory doesn’t make sense for a lot of reasons, the first one being that the “money supply” isn’t something tangible: it can change.

Originally, the Austrian school of thought postulated that inflation was entirely explained by the amount of money out there, i.e., the money supply:

M = P x Y

where P is the price level, Y is the real global production of goods and services, and M is the money supply. If you managed to bring Hayek back from the dead and explained to him the Fed’s Quantitative Easing, he would bet his life that inflation currently is out of control. And he would be dead again, because, of course, the formula above is wrong. The real stuff looks like this:

v.M = P x Y

where v is the velocity of money; very simplistically, it’s the speed at which every coin and banknote changes hands among economic agents.

The velocity of money varies wildly - here’s what it looks like in the United States:

You can clearly see that an exogenous shock to the money supply - the Fed “printing money out of thin air” - simply crushed the velocity of money, and inflation remained stable throughout the period.

It’s not that easy to inflect the course of the economy. Changing the money supply simply changes the velocity of money. And we don’t even need a central bank to do that. For example, if businesses started to pay their employees every day instead of once a week or once a month, money velocity would explode, and money supply would implode - but that wouldn’t change anything about prices or GDP.

Valuing Bitcoin according to the money supply is stupid because the money supply can be changed at will without much consequences.

Bitcoin wouldn’t even be a deflationary currency

As the section above demonstrated, a limited money supply wouldn’t necessarily mean low inflation, because the “invisible hand” of the economy would step around constraints on money supply through spikes in money velocity. Economic agents (people) are very resourceful when it comes to finding solutions to artificial problems. Just ask Venezuelans how they manage to come around their days with inflation in the low billions. They’ll all tell you: “well, US dollars, of course!” Because, you see, US dollars are a much more convenient solution than Bitcoin.

The only thing that has a proven track record in controlling inflation is monetary policy through interest rates. Interest rates higher than inflation incentivise people to save, reducing money velocity and money supply at the same time, thus reducing inflation. A 5 year old could understand that. But not Bitcoin maximalists, apparently.

Bitcoin as a launchpad for financial experiments

So, does it mean that Bitcoin is essentially worthless? No, absolutely not.

In reality, Bitcoin’s core value hasn’t changed much since its very beginnings. It’s a very, very interesting experiment. It has a reach - currently around half a million of unique adresses transacting with one another every day.

If someone wanted to launch a financial revolution, Bitcoin is the best petri dish to start it, with hundreds of thousands of financially curious participants.

Of course, it is in competition with Ethereum, whose network value seems to be only marginally lower, with around 320k active addresses as I’m typing this. However, one needs to understand that Ethereum has attracted a lot of activity by offering a platform for decentralised applications (dApps), most of which won’t survive - which will put a downward pressure on Ethereum’s network value over time.

Cryptocurrencies don’t make any sense

Bitcoin isn’t a currency, it’a a payment system. It’s written pretty clearly in the original whitepaper. The current state of affairs, where Bitcoins are both the product and the shares of the whole enterprise, doesn’t make much sense. This double nature did make a lot of sense at the very beginning, when the system of miner rewards was an incredibly smart way to build the network without requiring people to put up money to become part of the network. Without miner rewards, there would be no cryptocurrencies today.

However, today, with half a million of active addresses, the miner rewards system is anachronistic nonsense. It brings nothing to the network, as mining hash power is extremely centralised, and costs billions per year in electricity and ASIC hardware. However, putting an end to the Proof of Work system will be extremely hard, as miners control everything, from PR (think news websites, Twitter shill bots) to the network itself. Even Ethereum, with its demi-god Vitalik Buterin favouring the move, failed to break away from Proof of Work last year. But I digress.

Bitcoin is a system for transferring stuff, and its users simply agreed that it would transfer units of value, which turn out to also be shares of the network. This makes almost as much sense as a pig that’s also a typewriter. That’s why nobody has manager to come up with a valuation model for Bitcoin, the way it is now.

Forget virtual magical coins, welcome the network

Anyone who’s tried his hand at business knows that technology means nothing, and reach means everything. The true value of Bitcoin comes from its network. In this model, Bitcoin’s value depends on who owns it - the more people are involved, the better. Crypto thought leaders tried to bank on this network value already, over the last two years, by forking the blockchain into new versions of Bitcoin. These experiments turned out to be a string of failures for lack of imagination. Just think about it: they had at their disposal the greatest decentralised network that ever existed, and all they came up with, was to use it to issue new virtual magical coins that were in essence just a free crypto dividend for all the HODLers. What a disgrace.

What if Bitcoins were, instead of virtual magical coins, shares of a company that actually produced something, instead of just transferring shares from one shareholder to the other? For now, that company has no revenue, and is bleeding cash, to the tune of $5 million per day in electricity and ASIC hardware costs. But it has a priceless asset: a network of financially curious shareholders.

Bitcoin isn’t like the early Internet, but it could be

Use the Bitcoin network of shareholders, by opening access to anyone who wants to launch a financial revolution. Get rid of the blood-sucking miners by switching to Proof of Stake.

The moment Bitcoins start to generate actual revenue, they’ll have a basis for valuation, because Bitcoin holders could expect future cash flows. And you know how Bitcoin ownership is today highly concentrated in the hands of a small group of “whales”? Well, if Bitcoin is valued for its network, in order to maximise their wealth, the whales would have a financial incentive to let go of a portion of their holdings to even out the distribution of holders. Because the value of the network would grow when new participants join in.

Owning Bitcoin would then indeed be like owning a stake in the future Internet. Even if we don’t know what it will turn out to be. And I don’t know if it would all be worth $80 billion, as it is now. But at least it would be fundamentally worth something, unlike today.