Bitcoin's Store of Value Paradox

Can bitcoin succeed as a store of value even if it does not succeed as a medium of exchange?

In the early stages of bitcoin adoption that we are in now, bitcoin only has a very limited use as a medium of exchange, especially when you compare it to the dollar or the euro. The expectation, however, is that this will change, that bitcoin eventually becomes widely used as a medium of exchange in the future. If it does, then demand for bitcoin and hence the price of bitcoin will be much higher than they currently are.

There have been several estimates and studies that tried to determine how much 1 bitcoin could be worth in the future and it is not uncommon for these studies to say that a $100,000 bitcoin or even a $1,000,000 bitcoin are very well possible if bitcoin were to become widely used as a medium of exchange. And it is the possibility of this big future price increase that is what is behind the current price.

Now what would happen if it becomes clear that bitcoins will not become a widely used medium of exchange in the future? The obvious answer would seem to be that the price would crash.

But once we look more closely at the logic that explains the value of bitcoin, this suddenly does not seem so obvious anymore.

How Does Bitcoin Grow?
How does the price of bitcoin correlate with use of bitcoin as a medium of exchange?

One scenario is for growth in the price of bitcoin to simply follow the growth in the actual use as a medium of exchange. The more bitcoin is used as a medium of exchange the higher the demand for it in that use and hence the higher the price. In an interesting exchange at Coin Summit last month a panellist argued that this is essentially how bitcoin has in fact grown so far: the growth in price has essentially followed the growth in the transaction volume.

But this would be odd: If I think there is a 70% chance that bitcoin will eventually be a widely used medium of exchange and that in such a scenario it will be worth say $100,000, then I have all the incentive in the world to buy as many bitcoins as I can right now at $450 so that I can profit from the coming price increase. And others who are also at least somewhat optimistic (or even just not terribly pessimistic) would think likewise.

What would happen then is that the expectation that bitcoin will succeed as a medium of exchange will already drive up the price, well ahead of any growth in the actual use as a medium of exchange. Only if investors did not look to bitcoin's future at all, would the price increase strictly follow the transaction volume increase. This is one reason why it was not surprising to hear another panellist at Coin Summit say that his analysis did not at all find such a parallel development between the increase in transaction volume and the increase in price (although that is not to say that the second panellist would agree with the rest of my analysis).

Given the logic above there is good reason to think that in fact it has been this speculative demand rather than growth in the actual use as a medium of exchange that has played the primary role in bitcoin's price increase so far. (It would, however, be interesting to see more empirical research on this question in general, and to see a more detailed discussion between the two panellists just mentioned in particular.) If this in fact is the case, then the demand for bitcoin as a store of value has so far been greater than the demand for it as a medium of exchange. Speculators buy bitcoins not to use them in day-to-day economic transactions but because they think they are a good investment: they can buy them at a low price now and sell them for much more later.

Value and Exchange
But crucially, this speculative demand for bitcoin as a store of value then ultimately does seem to be based on its role as a medium of exchange. Sure, the store of value function seems to sort of get ahead of the medium of exchange function, but in the end it is based on the expectation that in the future bitcoin will be widely used as a medium of exchange.

And this is what makes bitcoin different from other goods that are typically used as stores of value. Diamonds and works of art, for example, are not even suitable as media of exchange, but they are as stores of value. Gold on the other hand does have features that would also make it a useful medium of exchange - features such as durability and divisibility - and it has a history of such use, but currently the main reason people buy gold is because of its role as a store of value, not its role as a medium of exchange. Bitcoin is different from these goods though in that it doesn't seem to have any non-monetary roles. Diamonds, gold and works of art all derive part of their value from the demand for them in jewellery, industrial processes or aesthetic consumption, but bitcoin has no such non-monetary roles. Its use as a store of value seems to be primarily based on the expectation that it will be widely used as a medium of exchange in the future.

But what if this expectation of future popularity as a medium of exchange disappears? What if it becomes clear that for whatever reason bitcoin will not become a widely used medium of exchange?

Would the price collapse? Or could bitcoin survive as a store of value even if there is no expectation that it will succeed as a medium of exchange?

At first you might think: Of course the price would collapse. What would possibly still underpin bitcoin's price if it's not going to be the demand for it as a medium of exchange? What would be its value without such demand?

And this is how I think most bitcoin enthusiasts would respond to such a scenario.

But here things get tricky.

Good Circularity
After all, haven't bitcoin criticis been using that exact same argument against bitcoin from the get-go? Haven't they argued that bitcoin could not possibly succeed as a medium of exchange because there is nothing underpinning its value?

The challenge of the critics has always been: how could bitcoin possibly succeed as a medium of exchange when it has no (or only negligible) non-monetary uses, something that gold for example does have.

Sure, dollars and euros are successful media of exchange despite having no non-monetary uses but these currencies have governments and central banks that create and guarantee a certain demand for them through the requirement to pay taxes in them and the ability and willingness of central banks to buy them back if demand for them drops too much. Bitcoin on the other hand is a private and decentralized money with no such institutions backing it, so the problem remains:

How can bitcoins have value solely by being a medium of exchange, and how can they come to be used as a medium of exchange in the first place if they don't have governments or central banks to guarantee demand?

Bitcoin enthusiasts answered that question in two parts. The first part of the answer was that  bitcoin excels at the commonly mentioned requirements for a medium of exchange: it is for example easy to transport, easy to divide without cost, it is durable and almost impossible to counterfeit. But although its excellence in these respects is likely a necessary feature of its success as a medium of exchange, it is by no means a sufficient one.

For one thing, almost all alt-coins for example have similar features but they cannot all succeed. Moreover, for most people bitcoin currently offer little or no advantage over dollars as a medium of exchange: buying bitcoins is a hassle; you can't spend them in nearly as many places as you can dollars; storing them appears to be risky; the costs of converting from and back to dollars are not that much lower than the costs of credit card transactions; etc.

All else being equal bitcoin might be a superior medium of exchange compared to dollars, but all else is not equal: the dollar has an enormous head start on bitcoin, a head start that is embodied in the entire economic, financial, political, technological and cultural infrastructure being well suited to the dollar and not currently very well suited to bitcoin.

This brings us to the second part of the answer that bitcoin enthusiasts for why people would use bitcoins as a medium of exchange: bitcoins come to be used and come to be valued because enough people expect that enough other people will accept and continue to accept bitcoins as payment in the future. It does not matter that bitcoin does not have any or only negligible non-monetary uses and it does not matter that there is no government or central bank that guarantees a certain demand for it and hence a price floor.

It does not even matter that currently the infrastructure is not yet that well suited for bitcoin's role as a medium of exchange, and that currently such use as a medium of exchange is quite low.

Ultimately the only thing that matters in people's decision to use bitcoins as a medium of exchange is their expectation that enough other people will accept it as payment in the future. That alone is enough basis for people to buy bitcoins now and to invest in the bitcoin infrastructure now.

The circularity involved in the argument is unmistakable but unavoidable and, according to the bitcoin enthusiasts, unproblematic. That's just the thing about a good that is used as money or is expected to be used as money in the future: people value the good because they think that enough other people will value it. The circularity is just the network effect in action.

Ultimately the only thing that bitcoin needs to come to be used as a medium of exchange and to acquire value is the expectation that other people will also use it now or at least that they are expected to in the future.

Bad Circularity
This circularity is probably what most people who are or were skeptical about bitcoin find or found the most difficult to understand, let alone accept. Bitcoin enthusiasts on the other hand are those who took the plunge and now accept this argument.

The problem, however, is that the argument seems to prove too much.

Recall the scenario sketched earlier: what if the expectation that bitcoin will become widely used as a medium of exchange disappears? Would bitcoin's price collapse? It seems that we would be inclined to say that yes, its price would collapse. Without at least the expectation that it will have a role as a medium of exchange in the future, there is nothing that underpins bitcoin's value, so how could it possibly continue to function as a store of value?

Now let's apply to this situation the circularity-argument that I just described: would not be the only thing that matters for bitcoin's use as a store of value the expectation that other people will continue to accept bitcoin as something valuable in the future? As long as people continue to regard it as valuable it will continue to function as a store of value, even if it has no other uses. After all, bitcoin enthusiasts agree with exactly that argument when used in favor of the point that bitcoin can come to be used as a medium of exchange even though it has no non-monetary value and even though there is no state or central bank that guarantees a certain demand for it as a medium of exchange.

Why would not the exact same argument apply to bitcoin's role as a store of value?

Moreover, the same features that make bitcoin such a potentially superior medium of exchange also make it a potentially superior store of value: it is durable, divisible, easy to transport and so on. Diamonds, works of art, gold and other traditional stores of value are all inferior to bitcoin in these respects.

So the very same two arguments that bitcoin enthusiasts typically use to show how bitcoin could succeed as a medium of exchange - its superior qualities and the circularity-argument - would also show that bitcoin could succeed as a store of value even if the expectation that it will be widely used as a medium of exchange in the future disappears.

So it seems that in order for them to dissolve this apparent contradiction, bitcoin enthusiasts have a choice to make: either they continue to believe that bitcoin does not need non-monetary uses or a government or central bank backing it for to succeed as a medium of exchange or they stop believing that. If they choose the former they will now also have to accept something they did not accept before, namely that bitcoin could succeed as a store of value even if it doesn't have any other uses or any institutional backing. If on the other hand they choose the latter, they will have to reconsider what may very well be their most important argument in favor of their belief in bitcoin.

An alternative would be for them to poke holes in the argument I've presented or to offer other ways of dissolving the paradox.