Tuesday, March 11, 2014

Why Bitcoin Needs Neither 'Intrinsic Value' Nor Government Backing

One of the things that puzzles people most about Bitcoin, and what makes them most skeptical about its future, concerns the very nature of bitcoins and the source of their value. Put simply: Just what the hell are bitcoins exactly and why would anybody want them?

The most basic answers to these two questions are, respectively, that a bitcoin is a spot in a distributed ledger, and that what makes a bitcoin valuable is that it is a medium of exchange that at least some people are willing to accept as payment for other goods or services.

These answers, however, do little to take away the confusion and/or skepticism, because bitcoins are by nature so very different from other media of exchange that we are familiar with.

This becomes clear when we look at the different ways in which this type of confusion and/or skepticism is expressed by a wide variety of both experts and laypeople, including top economists like Paul Krugman, former central bankers like Alan Greenspan and Nout Wellink, Fed critics and hard money advocates like Peter Schiff, sympathetic Bitcoin observers like JP Koning, and many many more. Here are the most common points these critics make:

  • Bitcoin doesn't have any 'intrinsic value': While for example gold is also demanded for use in jewellery or some industrial processes, there is no such non-monetary demand for bitcoins [1]. 

  • Bitcoin is nothing more than a spot in a ledger: While for example an airline ticket is also a spot in a ledger it is one that represents and entitles you to a seat on a flight. Similarly, an IOU refers to and entitles you to something other than itself (a good, a service, or a money). Bitcoins on the other hand don't represent or entitle their owners to anything outside themselves. A spot in a ledger is all that a bitcoin is.[2]

  • Bitcoin doesn't have a government backing it: While for example the US dollar is backed by the US government that requires citizens to pay taxes using dollars, thereby creating a more or less guaranteed demand for dollars, there is no such institution in the case of bitcoins.[3]  

  • Bitcoin doesn't have an institution that can prop up demand: JP Koning describes how a central bank can protect the value of a currency: 'If all transactors and speculators try to flee a currency then inflation emerges. To meet its inflation targets, a central bank will start to conduct massive open market saless. Blowfish-like, it sucks in all unwanted currency and reserves until panic-selling by transactors and speculators has subsided.' Bitcoin doesn't seem to have an institution that can perform a similar function to the same extent. 

Worst of Both Worlds
All the above criticisms boil down to the claim that there is no more or less guaranteed demand for Bitcoin, either in the form of a non-monetary market demand or a governmentally created or ensured monetary demand for it.

So Bitcoin as a 'fiat market money' seems to have the worst of both worlds: While gold is demanded on the market in part because of its non-monetary uses, bitcoins is subject to the same market forces but without the support of any non-monetary demand, and while dollars and Euros don't have any non-monetary demand either, they do have the support of governments and central banks, while Bitcoin has the support of neither.

Instead, the demand for bitcoins is determined entirely by market participants' expectations about Bitcoin's future use as a medium of exchange, whether this demand comes in the form of people wanting to hold cash balances in bitcoins in order to engage in transactions with them, short-term traders who want to arbitrage between exchanges or profit from short-term market volatility, or long-term investors or speculators who hold bitcoins for longer periods hoping the price will go up in the future. All these actors hold bitcoins not because they want to somehow consume bitcoins or pay taxes with them, but because they want to exchange them for something else in the near or distant future. In JP Koning's great phrase: Bitcoin is pure moneyness!

Because Bitcoin has neither the advantage of a non-monetary market demand, nor of governmental institutions that more or less guarantee a certain demand for its monetary services, there is nothing preventing bitcoins from becoming literally worthless. Once market participants start to lose faith in Bitcoin's future monetary roles, there is nothing to stop the price of bitcoins from going all the way down to zero, while in the case of for example gold the non-monetary demand would provide a floor to the price and in the case of the dollar the government and central bank would provide such a floor by creating or propping up demand, respectively.

The first point I'd like to make in this article is: So what?

It's All about the Moneyness
The fact that there is little to no non-monetary market demand for bitcoin and no government institutions that would guarantee a demand for it, and that as a result the Bitcoin price could drop all the way down to zero, need not make bitcoins any less attractive as a speculative investment or ordinary medium of exchange than something like gold.

The demand for gold consists of the demand for its non-monetary roles and the demand for its monetary roles. Now suppose that you are an investor and you're interested in buying some gold. Suppose moreover that the current price of gold is $1,000 per ounce. That price is determined by both the monetary and the non-monetary demand for it. Let's say that 20% of the demand is for non-monetary purposes (so the demand by jewelers, manufacturers, dentists and so on) and 80% for its monetary roles (for example as a store of value, medium of exchange, its potential for potential further monetization in the future). Now suppose that for whatever reason, for example because of some government regulations, the monetary demand for gold disappears entirely. The price then drops to $200 per ounce. As an investor you will have lost $800 or 80% of your investment. 
Now consider the case of bitcoins. The market price at the time I write this is about $800 per bitcoin. For the sake of the argument, let's assume that there is no non-monetary demand for bitcoins. Suppose you are an investor and you buy 1 bitcoin. Then for whatever reason (e.g. government regulation) the demand for bitcoins disappears entirely and their price drops to zero. As an investor you will have lost $800 or 100% of your investment.

Now why would you be worse off as an investor in the case of bitcoin than in the case of gold?

A first answer might be that with gold at least you have some value left due to the non-monetary demand for it. You still have $200 worth of gold while in the case of your bitcoin you have nothing left. That's true, but not relevant. After all, you already paid a premium of exactly $200 for that $200 that you still have left, while in the case of bitcoin you paid $0 for the non-existing non-monetary demand. So in reality your absolute loss is the same.

Percentage-wise you may seem to be worse off in the case of bitcoin because you lose 100% rather than just 80% of your investment, but this is only apparent as in the case of bitcoins you did not spend the $200 extra that you paid when you bought gold and so in the case of bitcoin you actually had $200 left that you could have spent on some other asset. So in both cases you keep $200 or 20% and lose $800 or 80%.

Panic Schmanic
The fundamental equivalence between gold and bitcoin from an investment point of view also provides us with a perspective on the inference that is commonly made on the basis of Bitcoin's lack of non-monetary market demand or government support, namely that because bitcoins aren't anchored in anything and the price could go all the way down to zero, this very fact might make a panic among investors much more likely in the case of bitcoins than in the case of other assets such as gold. The sympathetic and insightful Bitcoin observer and critic JP Koning describes the argument as follows:
If all transactors and speculators try to sell their gold then its price collapses. Jewelers, dentists, and manufacturers begin to withdraw gold from the market at these advantageous prices because they can use the metal to displace more expensive alternative materials. All unwanted monetary gold will be removed into the inventories of jewelers, dentists, and manufactures, or into their finished product.

My incessant concern with a speculator-driven collapse in monetary value isn't just me being ornery. Any given asset faces a daily threat of liquidity flight. These sorts of runs can quickly become self fulfilling phenomena. If one speculator causes an asset's price to fall by selling it off, more speculators might bolt, thereby causing yet another fall in price, causing more speculator flight, ad infinitum. Similarly, as transactors make less use of an asset, that asset loses liquidity, causing transactors to use it even less, causing it to lose liquidity, and so on and so forth. The moneyness of an asset can quickly implode,blackhole-like.

Gold, stocks, and central bank reserves/cash all have fundamental mechanisms for ensuring that this sort of flight is dampened. In the case of bitcoin though, if transactors and speculators get spooked there is no central bank to suck bitcoin back in, nor a CFO to conduct buy backs, nor dentists or jewelers to re-purpose it for alternative uses. Bitcoin is 100% moneyness. Whenever a liquidity crisis hits, the only way for the bitcoin market to accommodate everyone's demand to sell is for the price of bitcoin to hit zero—all out implosion.
Koning may very well be correct that in the case of Bitcoin a liquidity flight can become a self fulfilling phenomenon, instantiating a downward spiral that doesn't stop until bitcoin's price reaches zero. 

But what makes bitcoin special in this regard? True, in such a panic bitcoins would lose all of their moneyness and hence go down to zero, but why wouldn't the same be true for gold?

The current mechanism that provides gold with a price floor is due to the non-monetary demand for gold. But why would the non-monetary demand prevent the monetary demand from collapsing? There may be a mechanism that might allow for this but if there is, Koning doesn't mention it.

And if there isn't, then it seems that it is, all else being equal, as possible or likely for gold to lose all of its moneyness in a panic as it is for bitcoins. As I argued in the previous section: So what if when the monetary demand for gold collapses its price is still higher than zero while if the same happened to bitcoin its price would be zero? From an investor's point of view, this is irrelevant: both the absolute and relative losses would be the same in the cases of gold and that of bitcoins.

And if this is the case, then it seems unlikely that the psychology of the investor, the force that drives the market, would be different during a liquidity run in the case of bitcoins than during a liquidity run in the case of gold.

So it's not at all clear why we would expect more of a panic, more of a cascading process, more of a down-ward spiral in the case of bitcoins than in the case of gold. This in turn means that one important alleged consequence of bitcoins' lack of a non-monetary market demand is actually not specific to bitcoins at all.

The implication of this is that to the extent that you think gold could successfully function as a widely used medium of exchange on the market, without any government support, and to the extent that up until now you thought that bitcoin could not so function because it is more susceptible to panic sales and downward spirals as a result of its lack of 'intrinsic value' (the lack of a non-monetary demand for it) it may be time to revise your opinion about bitcoin's chances of success as there does not seem to be any fundamental difference between gold's and bitcoin's susceptibility to panics and downward spirals.

It's the immaturity and uncertainty, stupid!
At the same time though, the current Bitcoin market and price are without a doubt much more volatile than the market prices of either dollars or gold (except for their price in bitcoins of course!). If its lack of non-monetary role is not or need not be the explanation for this, then what is?

One main cause of bitcoin's extreme price volatility may simply be the size of the market: As Jeff Garzik explains
 Although the market cap exceeds $6 billion -- over 12 million bitcoins at price $500 -- the amount of bitcoins available for trading on markets is a fraction of that. A large purchase might run up the price; a large sale will drop the price. Bitcoin behaves like a penny stock. Penny stocks are also volatile, for the same reason. Volatility is inherent in any system where traders may make million-dollar trades, yet the underlying commodity or stock's market liquidity is small in comparison.
Garzik also notes that another main cause of the volatility may be the lack of financial instruments such as options and futures that normally have the effect of dampening price fluctuations by bringing more information to the market. 

Likely due to regulatory and technological constraints as well as the sheer novelty of bitcoin and the great regulatory and socioeconomic uncertainty surrounding it, there is currently a lack of such instruments in the bitcoin market.

In sum, then, the fact that the bitcoin economy is still so small, young and underdeveloped, and that its future is still very uncertain for economic, regulatory and institutional reasons may then be much more important causes of the volatility of the bitcoin price than bitcoin's essence as pure moneyness.

The currency and the protocol
While up until now I have, for the sake of the argument, assumed that there indeed is no non-monetary demand for bitcoins, and argued that even if this is the case it still does not mean that this makes bitcoin unsuitable or unworthy as a medium of exchange, my second point is that it is actually deeply problematic to claim that there is no non-monetary demand for bitcoins.

There are bitcoins and then there is Bitcoin. The former is the currency or medium of exchange, and the latter is the distributed ledger, which can function as a platform for financial innovation. As Andreas Antonopoulos explains it:
Bitcoin is much more than just a digital currency. It is a protocol, a network, a currency and a transaction language. Most of all, though, it is an application programming interface (API) for money. Nowadays, bathroom scales and fridges have APIs, so why not money?

Traditional money does have APIs, but they are closed. You can program the merchant API of the VISA network if you are a trusted merchant. You can send and receive FIX messages if you are a stockbroker or exchange. Regular people, however, don’t even have APIs into their bank accounts, let alone the broader economy. Bitcoin changes all that by not only offering an API for accounts (wallets) and transactions, but also making that API available to everyone.

In a traditional financial network, trust is achieved through a complex web of regulations, fraud detection, and accreditation — but most of all exclusion. Financial networks remain secure by keeping the APIs closed and inaccessible except to the few who are trusted, and thereby keep out bad actors (at least in theory). Bitcoin shifts the model from “trust by exclusion” to “trust by computation.” Trust is distributed across a large (and ever-growing) network of collaborators who continuously check one another, making it increasingly difficult for any bad actor — or even a set of bad actors — to hijack the network. As a result, there is no need for exclusion or access controls. Anyone can participate in the Bitcoin network and see all the transactions, or rather everyone can access the APIs.
The distributed ledger currently is primarily being used as a payment network that enables people to send bitcoins anywhere in the world quickly, securely and cheaply. But more and more applications and services are being built on the basis of this protocol and the protocols created on top of it, some of which will make it much easier or cheaper to do things that financial institutions are already doing, and some of which will make it possible to do all sorts of new things that up until now were not possible or even dreamed of. Bitcoin could revolutionize the banking and other industries. 

Arguably, bitcoin the currency and Bitcoin the protocol or platform for financial innovation are inextricably linked in that one could not function without the other or could only do so at great expense. One could for example create a new block chain that would serve as the protocol for applications but without something like the massive computing power currently protecting the Bitcoin network such an alternative platform would likely suffer from significant security problems. And without the potential profits that are to be had from mining bitcoins there is little incentive for people to devote resources to securing the alternative blockchain.

So because bitcoin the currency and Bitcoin the distributed ledger that functions as a protocol and platform for financial innovation are so inextricably linked, and because all the actual and potential applications made possible arguably serve not just purely monetary purposes, it is actually deeply problematic to claim that bitcoins don't have any non-monetary role or that they don't refer or aren't linked to anything outside themselves.[4]

In conclusion
There are many reasons to be confused about bitcoin – it is, after all, a highly sophisticated and original answer to a wide variety of complicated problems in a wide variety of domains (e.g. cryptography, economics and politics).

There are also many reasons to be skeptical about bitcoin and the potential value it could deliver: There may be yet undiscovered serious problems in the concept and/or technology, or unforeseen and damaging economic consequences, regulatory obstacles that block its quantitative and qualitative growth, superior competition from other technologies and businesses, inferior competition that nevertheless gets the support of enough influential political and economic actors, and so on and so forth.

But although there are many many reasons to be confused about or skeptical of bitcoin, I have argued in this article that there are good responses to the reasons that critics commonly give for their confusion and/or skepticism: Bitcoin's alleged lack of intrinsic value, lack of reference to anything outside of itself, lack of a non-monetary role and lack of support by governmental institutions that can create or prop up demand):

  1. Even if bitcoin doesn't have these features, this does not mean that qua its role as a medium of exchange it is all that different from media of exchange like gold that do have a non-monetary use. And if this is the case, and if it is true that gold and other media of exchange that do have a non-monetary use but are not backed by a government could successfully function as media of exchange in the market, then it seems that media of exchange that don't have a non-monetary use and that, like gold, aren't supported by a government either, could successfully function as media of exchange as well.
  2. But Bitcoin arguably actually does have several non-monetary uses (although these may be difficult to separate, conceptually and/or in practice, from its monetary role) that might strengthen the demand for bitcoins.


[1] Pretty much every time a bitcoin critic or a bitcoin defender uses the term 'intrinsic value' there will be some person (often an adherent of the Austrian School of Economics) who immediately comments that nothing has intrinsic value and that value is subjective. That's all very true but typically what people mean by 'intrinsic value' in the context of Bitcoin is 'non-monetary use', not something like 'objective value' or 'value even without a valuer', and as such to say that for example gold has 'intrinsic value' is not in opposition to the idea of value being subjective. It's just a confusing way to say that gold has a non-monetary use for which people value it.

Even the Austrian economist Ludwig von Mises has at times used this confusing terminology:
The Necessity for a Value Independent of the Monetary Function before an Object can serve as Money

If the objective exchange value of money must always be linked with a preexisting market exchange ratio between money and other economic goods (since otherwise individuals would not be in a position to estimate the value of the money), it follows that an object cannot be used as money unless, at the moment when its use as money begins, it already possesses an objective exchange value based on some other use. This provides both a refutation of those theories which derive the origin of money from a general agreement to impute fictitious value to things intrinsically valueless[...] and a confirmation of Menger's hypothesis concerning the origin of the use of money. (Theory of Money and Creditp. 110 of some edition of the book. Emphasis added) 
Obviously Mises realizes that value is subjective, so the problem here with regard to his use of 'intrinsic value' or 'intrinsically valueless' really is only a terminological one. To avoid this kind of confusion I use 'non-monetary' where other people might use 'intrinsic'.

[2] For the sake of the argument I here assume that there is no non-monetary demand for bitcoin, but this is actually not quite true, for at least two reasons: 

  1. Some have argued that bitcoins may be demanded as collector's items, or as status symbols, expressions of idealism or ideology and so on. While this probably is the case, this type of demand is probably really quite small and negligible for practical purposes.
  2. As I discuss later on in this article, Bitcoin as a distributed ledger provides a protocol for developing applications and as such can function as a platform for financial and other kinds of services, which would imply a non-monetary demand.

[3] To be sure, one could use bitcoins and/or features of how the block chain works and/or entities created in applications built on top of the Bitcoin protocol to represent and/or function as titles to non-Bitcoin goods and services and information such as gold and stocks and other types of property, but this would be something in addition to what bitcoins are in their basic form and function, and different from how bitcoins are currently being used and traded.

[4] But crucially, the relation between the monetary and the non-monetary demand for bitcoins is really quite different than it is in the case of for example gold. In the case of gold it is relatively easy to imagine how the monetary demand might collapse without this resulting in the collapse of the non-monetary demand, and vice versa (at least as long as gold was already widely being used as a medium of exchange and unit of account). This is much more difficult to imagine in the case of Bitcoin, where the monetary and the non-monetary demand seem much more dependent on each other and much more likely to rise or fall together. I will have more to say about this in a future post.

Further Reading
Two other people who have defended bitcoin against some of the charges made against it concerning its alleged lack of 'intrinsic value' are Erik Voorhees and Vitalik Buterin

1 comment:

  1. In my two cents, bitcoin’s intrinsic value is not valuable. Yes, bitcoin is risky because it is not “backed” by any government, asset, or commodity. But try to figure it out, US currencies has no REAL backing, it's fully based on the fractional reserve system.