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.

Podcast #1: Bitcoin and the Origins and Nature of Money

This week I had a conversation with Vijay Boyapati about how the emergence of Bitcoin has revealed some serious problems in the traditional Austrian account of the origins and nature of money.

Topics include: how Menger and the Austrians failed to understand the bubbliness of money; how speculation rather than use as a medium of exchange is what bootstraps bitcoin; what bitcoin can or cannot tell us about the origins of money; how money is actually better off without 'intrinsic value'; how the success of gold shows that bitcoin can have a future; how bitcoin isn't quite money yet and what this means; and much much more.

Why start or invest in Bitcoin companies? Why not free ride Instead?

Most of the companies building or servicing the Bitcoin economy require significant investments. But why would you invest that money in a Bitcoin company if instead you could just use the money to buy bitcoins and wait for those to increase in value?

Individual companies vs. the whole industry
The remarkable thing about the Bitcoin industry is that it is possible to invest in the industry as a whole rather than (or in addition to) in specific companies in that industry.

This is very different in other industries: You can't make investments in 'the car industry' or 'the food industry', only in specific companies in these industries. Similarly, the current state of the Bitcoin industry is sometimes compared to the early internet: still very underdeveloped but with great potential. Now in the case of the early internet it was not possible to invest in TCP/IP, the general protocol underlying it, or even in the protocols built on top of that such as HTTP. If you were excited about the potential of the internet you couldn't invest in the protocols themselves, only in specific companies creating and/or using these protocols.

With Bitcoin on the other hand you can invest in the Bitcoin industry as a whole, in Bitcoin as a protocol for financial applications, namely by buying bitcoins. If Bitcoin as an industry and protocol succeeds, your bitcoins will go up in value and price.

Bitcorati's overview of existing Bitcoin companies

Understanding Krugman on Bitcoin

In his column 'Bitcoin is evil' Paul Krugman writes:

I have had and am continuing to have a dialogue with smart technologists who are very high on BitCoin [sic] — but when I try to get them to explain to me why BitCoin [sic] is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem. And I haven’t been able to get my correspondents to recognize that these are different questions.

Krugman is entirely correct in that

1) the medium of exchange function and the store of value function are two distinct issues,

2) even if we were to assume for the sake of the argument that bitcoin was a successful medium of exchange this in and of itself need not thereby also make bitcoin a reliable store of value, and hence

3) we would need an additional argument to demonstrate that bitcoin could also succeed as a store of value.

None of these points seems particularly controversial, which makes it all the more surprising that Krugman writes that none of the smart technologists and bitcoin enthusiasts he's been in dialogue with even seem to recognize or acknowledge them.

Never one to shy away from speculating about what psychological and/or moral defects may cause the people who disagree with him to behave in such an apparently irrational and/or dishonest manner, Krugman devotes much of the rest of his column to suggesting that it is really an evil libertarian agenda rather than intellectual understanding and conviction that is what drives many bitcoin enthusiasts.[1]

The problem, however, may lie with Krugman rather than with the bitcoin enthusiasts.

Why your bitcoins won't make you as rich as you may think they will

Suppose you have a bunch of bitcoins, let's say 50 of 'em. As you're leafing through your copy of Yachting Magazine, thinking about the day when 1 bitcoin will be worth 1 million dollars, you see an ad for a impressive $50,000,000 yacht and think to yourself: That's what I will buy once bitcoin hits a million! 

The problem here is that you are actually overestimating how wealthy you will be once bitcoin hits a million. Of course there's taxes and what not and these will take chunks from your wealth, but that's not what I have in mind here. My point is that once 1 bitcoin is worth 1 million dollars, 50 million dollars simply won't mean the same as it does now, in that it won't buy you as much as it does in 2013 dollars.

Who benefits if Bitcoin succeeds?

To answer the question who will benefit if Bitcoin is successful it is important to distinguish between two different processes that take place during Bitcoin's road to success:

1. Bitcoin monetization
2. Growth of the bitcoin economy

As I will explain below, each of these developments results in different kinds of benefits for different groups of people.

Why an end to Bitcoin's growth need not result in its collapse (unlike Ponzi schemes and bubbles)

Hardly a day goes by without somebody accusing Bitcoin of being a Ponzi scheme, or being like a Ponzi scheme.

At first sight this may seem like an odd charge: A Ponzi scheme is a fraudulent, secretive operation masquerading as an investment scheme while Bitcoin is an open-source currency and protocol.

Moreover, a Ponzi scheme is operated by one person or organization while Bitcoin is decentralized and not controlled or operated by any one person or organization.

Also, in a Ponzi scheme people are promised that their investment is low-risk while just about anybody in the world of Bitcoin will tell any prospective buyer that the risk is huge and that they should not invest more money than they can afford to lose.

Lastly, in a Ponzi scheme the (non-existent) returns are typically very steady while Bitcoin is notorious for its enormous volatility in price (and hence returns).

The same logic?
But while most critics would probably agree that Bitcoin is not a Ponzi scheme in these four respects, they would point to a more fundamental similarity, a basic logic that Bitcoin has in common not just with Ponzi schemes but also with manias and bubbles (e.g. here & here & here & here & here), a logic that goes a little something like this: