Divining The Underlying Value Of Bitcoin

Business Insider’s Joe Wiesenthal today published an interesting piece on Bitcoin, partially responding to Paul Krugman’s somewhat inscrutable recent blog post that called the cryptocurrency “evil,” and partially answering the question of why Bitcoin has value. It’s been a topic we’ve been discussing for months, making Wiesenthal’s argument worth digging into.

He breaks Bitcoin into three interrelated characteristics that support one another: It’s a currency, equity, and a social network.

Bitcoin acts as a currency because you can use it as a generic exchange medium in lieu of dollars and other traditional currencies in a growing number of places. Bitcoin also at least behaves as an equity, because the more people who use and accept it, the more the value of each coin — at least thus far — generally rises.

Interestingly, Bitcoin’s ability to act as a currency and an equity are both predicated on its network effects. Wiesenthal puts this succinctly: “Strong, robust network effects are crucial for making the whole thing work.” He links to Antonis Polemitis who makes the same argument: “If people stop using bitcoin, its intrinsic value is zero. Its value is 100% derived by the fact that it is a network.”

If we view Bitcoin’s value as a currency and an equity as supremely predicated on its strength as a network, we can then state that its value rises and falls with the strength of that network. This means that Bitcoin’s value is something that we can therefore better understand.

The gist is that it’s been frakking hard to explain to anyone why Bitcoin makes more sense at $700 than $800 or even $300. However, if we can consistently point to an expanding network, we can presume that Bitcoin’s value should therefore be rising.

This does not allow us to say that Bitcoin’s current price, and its requisite swings, match its inherent value. In fact, I think that we can presume that they do not. According to Coinbase, Bitcoin spiked from $208 at the start of November to $1,049 on the first of December. If we assume that Bitcoin’s network effects gave its exchange rate (currency) or asset value (equity) a proper valuation at the start of the month, we can either argue that its network became (roughly) five times as valuable in the month, or that investors overbid Bitcoin. Its ensuing price slump would point towards the latter.

I’ve correlated the price of Bitcoin to its current news volume a few times, and it’s a connection that I think is quite plain. That’s not a bad thing, of course, as Bitcoin needs the public to become better informed about its existence so that it can grow its buying class and bolster the cohort of sellers willing to accept it.

But if the growth of the network is the growth in Bitcoin’s value, does it not have a risk of negative reinforcement? That’s to say that a strong negative correction in Bitcoin’s price would harm both sides of the table, skewering the positive impacts of network effects by flipping them around.

Does Bitcoin’s reliance on its network make it less stable than a traditional currency? I think so, but not necessarily fatally. Krugman quotes Brad Delong on the things you can’t do with Bitcoin:

Underpinning the value of gold is that if all else fails you can use it to make pretty things. Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year (yes, I know).

You could argue that paying your taxes with dollars is a form of network effect, but that feels like a stretch. What this means is that Bitcoin’s value is less moored to things that we can jokingly call offline.

What is important to take from the above is that Bitcoin’s ability to expand its network is critically important as the supply of coins continues to grow. There is a hard cap of Bitcoins that will be released, but we are not there yet. So, Bitcoin fans want expanding utility (network) to grow at a higher rate than new coins are introduced.

There is another issue involved with the long-term utility of Bitcoin that is worth discussing, which is that its price volatility makes it hard to sell tangible goods (as opposed to non-tangible digital services, etc.) with the stuff. If I sell you a Tesla with Bitcoin, and the next day Bitcoin falls 25 percent before I can cash out my coins, that’s a pretty big deal. So Bitcoin needs a more stable price, which can only come to fruition after its network becomes large enough to have validated the price of Bitcoin at a certain level. And for that it needs to attract more retailers, which are kept out by its price swings.

This is all simple in summary: The utility of Bitcoin as a currency and its value as an equity depend on its network, which provides the market opportunities for Bitcoin to behave as either.

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