Three things in life are certain for a practicing economists in 2019: death, taxes, and colleagues asking whether they should buy bitcoin. On the face of it the question is deceitfully simple: all you need to know is the value of bitcoin today and where you think it will be tomorrow. However, sometimes the simplest questions can have the hardest answers.
It’s been a wild ride thus far
On the first day trading in 2019 bitcoin exchanged hands at USD 3890.79 apiece. At the time of writing in September, the same tokens are being swapped at USD 10,383.10—a rather neat gain of more than 150% within eight months and a few odd days in between. In fact, you would be hard pressed to find other assets that have pulled off similar triple-figure-vaults in a year pockmarked by fitful trade wars, the worst declines in Germany’s production figures in decades and an overbearing melancholy about the state of the global economy.
For many pedestrian traders as well as bitcoin-professionals, including a cackle of BI-powered chartists at Goldman Sachs, the recent rally has been reason enough to make the dive and go long on bitcoin with all that they have. On the other hand, others have been quick to dissent and remind you of the threats of buying in given how far bitcoin has fallen since reaching its 20k highs in December 2017.
To see which side is right (hint: it’s usually not the pessimists) and why a valuation of 10k is not going to cut it, we need to wade through some theory on the fundamental drivers of bitcoin’s value first. Put your thinking cap on and let’s get started!
Not your granddaddy’s asset
If you ever need proof that economics is truly the science of scarcity, try searching for a sound theoretical basis for the value of bitcoin. To date, even the most valiant attempts at defining the fundamental value of of our beloved cryptocurrency have been little more than essays in futility, mostly because the majority of economists seem hell-bent in understanding bitcoin as a form money.
From Investopedia’s entry on the intrinsic value of bitcoins to the intellectual musing of investment experts, the search for the fundamental drivers of bitcoin’s valuation has focused on assessing it from the viewpoint of the three functions of traditional forms of money. As any decent entry-level course in finance would tell you, money can function as store of value, means of exchange, and as a measure of nominal value. When Roubini and company lambast bitcoin (and blockchains) being nothing more than a glorified spreadsheet, the critical reader will understand that they are ultimately arguing that bitcoin does not perform any of these functions adroitly enough to be considered money.
What has eluded most economists thus far is that bitcoin cannot be fully understood as a form of money to begin with. Rather, it is best described as being the first representative of a new asset class, which combines features of money (i.e., the ability to be harnessed for economic ‘work’ just like the dollar) with the makings of a novel platform for complex transactions and data exchange.
And for this new class of assets, the drivers of intrinsic value boil down to three words: function, faith and alternative assets.
The goggles do nothing
Joseph Stiglitz was right when he quipped that bitcoin does not serve any socially useful function. From the perspective of the traditional functions of money, bitcoin has certainly struggled to establish itself as a meaningful alternative to fiat or commodity monies in circulation today.
Firstly, the wild gyrations of bitcoin’s market rates make a valid argument for dismissing it as a store of value. Recalling that one of the first tangible purchases made by bitcoin was for two pizzas (from Papa John’s of all places) at the going rate of 5,000 bitcoins each, it is rather hard to disagree with the sentiment that bitcoin is too unstable to be actually usable.
Commercial vendors have also been slow to adopt bitcoin, placing its value as a medium of exchange into question. While the number of companies that do accept bitcoin continues to grow, we are still seemingly years away from a sufficiently wide-spread adoption that is needed to make bitcoin a viable alternative to cash or credit in the realm of transactions. The lack of government endorsement, or the ability to pay taxes, is a yet another strike against bitcoin from which many think it will not be able to recover.
If all of the above points are true, how on earth is bitcoin trading at any positive valuation, let alone a five-figured one? For traditional economists the answer is simple: the market must be in the grips of irrational animal spirits that have made bitcoin into our generation’s version of the Dutch tulip mania.
When in doubt, think dynamics
A healthy dose of speculation most definitely is behind some, if not most, of bitcoin’s performance over the past years. However, Felix Martin had it right already in 2014 when he said that bitcoin’s real potential lies in its application as a hybrid payments technology.
In short, bitcoin has the potential to perform all of the functions of traditional money and then some. Most speculators are betting on this potential one day being fulfilled, at which point the criticism levelled by Roubini, Stiglitz and others will seem quaintly luddite instead of Nostradamian.
Put in another way, bitcoin has not failed to become money because it was never meant to be money. Instead, it was built with the potential to act as money as well as to be its own intermediary. This is what sets it apart from all other forms of money today as well as why we need to take a dynamic view when we look at its value today.
Life, and the value of bitcoin, is whatever we make of it
Just as each seller needs a buyer, the value of anything can always be measured by what you can get with it. From this perspective, the UK Financial Services Authority’s former Chair was spot on when he said that the value of bitcoin is “arbitrarily determined by the collective psychology of the mass of investors.” In other words, bitcoin's valuation is partly driven by faith and hopes of higher valuations in the future.
Just like fiat money, bitcoin will work as long a sufficiently sizeable subset of the population has faith in it. Whether this faith is based on a belief in bitcoin replacing cash and credit cards or simply a blind bet on bitcoin increasing in value is immaterial.
What matters is that people continue to exchange and hold bitcoin. Whether they ever use their bitcoins is about as important as whether you ever spend that gold bar you have been hoarding as a defensive asset or whether you have ever exercised your post-IPO voting rights on Uber.
Why 10k won’t be enough
Economics is at its best when it is the science of choice. Regardless of the value of the transaction, a decision to buy, hold, or sell bitcoin must always be assessed in the overall context in which the decision is made. In other words, the appeal and availability of alternative assets is a significant driver of the intrinsic value of bitcoin.
In a world of negative interest rates, escalating trade wars, and an equity-bust waiting to happen, the speculative appeal of bitcoin is likely to trump fears about a lack social function or stability. At the same time, the fact that platforms such as Robinhood continue expanding into crypto-trading will only serve to make the asset class more accessible and further deepen daily trading volumes. This in turn will increase the pull on bitcoin’s valuation, and we are bound to see several more revolutions of the bitcoin hype-cycle as we move into 2020.
And while idiosyncrasies such as government bans and involuntary forks may shake up the scene, one thing is clear: there is nothing stopping bitcoin from trading above USD 10,000. On the contrary, we have every reason to believe that 10k will scarcely be enough as the years go by.
[Anti-disclaimer: I do not own bitcoin nor do I intend to trade in it in the near future. Instead, I plan on spending the next years examining how this new asset matures and how investors' decision-making around it evolves.]
