BTC to Zero

A disguised theory of money

Before I go any further, some housekeeping: nothing in this essay is investment advice, the mistakes are my own, and read the whole thing before commenting. 

“Haven’t you heard? $DOGE is going to $1, to the moon. Buy in now!”
“What do you mean ‘why’? It’s going to $1!”
“Well, so you can be rich of course. Then we’ll all sell at $1!”
“What do you mean ‘who’s going to buy it’?”

“If you’re seeing bitcoin on a bus”, says one set of adverts in London, “it’s time to buy”. A rather different view is summed up in the story about Joe Kennedy: “if shoe-shine boys are giving stock tips, then it’s time to get out of the market”.

A simple definition of a bubble is an extended deviation from fundamental value. Bitcoin has no fundamental value. You can’t eat it. You get no enjoyment from it. You’d be better off for entertainment value with a pet rock. The fundamental value is zero. That doesn’t mean its actual value will be. It’s perfectly possible to have rational and sustained bubbles (although as they tend towards multiple equilibria there’s always the disquieting possibility that people might one day wake up, think ‘wait, this is all just digits’, and the whole edifice will vanish in a puff of logic). 

With that said, I don’t think that’s quite where Bitcoin is at the moment. While there are smart, thoughtful cryptocurrency enthusiasts who really are placing bets on the emergence of a new medium of exchange, there are also an awful lot of people posting rocket emojis who are in it to get rich quick. A situation where prices rise because people buy an asset expecting the price to rise and keep on rising is one where the bubble will, eventually, pop. 

This isn’t the same as saying all market participants are irrational. There’s plenty of room for different types of agents with different levels of awareness of what’s actually going on. Some people are buying in the genuine belief that they’ll be able to sell when the asset reaches some ill-defined plateau, and others are quietly trying to time the market to get out before the thing crashes — selling to a ‘greater fool’ — and in order to speculate on the bubble, they have to buy in.

The way people discuss bitcoin and other cryptocurrencies on social media strongly indicates this sort of behaviour to me. If you’re buying in the expectation that Elon Musk will make a joke about Dogecoin and induce more people to buy in the expectation of further price rises, you’re attempting to surf a bubble. 

A more interesting question is whether Bitcoin will go to zero in the long run, or whether it will find a way to sustain a rational bubble. 

Wait. What’s money, anyway?

“It is obvious even to the most ordinary intelligence, that a commodity should be given up by its owner in exchange for another more useful to him. But that every economic unit in a nation should be ready to exchange his goods for little metal disks apparently useless as such…”  — Karl Menger, 1892

Let’s back up a step here. My beef with cryptocurrency is that it doesn’t have any intrinsic value. Fine, says the bitcoiner, but what’s the value of those notes in your wallet? Then I say it’s that it can be exchanged for goods and services (illustrated here), then they ask why it should be accepted and how this is different from buying something with bitcoin, and then I go a funny colour and mumble about how it’s complicated. 

The standard explanations for the use of money run down a few lines; we need a unit of account, we need to be able to store value, we need a useful unit for exchange (small, portable, long-lasting), and we want to avoid the hassle of finding someone to barter with. If you want an economy of any real complexity, barter isn’t going to cut it; I need to be able to obtain goods and services from people who aren’t interested in (for instance) rambling essays on economics. 

But when it comes to actually reasoning out why people then choose to transact in money, models are infuriatingly vague. They handwave about the need to have cash in hand to carry out a transaction, or assume people gain utility from holding little bits of paper. Why exactly are people willing to assume money has value?

Samuelson comes out with a simple explanation: money is a social collusion, unofficially agreed through custom, that these pieces of paper have value. Because we all expect it to have value tomorrow, we — hang on, isn’t this a bubble? Well, yes*. And in fact that’s a very standard way of explaining the existence of money. There’s a need for something to fulfil this role, and we’ve coordinated on bits of paper. 

In fact, we can go further than that. The intrinsic value of gold is determined by its use in manufacturing electronics, and in decoration. Say what you will about the weight of tens of thousands of years of history in giving gold a certain aura, but I doubt the market price of gold reflects only these sources of demand. There is a certain level of entertainment in the idea that the people who decry fiat currency are actually just lobbying for a different sort of bubble, but the reality is that something resting on a social norm absolutely does not make it flimsy.

This is in fact one of the arguments for Bitcoin continuing to hold value; anyone can start a cryptocurrency, just as anyone can start printing bits of paper with their face on them and declare it a private currency, but that doesn’t mean other people will coordinate on their use. Bitcoin was first, so it has history on its side. 

But what money has on its side that Bitcoin does not is the backing of the state. As Abba Lerner observed, “the modern state can make anything it chooses generally acceptable as money… if the state is willing to accept the proposed money in payment of taxes”. This is of course exactly what some prominent Bitcoin advocates want to move away from. 

Bitcoin is not good at being (mainstream) money

So far I’ve been talking about bitcoin as proper money, something people use as a medium of exchange. The problem with this is that, frankly, it’s bad at it. It’s slow, can’t be scaled, and deflation is inbuilt. If you’re basing your valuation of Bitcoin on cryptocurrency becoming a mainstream medium of exchange, there are better coins out there. 

What Bitcoin is good at being is a highly volatile way to hold value for people who might not want to use regular currency. You can access it no matter where you are in the world, you don’t need to deal with a bank or institution to store it, and it’s pseudonymous (every transaction is public but tied to an address rather than a name). There’s a reason the group involved in the Colonial Pipeline hack asked for payment in Bitcoin. Rather than displacing money entirely, all Bitcoin has to do is become the socially-agreed-upon mechanism of exchange for underground transactions.

We can even take a very back-of-the-envelope guess at what that might look like in terms of valuation. The global economy is about $88 trillion. Let’s say something like 5% of this is criminal activity, and half of that might feasibly be conducted in Bitcoin. The total number of Bitcoins that can ever exist is 21m, and 3.7m of these have been permanently lost. At one point last year — as I read this chart — the average coin changed hands about 20 times, so the average coin still in circulation changed hands about 25 times. That gives us a value for Bitcoin of around $5,100 today, and a growth rate equal to that of the criminal economy. 

The problem with this is that it’s self-defeating. If Bitcoin is associated with criminal activity rather than speculation — and I would suggest that governments are very unlikely to react well to the idea of losing control of the monetary system to the degree that mass adoption would entail — then governments are likely to treat it as such. 

Which is to say in the long run? BTC -> 0. 

*(Paul Krugman has written a piece arguing that social norms are distinct from bubbles; I don’t think we disagree on the material elements of the stability of value, just on the technical grounds of whether rational, stable bubbles qualify as such. I say that they do.)