How Do Classical Economic Theories Value Bitcoin?

About 700 years before Sweden issued the first European banknotes in 1661, China cracked their head on how they could lighten the load of the people carrying copper coins everywhere they go.

These coins made life difficult: it is heavy and it can make traveling dangerous. Subsequently, merchants decided to deposit these coins with each other, issuing paper certificates for the coin’s value.

The private issuance gave rise to soaring inflation and devaluation: the government swooped in after, issuing their own banknotes backed by gold reserves, arguably becoming the first legal tender in the world.

Over the past few centuries, countries began to adopt the ‘Gold Standard’, using commodities like gold and silver to mint coins that had a certain weight. That represented a certain amount of value until the coin is tampered with, which led to the rise of representative money.

Banks issued ‘gold certificates’—having a note with a denominator of 50 meant that you could exchange this note for $50 worth of gold.

Then, in 1944, the Bretton Woods system determined that the forty-four countries present at the meeting would keep their currencies fixed to the US dollar since it was backed by gold reserves.

That essentially meant the US dollar could be converted to gold at any time.

That worked well, but not for long. Growing public debt, monetary inflation and, negative balance of payments meant added pressure to the US dollar. In response, some European countries even left the system to redeem their dollars for gold.

By then, there were more dollars than gold in their reserves.

This changed in 1971 when former US President Richard Nixon closed the gold window: foreign governments had too many US dollars and the US was vulnerable to run on gold. Together with fifteen other advisers, they announced the new economic plan to stave off inflation, lower unemployment rate, and transform the US dollar into fiat—essentially relying on the consent of currency users rather than commodities and standards.

Hence, you are counting on whether parties will accept your currencies, powered by pure faith.

The same could be said for bitcoin, a cryptocurrency that once hit an all-time high of US$19,783.06. What is it that is giving Bitcoin its value? Claiming that it is through supply and demand does not seem to cover the whole picture: it is backed by nothing, controlled by no one.

At the very least, you could depend on legitimate governing bodies to uphold a currency’s value.

Bitcoin was created with fiat characteristics. Yet, no one ‘owns’ bitcoin, in the governance sense. It also seemingly operates the same way as fiat cash does but the inherently different ecosystem leaves economists and financial experts thinking: who actually gives it its price?

class CInputCoin {
public:    
CInputCoin(const CTransactionRef& tx, unsigned int i) {        
if (!tx)            
throw std::invalid_argument("tx should not be null");

You’re looking at five of the million lines of code in bitcoin. Originally only a few thousand lines of code, bitcoin was developed by Satoshi Nakamoto in 2008 before its release in early 2009. Nakamoto detailed the concept of bitcoin in the famous whitepaper titled Bitcoin: A Peer-to-Peer Electronic Cash System. 

The original vision was to create a form of cash that did not require going through a financial institution, due to its cryptographic nature.

The biggest innovation was its utilization of Blockchain technology. Every Block represents a transaction made in the bitcoin network—the more Blocks there are, the longer it goes.

Thus, it forms a ‘chain’, giving it its name. For a block to appear, miners needed to use raw computer processing power and heaps of electricity to verify that a transaction between person A and B, with X value and Y time, does exist.

When it gets confirmed, the block appears and the transaction goes through. The miner is rewarded with Bitcoin.

Yet, this digital currency had no intrinsic value—it cannot be used as a commodity. Bitcoin skeptics would often argue that for it to viable, it must be first be accepted and used for some other commodity purpose.

Slowly, it will then become money over time. For instance, people stockpiled gold to store value since it was used in jewelry and electronics.

In one of Austrian economist Carl Menger’s seminal works, he began describing money as “the fact of certain commodities becoming universally acceptable media of exchange”. Fellow economist Ludwig von Mises built on Menger’s work, attributing commodity money to sort of money that is “at the same time a commercial commodity. Fiat money is money that is comprised of “things with a special legal qualification”.

“…the name fiat money to money that comprises things with a special legal qualification…”—Ludwig von Mises, The Theory of Money and Credit

The idea of intrinsic value is persistent in mankind: even Aristotle wrote about why money needs to be intrinsically useful. Essentially, whatever currency it was, it must derive its value from being useful in itself. This argument breaks down as history shows that commodity value is not needed for anything to become money.

Through Africa and parts of North America, glass beads were used for monetary purposes, even though they proved to be of little use as a commodity. The Yap people in the Pacific used limestone coins as money.

Bitcoin skeptics often used the intrinsic value argument to denounce bitcoin’s survivability. Unfortunately, the Bitcoin is a purely digital existence, thus making it free from the restraints of the physical world.

It does not need to be inherently valuable like gold and neither does it need special rights granted by others to make it a fiat money.

Though that may seem like an explanation—Bitcoin being a whole new entity free from our mortal rules—it still does not make complete sense.

Think of it this way: Bitcoin and fiat are both different financial ecosystems.

Fiat belongs to the physical world, which thus brings other monetary restraints. Power goes to those who control the currency and the Central Bank can always print more banknotes to drive inflation and circulation.

Yet, no one can tell you exactly how many physical dollars are there floating in the world.

Gold has limited supply but that can be subjected to inflation. If someone finds a large amount of gold outside of the current supply, ownership can be radically diluted. Innovations in material science may also reduce the need for using gold in electronics and consumer products.

Bitcoin’s digital nature calls for a new theoretical foundation. Economists have long realized the constraints of precious metals and fiat. Hence, bitcoin’s introduction gave rise to a new set of rules, one that many dubbed as an upstart financial ecosystem.

The problem is both the fiat and cryptocurrency ecosystem cannot truly co-exist, as bitcoin maximalists will tell you. With no inherent value as a financial instrument, investment product or security, the biggest bet is to have bitcoin become a global currency.

Today, the global money supply (M1), stands at $7.6 trillion. If you add in checking deposits, short-term bonds, time deposits, and other financial instruments, that comes to a whopping $90 trillion. To become a global currency, bitcoin needs to be worth at least the global money supply—that is not the case, as bitcoin’s market capitalization is barely USD$130 billion at the time of writing.

However, burgeoning sovereign and foreign debt may spur investors to start finding a reflation hedge more accessible and fungible than gold. That may drive bitcoin’s valuation since it has utility as a store of value. To combat inflation, many were content to hold USD, EUR or JPY in their portfolio— Argentineans and Venezuelans did that with the relatively stable USD.

To become a global currency, Bitcoin needs to be worth at least the global money supply—that is not the case, as bitcoin’s market capitalization is barely USD$130 billion at the time of writing.

That may give it utility value: bitcoin can function as a store of value.

Let’s view it as an asset. If it is, then bitcoin is inherently a disinflationary one. To incentivize network growth, 50 new bitcoins were minted every time a new block in the blockchain was created.

After every 210,000 blocks, the reward will be halved (every block now gives 12.5, which will be halved to 6.25 on 14 May 2020). Along with built-in scarcity with a supply cap of 21 million bitcoins, it is a small wonder why people and financial institutions alike can view bitcoin as a hard currency (aka safe-haven currency).

That means the built-in monetary policy is driving Bitcoin’s purchasing power—but what determines it’s price?

If you look at the classical school of economics, you can argue that Bitcoin’s price is determined by its production cost. That means hardware and electricity. As Bitcoin continues to experience disinflation, the number of miners will gradually dwindle as it gets too costly to mine.

Despite so, there are still miners who are willing to do it at a loss, which may suggest that there are people who are hedging on bitcoin’s rise again in the future: price does not solely depend on production costs, albeit it being a factor.

The neoclassical school of economics expanded on that theory, adding another objective factor to it: supply and demand. Since the supply of bitcoin is capped and the number of bitcoins being mined will diminish over time, demand for more bitcoins may rise. More demand equals to higher prices.

Relying on only objective factors does not seem to paint the full picture either. If production cost is a major reason, then bitcoin should be marginally close to being worth as much as the broad money supply (M3) for the US.

Despite so, miners are at a loss, even though it costs more to mine Bitcoin.

If the equilibrium of demand and supply matters, then Bitcoin’s clear-stated and audited supply cap should determine a consistent demand. Yet, bitcoin is still prone to extreme volatility with the potential to crash and skyrocket within the same day.

Enter the Austrian school of economics, which bitcoin backers are very much adopters of. The Austrian economists believed that the price of anything is determined by subjective factors, even the cost of production. Supply and demand is determined by individual preferences.

As such, it can explain bitcoin’s value—perceived value and subjective factors may be a bigger player here.

It can be seen that there’s no clear explanation as to why cryptocurrency—or even money—has value. Bitcoin’s price, in this case, seems to be driven by a blend of classical economic models, sentiment and in-built monetary policies.

However, regardless of the economic theory that one adopts, cryptocurrencies are still poised for a financial revolution. If it can evolve into an alternative form of global money, the world financial ecosystem will be overturned (for good or worse, we do not know).

Ultimately, Bitcoin is a launchpad for financial experiments. Utilizing blockchain technology spearheaded the cryptocurrency boom from 2016–2017, which leads to a whole new world of blockchain innovations. Today, we are looking at actual stable cryptocurrencies that can maintain a consistent price of $1, using a mix of asset-pegging and reserve-banking concepts.

Rather than thinking of Bitcoin as a form of currency, think of it as a payment system.

Thus, the true value of Bitcoin lies in its network. The more people involved, the better. Essentially, that means bitcoin’s value depends on who owns it. Today, as bitcoin adoption (not for daily usage, but for investment and trading) grows, more and more curious people are coming on board this new technology. That means more distribution.

However, for Bitcoin to truly function the way it was intended to do, it needs to rid itself of miner and mining pools by switching to a Proof-of-Stake (PoS) system. Bitcoin’s Proof-of-Work system makes transactions unusually expensive—miners are burning millions to verifying bitcoin transactions on the network with electricity and raw computer processing power.

With the PoS system, bitcoin will be valued for its network. Majority stakeholders will let go of a portion of their holdings to allow the network to grow, thereby proportionally growing their holdings.

It sounds simple, but a majority of bitcoins today are mined by China miners. If it can replace, for instance, the broad money supply in the US, what would give the administration a reason to adopt a global currency controlled by miners from an opposing superpower?

If superpowers are unwilling, why would smaller nations follow? The global currency goal seems like a pipe dream, but in the end, whether Bitcoin is going to work or not will depend on who you are hearing it from, just like where it gets its value from.