Why Bitcoin is not (necessarily) in a Bubble

With the meteoric rise in the price of Bitcoin this year (above $9k/BTC) there is a lot of talk about Bitcoin being in a bubble.

Here is a recent article that takes this stance. https://www.bloomberg.com/news/articles/2017-11-27/citadel-s-ken-griffin-says-bitcoin-bubble-may-end-in-tears

There are some common themes in articles like this, viz.

1. Bitcoin has no intrinsic value (compared to say a Stock, commodity currency like Gold or Fiat currency like the US Dollar)
2. There has been a huge price runup recently.
3. The price rise is based on the greater-fool-theory

Point #1 is the key point to address as it relates to the idea of ‘fair value’ and thus implicitly covers points #2 and #3.

If the fair value is greater than the current price, then the recent huge runup is not a long-term problem and #3 can be re-phrased to the price rise is based on the ‘bet-on-the-yet-to-be-convinced’ rather than ‘bet-on-the-greater-fool’ theory.

So, it all hinges on the fair or true value of Bitcoin. One of the arguments that I see over and over again to prove that Bitcoin is overvalued (or should not have any value at all) is that it has no ‘intrinsic’ value.

This is based on a flawed understanding of currencies. This is best understood in comparison to commodity currencies like gold.

Currencies like gold have both an intrinsic value (use in Jewelry, industrial uses etc.) as well as marketability value.

Marketability value is basically an economic actor’s belief that if they accept payment in (say) gold, they will likely be able to use it to buy something else in the future.

Marketability value also goes by the name of network-effect-value, liquidity value or (to the naysayers) greater-fool-value.

Now it turns out that for commodity currencies like gold the marketability value far outstrips the intrinsic value. So, the best one can say about intrinsic value is that it provides a floor on the value of the currency.

The other thing about intrinsic value is that it is one mechanism for the bootstrapping of a traded commodity into a currency. This is in fact the Austrian economist theory of the origin of money. [Ironically, a significant proportion of Austrian economists who are all about sound money (which bitcoin could be) assert that Bitcoin cannot (or should not) exist because it wasn’t bootstrapped from an intrinsic value (commodity) source!]

So, if a currency can somehow bootstrap into marketability, liquidity or network effect without intrinsic value, then at that point the lack of intrinsic value is much less relevant. The intrinsic value just provides a (pretty low) floor to the currency value.

The question of how Bitcoin bootstrapped to network effect without intrinsic value is a question for another post. (which will no doubt bring down the wrath of the Austrians on me).

Back to the question of whether Bitcoin is in a bubble or not. According to the arguments presented above, we cannot say for sure that the lack of intrinsic value automatically means that bitcoin is in a bubble and that is the main point of this post.

Bitcoin may be in a bubble, but that depends on whether the network effect will continue to accelerate or whether there will be a loss of faith and a reversal of the network effect.

Arguments that the network effect will continue to accelerate:

• Bitcoin has name and brand recognition as the leading cryptocurrency
• It is a plausible winner in the “store-of-value” use case. If bitcoin were to “win” this use case, then a much higher value could be plausibly argued than even today’s high value.
• It has shown staying power over a relatively long period of time with huge swings in between. (10 years)
• More people come to understand that bitcoin is potentially sound money (with its 21 million cap on number of bitcoins) and thus a good store of value.
• High switching costs to another (potentially somewhat superior) network. Network effects tend to be powerful.

Arguments that the network effect will terminate or even reverse

• A much better cryptocurrency comes along and displaces it.
• Currencies have historically been used as a store-of-value AND a means-of-exchange. With bitcoin’s well-known scalability problems it may not be able to function as a means-of-exchange for low value exchanges. This would marginalize it to the so-called settlement layer. This is mitigated by two factors. Firstly, Bitcoin may solve its scalability issues. Secondly it’s not obvious that it being unable to be used for low value exchanges is a death knell for the store-of-value use case.
• A catastrophic bug or discovery of some fundamental weakness in the protocol.
• Significant government crackdown on cryptocurrencies in general and bitcoin in particular.
• Governance issues cause bitcoin to become unresponsive to the market. More hard forks, confusion and brand dilution amongst consumers.
• The lack of intrinsic value can exacerbate an unwinding of network effects (i.e. panic) which may be triggered by other factors due to the lack of even a low (intrinsic) floor on value. This is the true impact of bitcoin not having intrinsic value. Some cryptocurrencies can and will go to literally zero value.
• Usability challenges for mainstream adoption. For example the conundrum of how you keep your private key so secure that no one can find, destroy or steal it, but that somehow you can find it and use it (and also safely will it).
• Bitcoin is deflationary and economies cannot run with a deflationary currency. This is an interesting topic all by itself. Firstly it presupposes that bitcoin becomes the predominant currency which seems far-fetched at this point. Secondly there are plausible arguments that deflationary economics leads to a different kind of economics which is skewed heavily towards high-returning investments over consumption. Given the number of interacting variables in an economy, it remains to be seen if an economy cannot be run successfully in a deflationary model.
• Too much volatility to be a store of value. Clearly, the huge volatility we currently see argues against Bitcoin winning the ‘store-of-value’ use case. However, bitcoin is volatile precisely because the potential end-prize is so large that small changes in assumptions now have massive impacts on belief of whether the end-prize is achievable. In supply chain this is sometimes called the bullwhip effect. If bitcoin continues to gain (or lose) market share in the store-of-value use case, this volatility will automatically start to dampen as participants become more sure about the outcome.

All of the above are major risks to bitcoin, but must be balanced against the significant strengths of bitcoins in assessing whether we are currently in a bubble.

As with most bubbles it is hard to tell whether one is in a bubble except in retrospect. Different economic actors will weigh the above factors differently.

To summarize this article, bitcoin may or may not be in a bubble. But the lack of intrinsic value and current run up in price are not automatically reasons to assert that we are in a bubble.