How Bitcoin is somehow worth more than the paper it’s printed on

Bitcoin and similar blockchain-based cryptocurrencies exhibit the same radical divergence from the traditional economics of scarcity that we first saw when MP3 and Napster cut physical album sales at the turn of the century. Unlike gold, which derives its value from both its myriad uses in fashion and industry and the difficulty of mining it from Earth, acquiring a new Bitcoin is as simple as digitally mining more stuff. In his latest book, The future of money, Senior Professor of Trade Policy at Cornell University, Eswar S Prasad cleverly examines how we collectively place value on these digital constructs and what that means for the economy of tomorrow.

The dust jacket of the future of money

Copyright © 2021 by the President and Fellows of Harvard University. Used with permission. All rights reserved.

At a conference in Scotland in March 2018, then-Bank of England Governor Mark Carney observed that “the prices of many cryptocurrencies have exhibited the classic characteristics of bubbles, including justifications for new paradigms, widening enthusiasm. retail and extrapolative price expectations that depend in part on finding the biggest fool. “The last sentence of his statement was an allusion to the period of seemingly steadily rising home prices during America’s housing boom of the early to mid-2000s. the 2000s. The high and rising real estate valuations seemed to be based on the notion that all it took to make money on a house bought at inflated prices was to find a single buyer, a fool even greater than yourself, willing to pay an even higher price.

Carney’s speech came immediately after another by Agustín Carstens, director of the Bank for International Settlements; he described Bitcoin as “a combination of a bubble, a Ponzi scheme, and an environmental disaster.” Skeptics, including central bankers and academics, correctly note Bitcoin’s extremely volatile prices and the periodic price crashes it has experienced. In fact, from an economist’s perspective, there is no logical reason why Bitcoin should be priced beyond its value by providing an anonymous payment mechanism, much less the kind of value it has. However, even when it has been stripped of any pretense of being an efficient medium of exchange, Bitcoin has kept the faith of its followers. It seems not only to persevere, but it has become an increasingly precious store of value, or perhaps more accurately, an attractive speculative asset (at least as this book is written, this could all change in a moment). What explains this?

To address this question, we must first consider what gives a financial asset, tangible or not, economic value. On the one hand, an asset represents a claim on future goods and services. Owning a share or debt issued by a company is a right to the future earnings of the company, which in turn is based on its ability to create real products or services that have monetary value. The same goes for real estate, which provides real services to owners or tenants that can be monetized. Owning a government bond is, in principle, a claim on future government income, which could come from taxes or other sources.

Gold is different. It has intrinsic value based on its industrial use, and is also used in jewelry (and dental fillings). But its market value seems much greater than its intrinsic value based on these uses. Gold seems to derive its value primarily from scarcity rather than utility or whatever claims it offers for a future flow of goods and services. It is clear that scarcity alone is not enough; there also has to be enough demand for an asset. Such a claim could hang by as thin a thread as a collective belief in the asset’s market value; If you think there are other people who value gold as much as you do, and enough people feel the same way, gold has value.

So is Bitcoin just a digital version of gold, with its value primarily determined by its scarcity? The twenty-one million bitcoin limit is hard-coded into the algorithm, making it sparse by construction. But there must still be demand, as even Bitcoin cannot escape the basic laws of the market economy, especially price determination based on supply and demand. Of course, such demand could be purely speculative in nature, as appears to be the case now that Bitcoin is not performing well as a medium of exchange.

Large amounts of computing power and electricity are required to mine Bitcoin, and unfortunately, computers and electricity must be paid for with real money, which is still represented by fiat currencies. It has been argued that Bitcoin’s reference price is determined by this mining cost. One research company estimated the electricity cost of mining a bitcoin in the United States to be approximately $ 4,800 in 2018. Another company estimated the equilibrium total cost of mining a bitcoin in 2018 at $ 8,000, suggesting that this was a flat for its price. But this is not reasonable logic. The fact that something requires a lot of resources to produce is not enough to create demand and therefore justify its price.

Bitcoin devotees, it goes without saying, have an answer for this; Given the technologically inclined nature of this community, it had to be a quantitative model. The model, if it can be called that, uses the relationship between existing stock and the flow of new units as an anchor for price.

Consider gold. The total stock of gold that exists in the world (above ground) is estimated at about 185,000 metric tons. Each year, approximately 3,000 tons of gold are mined, which is equivalent to approximately 1.6 percent of existing stocks. Therefore, the inventory-to-flow ratio is approximately sixty. It would take so many years for annual gold production, assuming it continues at the average rate, to replicate existing stocks. For silver, this ratio is approximately twenty-two. The logic of this pricing model seems to be that even doubling the annual rate of gold or silver production would leave their stock-to-flow ratios high, in which case they would remain viable stores of value with high prices. Physical supply constraints (increasing mining operations would take a long time) mean that there is little risk that a sudden surge in supply will knock down existing stock prices. In contrast, for other less precious commodities, including metals such as copper and platinum, existing stocks are equal to or less than annual production. Therefore, as soon as the price starts to rise, production can be increased, avoiding large price increases. With these commodities, prices are more closely linked to values ​​based on industrial and other practical uses.

In 2017, the stock of Bitcoin that had been mined was estimated to be around 25 times larger than that of new coins produced in that year. This is high, but still less than half the gold stock-to-flow ratio. Around 2022, Bitcoin’s stock-flow ratio is expected to exceed that of gold. Therefore, if one accepts this logic, the price of Bitcoin must eventually go up.

This assessment is based entirely on a shaky foundation of faith. As one influential Bitcoin blogger puts it: “Bitcoin is the first rare digital object the world has ever seen. . . . Without a doubt, this digital scarcity has value. “This blogger makes abundant allusions, which are repeated in most of the websites and chat forums frequented by Bitcoin followers, to how Bitcoin and gold are analogous:” It is [the] Constantly low rate of gold supply which is the fundamental reason why it has maintained its monetary function throughout the history of mankind. The high stock-flow ratio of gold makes it the commodity with the lowest price elasticity of supply. “Fiat money and other cryptocurrencies that have no supply cap, no proof-of-work consensus protocol, and no need for large amounts of computing power to keep running are seen as less likely to retain value because their supplies are unrestricted and can be influenced by the government or small groups of individuals or stakeholders.

Clearly, logic and reason are not important fundamentals of Bitcoin valuations. And it’s hard to argue, as I’ve learned, with a twenty-five-year-old who bought his first bitcoin at $ 400, then kept buying, and now sees every drop in Bitcoin prices as a buying opportunity to add to his stash. But, as an economist, you care about that young man (with whom I sat at a conference in January 2019 and with whom I ended up having a long and heated discussion) and others who have bet their life savings on Bitcoin and others. CRYPTOCURRENCY. On the other hand, with Bitcoin’s price being April 2021, it might have been better to spend my time in recent years acquiring some bitcoins rather than working on this book.

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