Bitcoin and similar blockchain-based cryptocurrencies show the same radical departure from the traditional economy of scarcity we first saw when MP3 and Napster sold physical albums at the turn of the century. Unlike gold, which draws its value from countless uses in fashion and industry, as well as the difficulty of extracting gold from Earth, acquiring new bitcoin is as simple as digitally digging up more things. In his latest book, The future of money, Senior Professor of Trade Policy at Cornell University, Eswar S Prasad skillfully examines how we collectively assign value to these digital constructions and what this means for the economy of tomorrow.
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At a conference in Scotland in March 2018, then-Bank of England Governor Mark Carney noted that “the prices of many cryptocurrencies have shown classic bubble signs, including new paradigm justifications, expanding retail enthusiasm and extrapolative price expectations that rely in part on finding bigger fools. “The last phrase in his statement was an allusion to a period of seemingly ever-rising real estate prices during the U.S. housing boom from the early to mid-2000s. The high and rising real estate values seem to have been based on the idea that everything needed to make money from a house bought at inflated prices was to find only one buyer – an even bigger fool than himself – willing to pay an even higher price.
Carney’s speech was followed by another Agustín Carstens, head of the Bank for International Settlements; described Bitcoin as “a combination of bubbles, the Ponzi scheme, and an environmental disaster.” Skeptics, including central bankers and academics, rightly note the extremely volatile prices of Bitcoin and the periodic price collapses it has experienced. Indeed, from an economist’s point of view, there is no logical reason to value bitcoin above its value in providing an anonymous payment mechanism, let alone the type of value it manages. Yet, although it has removed all threats of being an effective medium of exchange, Bitcoin has retained the faith of its supporters. Not only does it seem to persevere, but it has become an increasingly valued storehouse of value – or perhaps more accurately, an attractive speculative asset (at least as this book is being written – it could all change in an instant). What explains this?
To answer this question, we must first consider what gives financial assets, tangible or not, economic value. On the one hand, assets represent receivables from future goods and services. Possession of shares in shares or debts issued by a firm is a claim on the firm’s future earnings, which in turn is based on its ability to create actual products or services that have monetary value. The same goes for real estate that provides homeowners or renters with real services that can be monetized. Possession of a government bond is in principle a claim on future government revenues, which could come from taxes or other sources.
Gold is different. It has its intrinsic value based on industrial use, and is also used in jewelry (and dental fillings). But its market value seems far greater than its intrinsic value based on these uses. Gold seems to derive its value mainly from scarcity, not from its usefulness or any demand it offers about the future flow of goods and services. The deficiency alone is clearly not enough; there must also be sufficient demand for the property. Such demand could hang on a slender thread as a collective belief in the market value of an asset – if you think there are other people who value gold just as much as you and enough people feel the same, gold has value.
So is Bitcoin just a digital version of gold, the value of which is determined largely by scarcity? The limit of twenty-one million bitcoins is hard-coded in the algorithm, which makes it a scarce construction. But there still needs to be demand for that, because even bitcoin cannot evade the basic laws of the market economy, especially pricing based on supply and demand. Such demand could, of course, be of a purely speculative nature, as it seems even now that Bitcoin is not functioning well as a medium of exchange.
Bitcoin mining requires large amounts of computing power and electricity, and unfortunately computers and electricity have to be paid for with real money – which is still represented by fiat currencies. It was claimed that the base price of Bitcoin was determined by this cost of mining. One research company estimated that the cost of electricity to mine one bitcoin in the United States is about $ 4,800 in 2018. Another company estimated the total cost-effectiveness of bitcoin mining in 2018 at $ 8,000, suggesting it represents a lower price. But this is hardly reasonable logic. Just because something needs a lot of production resources is not enough to create demand for it and, therefore, to justify its price.
Needless to say, Bitcoin fans have an answer to 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 ratio of existing stocks to the flow of new units as an anchor for price.
Imagine gold. The total gold reserves that exist in the world (above ground) are estimated at about 185,000 metric tons. Approximately 3,000 tons of gold are mined annually, accounting for about 1.6 percent of existing reserves. Thus the ratio of supply and flow is about sixty. It would take so many years for annual gold production, assuming it continues at an average rate, to reproduce existing stocks. For silver this ratio is about twenty-two. The logic of this pricing model seems to be that even doubling the annual rate of gold or silver production leaves their stock-to-flow ratios high, in which case sustainable stock values with high prices remain. Physical constraints in supply – accelerating mining operations would take a long time – mean there is little risk of a jump in supply that would bring down the prices of existing stocks. In contrast, for other less valuable goods, including metals such as copper and platinum, existing stocks are equal to or lower than annual production. Therefore, as soon as the price starts to rise, production can be increased, thus preventing large price increases. For these products, prices are more closely related to values based on industrial and other practical uses.
In 2017, the Bitcoin stock mined was estimated to be twenty-five times larger than the amount of new coins produced that year. It is high, but still less than half the ratio of stock to flow for gold. Around 2022, the ratio of stocks and flows of Bitcoin is expected to surpass that of gold. Therefore, if this logic is accepted, the price of Bitcoin must eventually rise.
This valuation is built entirely on the fragile foundations of faith. As one influential blogger says about Bitcoin, “Bitcoin is the first scarce digital object the world has ever seen. . . . Surely this digital scarcity has value. ”This blogger gives abundant allusions, which are repeated on most websites and chat boards visited by members of Bitcoin, to how Bitcoin and gold are analogous:“ It is [the] consistently low rate of gold supply, which is the main reason for maintaining the monetary role throughout human history. The high ratio of inventories to the flow of gold makes it a commodity with the lowest price elasticity of supply. “Fiat money and other cryptocurrencies that have no supply limit, no proof of consensus protocol, and no need for large amounts of computing power to continue working are considered less likely to retain value because their stocks are unlimited and may be affected by government or small groups of individuals or stakeholders.
Obviously, logic and reason are not the essential foundations of bitcoin valuation. And it’s hard to argue, as I’ve learned, with a 25-year-old who bought his first bitcoin for $ 400 and then kept buying, and now sees every drop in the price of bitcoin as a buying option he can add to his stock. But as an economist, one worries about that young man (with whom I sat next to at a conference in January 2019 and with whom I ended up talking long and hard) and others who put their life savings on Bitcoin and other cryptocurrencies. On the other hand, given the price of bitcoin which is in April 2021, maybe my time would have been better spent in the last few years on purchasing some bitcoin rather than working on this book.
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