Bitcoin in the sky with diamonds
The price of bitcoin has tripled in the past two years and is now sky-high around $60,000. But unless you are involved in crime (either as a perpetrator or a victim), bitcoin has almost no practical use. How can something inherently useless have a high price?
That’s the “paradox of value” discussed by Adam Smith in The Wealth of Nations. Consider the price difference between diamonds and water:
Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.
Like diamonds and gold, bitcoin has value because it has value, not because it performs a useful function other than storing value. Now, some might argue that diamonds look pretty, and thus are actually useful, but we all know this explanation doesn’t work: fake diamonds are just as pretty as real diamonds.
You could use different terms to describe gold, diamonds, and bitcoin (such as “bubble” or “money”) but I will describe them as a “store of value.” To me, the two requirements to be a store of value are:
- Fixed supply.
- An enduring belief that other people believe the item is valuable.
The genius of bitcoin is that it uses mathematical mumbo jumbo to meet both these requirements. First, fixed supply is hardwired into the structure of bitcoin. Second, bitcoin has a mathematical mystique and a compelling narrative, as described by Shiller (2018):
And, as in the past, the public’s fascination with cryptocurrencies is tied to a sort of mystery, like the mystery of the value of money itself, consisting in the new money’s connection to advanced science. Practically no one, outside of computer science departments, can explain how cryptocurrencies work. That mystery creates an aura of exclusivity, gives the new money glamour, and fills devotees with revolutionary zeal.
The idea that gold and diamonds are valuable, and will remain valuable in the future, is a shared social belief that has been passed down to us by our ancestors. Samuelson (1958) described this process as a “social contrivance” that could allow people to store wealth over time in the absence of other storage technologies.
In order to assign bitcoin a high value, you don’t actually need to agree with or even understand the arguments made by bitcoin enthusiasts. For example, consider the following tweet from Michael Saylor in 2020:
Bitcoin is a swarm of cyber hornets serving the goddess of wisdom, feeding on the fire of truth, exponentially growing ever smarter, faster, and stronger behind a wall of encrypted energy.
You don’t need to believe in cyber hornets to believe that bitcoin is worth buying today. You just need to believe that other people will continue to value bitcoin in coming years. Similarly, even if you’re an atheist, you might be willing to hold U.S. currency that says “In God We Trust.”
Not everything that is scarce is a store of value; you need to have both finite supply and a self-perpetuating shared belief. Consider rhenium. Like gold, rhenium is a scarce mineral found in the earth’s crust. Rhenium is rarer than gold, difficult to produce, and was only discovered in 1908. So why is it that gold has a price per kilo that is 30 times higher than rhenium? Answer: there is no persistent belief in rhenium’s value, rhenium was not one of the gifts of the magi, and there are very few songs/stories/poems mentioning rhenium.
It is an arbitrary social contrivance that gold is a store of value and rhenium is not. Perhaps in the distant future, gold will lose its luster (Keynes called gold a “barbarous relic”), and rhenium will reign supreme. But for now, rhenium is not a store of value.
Since bitcoin was invented in 2008, bitcoin enthusiasts have launched an unending search for practical applications, the mythical “use case” that would justify bitcoin’s existence. Perhaps this search was unnecessary. All that is necessary for bitcoin to have value is for us to believe that it has value, or rather for us to believe that a significant fraction of the population will believe it has value.
If you’ve ever attended a staged performance of Peter Pan, you know that at some point in the play, Tinker Bell is near death. She will die unless the children in the audience clap, to show that they still believe in fairies. The play was first performed in 1904, and the children have been clapping at every performance since, so Tinker Bell still lives.
Right now, the children are still clapping for bitcoin. How long the applause will last is anyone’s guess.
References
Samuelson, Paul A. "An exact consumption-loan model of interest with or without the social contrivance of money." Journal of Political Economy 66, no. 6 (1958): 467-482.
Shiller, Robert. “The Old Allure of New Money,” Project Syndicate, May 21, 2018.
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