How we know Bitcoin is not a bubble

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How we know Bitcoin is not a bubble

The Value of Money

(NakamotoInstitute) No matter how many times Bitcoin grows by orders of magnitude,
holdouts still remain who argue that it is a bubble destined to fail. To
address this claim, I will describe a theory that describes how to
appraise Bitcoin according to the Austrian theory of money.
In Austrian economics, money is valuable because it is liquid. This
means that a given value of money is demanded everywhere and can easily
be traded for goods. For example, say I had enough bitcoins to buy a
100-oz gold bar. In late 2010, this would have been worth around one to
two million bitcoins and would have been impossible to sell on the open
market without drastically affecting the price. By contrast, in early
2014, 100 ounces of gold was worth about 100 bitcoins, and this amount
could easily have been traded quickly on one of the major exchanges
without affecting the price noticeably. Thus, in early 2014 Bitcoin was
more liquid than in late 2010, and was therefore a better currency.
Unfortunately, this insight about the value of money does not give us
a means of appraising it because the liquidity cannot be separated from
the price. This is kind of a problem—it sounds like a circular argument
because it says that Bitcoin’s value is caused by its price! This
allows for no way to detect whether Bitcoin is overvalued or
undervalued.
In order to prevent this model from being causally circular, a time
element is required. Our observations about money come from the past,
whereas our judgments about its value are about the immediate future.
This makes the value of money into a positive feedback loop. If the
network is growing, then it will tend to continue to grow, whereas if it
is shrinking, it will tend to continue to shrink.
This model of money has no independent quantity that estimates
anything like an underlying value. Any price is as good as any other—the
only thing that matters is the direction it is moving. This is not
really an appraisal after all—but it is still the right way to
understand Bitcoin’s price.

Bubbles

In the short term, there is money to be made by buying anything whose
price is showing an upward trend if one spots the trend early enough.
In other words, if one can predict that other people are likely to
appraise a good more highly in the future, regardless of whether that
appraisal is rational or irrational, then it makes sense to buy into the
change of sentiment. If lots of people begin to think this way, then
they can create a positive feedback among one another and bid up the
good beyond any rational appraisal of it. This is a bubble.
A bubble bursts because eventually people have to get around to using
a good for its ultimate purpose. Once it is understood that the people
who actually use the good are being bid out of the market, then the
price crashes because people stop predicting higher and higher
appraisals to the price.
Money, however, need not have any ultimate use. It may only ever
passed around from person to person, without ever being consumed. A
stock is valued by the sum of its interest-adjusted dividends. A bond is
valued by its redemption value adjusted by the interest rate and the
risk of default. A commodity is valued by the value of the goods it can
be used to produce. However, for money, there is no independent quantity
to provide a reality check. All money is like a bubble that never
bursts.

Metcalfe’s Law

Some of the theory of money can be understood in terms of Metcalfe’s law
from computer networking. Metcalfe’s law says that the value of a
network is proportional to the square of the number of nodes. The
rationale is that the network should be valued according to the number
of connections it supports, which is approximately proportional to n2 (for large n).
Consequently, as the network grows, it presents a better and better
opportunity for new members. As new members enter, the network improves
for all its present members.
Metcalfe’s law must be adjusted slightly to apply to media of
exchange because some nodes in the trade network will be more valuable
than others. Those who have a lot of the medium are potentially able to
spend more than those who have little. Therefore, use the market cap of
the medium of exchange as n instead of the number of people.
Similarly, some transactions are also worth more than others, so it
makes sense to use the transaction volume rather than the number of
transactions.
A striking test of Metcalfe’s law in Bitcoin recently appeared on the Bitcointalk forums, created by Peter R. I have made my own chart here.
Metcalfe's Law
This chart plots the market cap in blue and the square of the
transaction volume excluding popular addresses in green. The axis on the
is the price in dollars. Exactly as Metcalfe’s law predicts, the
transaction volume increases very neatly as the square root of the size
of the network. The correspondence is beautiful. I wish I had thought to
make it first!
I would like, however, to criticize the interpretation of the
diagram. On the original Bitcoin Talk, thread, the green plot has been
labeled as the “Metcalfe Value”, as if it is an appraisal of the Bitcoin
that estimates what it could cost.
This interpretation is incompatible with the theory of the value of
money I presented above. In my theory, the value causes the
transactions, whereas in the diagram, the transactions cause the value.
However, it is only potential transactions that cause the value. Past
transactions are of no value to anybody. The present size of the
network and the consequent opportunities is likely to provide tomorrow
will motivate people to buy and sell today.
This may seem like hair-splitting, but a confusion of cause and
effect can have serious consequences. For example, many people believe
that it is necessary to spend bitcoins and increase the transaction
volume in order to make Bitcoin more valuable. Of course this is
nonsense; all this does is fill up the network with transactions for
things that nobody actually wanted. That does not present a good value
for a newcomer because he will want a network that presents him with real
opportunities, not just ways of artificially increasing transaction
volume. The more that the Bitcoin network is focused on artificially
increasing the transaction volume to make it look good, the more it
resembles a Ponzi scheme. Rather, to make the network more valuable, we should be hoarders. This is more likely to present newcomers with lots of potential uses for Bitcoin as a medium of exchange.

Appraising Bitcoin

A real good, of course, can have value due to a network effect and some productive use. Gold, for example, can be money and used as components in electronics. If there were ever a time when gold were used only
for electronics, but were then to acquire use as money once a network
effect formed around their price, an investor might be excused to call
the price an unsustainable bubble. However, it would turn out to be a sustainable bubble that inflates until it fills the entire economy. At least until Bitcoin came along.
This brings us to Bitcoin. To what extent is Bitcoin’s price a
rational appraisal or an investment bubble? The answer is easy, much
easier than with a commodity like gold. Bitcoins have almost no use
other than as a medium of exchange. Thus, the fact Bitcoin has any
price at all is evidence that there is a real network effect. It is
much easier to prove that Bitcoin acts like money than that gold does,
in fact.
Each step in Bitcoin’s growth follows the same pattern. Any demand
for Bitcoin at all is enough to make it function as a medium of
exchange. If demand continues to grow, then it becomes a better medium
of exchange. There is no end to this process because the primary value
of Bitcoin is the network effect surrounding it, not any final
productive use.
Thus, Bitcoin is not a bubble. Its growth is like a self-fulfilling
prophesy: as more people believe in it as a medium of exchange and
become willing to buy it, they create the very conditions required of it
to make it more useful. There is nothing irrational, therefore, in
treating Bitcoin’s price as the cause of its value and no reason to
expect the momentum in its exponential upward trend to cease.1

Conclusion

Every time you buy Bitcoin, a fairy gets its wings. Now clap your
hands, click your heels together three times, and believe in Bitcoin! It
will only take faith the size of a mustard seed.
  1. This analysis leaves something to explain—if the value of a medium of
    exchange is just the market cap, why does Bitcoin go through hype
    cycles? Every time Bitcoin goes up in price, that is an increase in its
    underlying value, so why does its price ever crash? I don’t know the
    answer, but I think I have a reasonable hypothesis: the network takes
    time to adjust to the enormous number of newcomers during each hype
    cycle. Each member of the network adds value, but this takes time—the
    members of the network must learn something about one another before the
    value they add to the network is more fully realized. If this effect is
    real, then the price could temporarily rise more rapidly than the
    growth that the network can support.

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