{"id":271,"date":"2014-05-15T02:29:00","date_gmt":"2014-05-15T02:29:00","guid":{"rendered":"http:\/\/blog.holytransaction.com\/how-we-know-bitcoin-is-not-bubble\/"},"modified":"2014-05-15T02:29:00","modified_gmt":"2014-05-15T02:29:00","slug":"how-we-know-bitcoin-is-not-bubble","status":"publish","type":"post","link":"https:\/\/holytransaction.com\/blog\/2014\/05\/how-we-know-bitcoin-is-not-bubble.html","title":{"rendered":"How we know Bitcoin is not a bubble"},"content":{"rendered":"

\n The Value of Money
\n <\/h2>\n
\n (NakamotoInstitute<\/a>) No matter how many times Bitcoin grows by orders of magnitude,
\nholdouts still remain who argue that it is a bubble destined to fail. To
\n address this claim, I will describe a theory that describes how to
\nappraise Bitcoin according to the Austrian theory of money.\n <\/div>\n
\n In Austrian economics, money is valuable because it is liquid. This
\nmeans that a given value of money is demanded everywhere and can easily
\nbe traded for goods. For example, say I had enough bitcoins to buy a
\n100-oz gold bar. In late 2010, this would have been worth around one to
\ntwo million bitcoins and would have been impossible to sell on the open
\nmarket without drastically affecting the price. By contrast, in early
\n2014, 100 ounces of gold was worth about 100 bitcoins, and this amount
\ncould easily have been traded quickly on one of the major exchanges
\nwithout affecting the price noticeably. Thus, in early 2014 Bitcoin was
\nmore liquid than in late 2010, and was therefore a better currency.\n <\/div>\n
\n Unfortunately, this insight about the value of money does not give us
\n a means of appraising it because the liquidity cannot be separated from
\n the price. This is kind of a problem\u2014it sounds like a circular argument
\n because it says that Bitcoin\u2019s value is caused by its price! This
\nallows for no way to detect whether Bitcoin is overvalued or
\nundervalued.\n <\/div>\n
\n In order to prevent this model from being causally circular, a time
\nelement is required. Our observations about money come from the past,
\nwhereas our judgments about its value are about the immediate future.
\nThis makes the value of money into a positive feedback loop. If the
\nnetwork is growing, then it will tend to continue to grow, whereas if it
\n is shrinking, it will tend to continue to shrink.\n <\/div>\n
\n This model of money has no independent quantity that estimates
\nanything like an underlying value. Any price is as good as any other\u2014the
\n only thing that matters is the direction it is moving. This is not
\nreally an appraisal after all\u2014but it is still the right way to
\nunderstand Bitcoin\u2019s price.\n <\/div>\n

\n Bubbles
\n <\/h2>\n
\n In the short term, there is money to be made by buying anything whose
\n price is showing an upward trend if one spots the trend early enough.
\nIn other words, if one can predict that other people are likely to
\nappraise a good more highly in the future, regardless of whether that
\nappraisal is rational or irrational, then it makes sense to buy into the
\n change of sentiment. If lots of people begin to think this way, then
\nthey can create a positive feedback among one another and bid up the
\ngood beyond any rational appraisal of it. This is a bubble.\n <\/div>\n
\n A bubble bursts because eventually people have to get around to using
\n a good for its ultimate purpose. Once it is understood that the people
\nwho actually use the good are being bid out of the market, then the
\nprice crashes because people stop predicting higher and higher
\nappraisals to the price.\n <\/div>\n
\n Money, however, need not have any ultimate use. It may only ever
\npassed around from person to person, without ever being consumed. A
\nstock is valued by the sum of its interest-adjusted dividends. A bond is
\n valued by its redemption value adjusted by the interest rate and the
\nrisk of default. A commodity is valued by the value of the goods it can
\nbe used to produce. However, for money, there is no independent quantity
\n to provide a reality check. All money is like a bubble that never
\nbursts.\n <\/div>\n

\n Metcalfe\u2019s Law
\n <\/h2>\n
\n Some of the theory of money can be understood in terms of Metcalfe\u2019s law<\/a>
\n from computer networking. Metcalfe\u2019s law says that the value of a
\nnetwork is proportional to the square of the number of nodes. The
\nrationale is that the network should be valued according to the number
\nof connections it supports, which is approximately proportional to n<\/i>2 (for large n<\/i>).
\n Consequently, as the network grows, it presents a better and better
\nopportunity for new members. As new members enter, the network improves
\nfor all its present members.\n <\/div>\n
\n Metcalfe\u2019s law must be adjusted slightly to apply to media of
\nexchange because some nodes in the trade network will be more valuable
\nthan others. Those who have a lot of the medium are potentially able to
\nspend more than those who have little. Therefore, use the market cap of
\nthe medium of exchange as n<\/i> instead of the number of people.
\nSimilarly, some transactions are also worth more than others, so it
\nmakes sense to use the transaction volume rather than the number of
\ntransactions.\n <\/div>\n
\n A striking test of Metcalfe\u2019s law in Bitcoin recently appeared on the Bitcointalk forums<\/a>, created by Peter R. I have made my own chart here.\n <\/div>\n
\n\"Metcalfe's<\/div>\n
\n This chart plots the market cap in blue and the square of the
\ntransaction volume excluding popular addresses in green. The axis on the
\n is the price in dollars. Exactly as Metcalfe\u2019s law predicts, the
\ntransaction volume increases very neatly as the square root of the size
\nof the network. The correspondence is beautiful. I wish I had thought to
\n make it first!\n <\/div>\n
\n I would like, however, to criticize the interpretation of the
\ndiagram. On the original Bitcoin Talk, thread, the green plot has been
\nlabeled as the \u201cMetcalfe Value\u201d, as if it is an appraisal of the Bitcoin
\n that estimates what it could cost.\n <\/div>\n
\n This interpretation is incompatible with the theory of the value of
\nmoney I presented above. In my theory, the value causes the
\ntransactions, whereas in the diagram, the transactions cause the value.
\nHowever, it is only potential<\/em> transactions that cause the value. Past<\/em>
\n transactions are of no value to anybody. The present size of the
\nnetwork and the consequent opportunities is likely to provide tomorrow
\nwill motivate people to buy and sell today.\n <\/div>\n
\n This may seem like hair-splitting, but a confusion of cause and
\neffect can have serious consequences. For example, many people believe
\nthat it is necessary to spend bitcoins and increase the transaction
\nvolume in order to make Bitcoin more valuable. Of course this is
\nnonsense; all this does is fill up the network with transactions for
\nthings that nobody actually wanted. That does not present a good value
\nfor a newcomer because he will want a network that presents him with real<\/em>
\n opportunities, not just ways of artificially increasing transaction
\nvolume. The more that the Bitcoin network is focused on artificially
\nincreasing the transaction volume to make it look good, the more it
\nresembles a Ponzi scheme. Rather, to make the network more valuable, we should be hoarders<\/a>. This is more likely to present newcomers with lots of potential uses for Bitcoin as a medium of exchange.\n <\/div>\n

\n Appraising Bitcoin
\n <\/h2>\n
\n A real good, of course, can have value due to a network effect and<\/em> some productive use. Gold, for example, can be money and<\/em> used as components in electronics. If there were ever a time when gold were used only<\/em>
\n for electronics, but were then to acquire use as money once a network
\neffect formed around their price, an investor might be excused to call
\nthe price an unsustainable bubble. However, it would turn out to be a sustainable<\/em> bubble that inflates until it fills the entire economy. At least until Bitcoin came along.\n <\/div>\n
\n This brings us to Bitcoin. To what extent is Bitcoin\u2019s price a
\nrational appraisal or an investment bubble? The answer is easy, much
\neasier than with a commodity like gold. Bitcoins have almost no use
\nother than as a medium of exchange. Thus, the fact Bitcoin has any<\/em>
\n price at all is evidence that there is a real network effect. It is
\nmuch easier to prove that Bitcoin acts like money than that gold does,
\nin fact.\n <\/div>\n
\n Each step in Bitcoin\u2019s growth follows the same pattern. Any demand
\nfor Bitcoin at all is enough to make it function as a medium of
\nexchange. If demand continues to grow, then it becomes a better medium
\nof exchange. There is no end to this process because the primary value
\nof Bitcoin is the network effect surrounding it, not any final
\nproductive use.\n <\/div>\n
\n Thus, Bitcoin is not a bubble. Its growth is like a self-fulfilling
\nprophesy: as more people believe in it as a medium of exchange and
\nbecome willing to buy it, they create the very conditions required of it
\n to make it more useful. There is nothing irrational, therefore, in
\ntreating Bitcoin\u2019s price as the cause of its value and no reason to
\nexpect the momentum in its exponential upward trend to cease.1<\/a>\n <\/div>\n

\n Conclusion
\n <\/h2>\n
\n Every time you buy Bitcoin, a fairy gets its wings. Now clap your
\nhands, click your heels together three times, and believe in Bitcoin! It
\n will only take faith the size of a mustard seed.\n <\/div>\n
    \n
  1. \n
    \n This analysis leaves something to explain\u2014if the value of a medium of
    \n exchange is just the market cap, why does Bitcoin go through hype
    \ncycles? Every time Bitcoin goes up in price, that is an increase in its
    \nunderlying value, so why does its price ever crash? I don\u2019t know the
    \nanswer, but I think I have a reasonable hypothesis: the network takes
    \ntime to adjust to the enormous number of newcomers during each hype
    \ncycle. Each member of the network adds value, but this takes time\u2014the
    \nmembers of the network must learn something about one another before the
    \n value they add to the network is more fully realized. If this effect is
    \n real, then the price could temporarily rise more rapidly than the
    \ngrowth that the network can support.\n <\/div>\n<\/li>\n<\/ol>\n

    Open your free digital wallet here<\/a> to store your cryptocurrencies in a safe place.<\/p>\n","protected":false},"excerpt":{"rendered":"

    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 […]<\/p>\n","protected":false},"author":1,"featured_media":856,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[37,76,299,678],"tags":[764,975,1331],"yoast_head":"\nHow we know Bitcoin is not a bubble -<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/holytransaction.com\/blog\/2014\/05\/how-we-know-bitcoin-is-not-bubble.html\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"How we know Bitcoin is not a bubble\" \/>\n<meta property=\"og:description\" content=\"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. 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