- The critical value of scarcity
- Understanding the utility of the blockchain
- Will (can?) governments ban cryptocurrencies?
- A coming geometric explosion in the price of cryptocurrency?
In Part 1, we surveyed the exciting but confusing speculative boom phase of cryptocurrencies. In Part 2, we attempt to contextualize this mad swirl by running it through two filters: scarcity and utility.
What’s Scarce? Scarcity Creates Value
Regardless of one’s economic ideology or system, scarcity creates value and abundance destroys value. When we say supply and demand, we’re really talking about scarcity and abundance and the rise or fall of demand for the commodity, good or service.
In classical economic theory, scarcity is met with substitution: ground beef too expensive due to relative scarcity? Buy ground turkey instead.
But this model has weaknesses. There aren’t always substitutes, or the substitutes are more expensive or problematic than what is now scarce. Consider wild fisheries: as they are depleted (i.e. the ecology of the seas are disrupted/destroyed), the economists’ substitute is farmed fish.
But farmed fish is not a substitute to an ecologist viewing the stripmining of the seas with alarm. Nor is it a substitute for those monitoring the heavy use of chemicals to suppress algae blooms and diseases in the fish farms. Fish farms that attempt to mimic Nature as much as possible and eschew chemicals often go out of business due to the intrinsic high costs of this ecologically sensitive business model.
Then there’s oil: substitutes exist for some uses, for example, natural gas and electricity, but when it comes to jet fuel, these are imperfect substitutes.
As a general rule, profits flow to any scarcity of goods and services with high utility value. We value what’s scarce and useful, and place little value on what’s abundant and of limited utility.
Currency has three basic functions: a store of value (it will retain its purchasing power over time), means of exchange (we can use it to trade goods and services, pay debts, etc.) and as an accounting mechanism to track assets, debts, income, expenses and exchanges/trades.
We assume all currency has this function, but only currency that is easily divisible and easily tradable enables easy accounting. If a notched stick is a unit of currency, and one stick buys a pig, what do I use for purchases smaller than a pig?
In today’s world, a currency must be digital to act as an accounting mechanism.
In terms of currencies, what’s scarce? What substitutions are available that fulfill all the functions of state-issued fiat currencies?
Alternatives to state-issued fiat currencies are scarce. The list includes precious metals, which are imperfect means of exchange and accounting mechanisms unless they have been digitized, i.e. they are held in a digital account in which the precious metals can be traded for other currencies and/or goods and services.
Precious metals’ strength is their store of value utility: they cannot be created out of thin air like fiat currencies.
The other substitute for fiat currencies is cryptocurrency.
The general rap on cryptocurrencies is they are intrinsically worthless because they are created out of thin air like state fiat currencies. But if we look deeper, we find that isn’t a very accurate account of bitcoin (setting aside the other 400+ cryptocurrencies for the moment).
Bitcoin mining, i.e. the maintenance of the blockchain, consumes a lot of electricity and processing power. The cost of maintaining the blockchain consumes scarce resources (processing power and electricity) and so it is fundamentally different from fiat currencies that can be printed on paper for a few pennies or issued by central banks for a few pennies of processing power and electricity. After that, the fiat currency’s only maintenance cost is the cost of maintaining ledgers of credits and debits.
To match the intrinsic value of bitcoin, one would have to equal its vast computational resources. That’s not easy or cheap.
By this measure alone, bitcoin is scarce and thus a store of value.
Bitcoin’s other claim to being a store of value is its inherent scarcity: only 21 million can be mined, of which around 18 million have been mined. (It’s estimated that significant quantities have been lost due to hard-drive crashes or tossed hard-drives when bitcoin was worth less than a dollar, in addition to the founder’s 1 million coin stash that appears to be static for whatever reason.)
This differentiates bitcoin from fiat currencies in a fundamental way. The problem with fiat currencies is that there is no upper limit on their issuance, or on how much of the newly issued currency is funneled to banks and financial Elites.
As for being a means of exchange: I’ve used bitcoin to pay translators and editors in other countries, with modest fees and very little complexity. The process was basically like using PayPal or other such payment method.
While I’m told there are applications that allow one to buy a coffee with bitcoin, I haven’t pursued this sort of day-to-day utility. Making such transactions with cryptocurrency is undoubtedly a key area in development. In my view, bitcoin has already proven itself as a means of exchange.
Since bitcoin is easily divisible, and inhabits the digital realm, it’s already an accounting mechanism.
If you want to keep some of your financial wealth in a non-state issued currency, the options boil down to digitally-enabled precious metal accounts and bitcoin.
That these alternatives are intrinsically scarce will only drive their price higher should demand ever rise substantially—which it will should a major fiat currency enter a crisis that causes its purchasing power to plummet.
What’s the Utility Value of the Blockchain?
I personally haven’t found any real-world application for Ethereum or Dash, but developers are working to bring these blockchain platforms to the point that they solve real business problems.
Right now, we can be forgiven for wondering if Ethereum’s smart contract is a solution in search of a problem.
But the view that smart contracts could revolutionize many business transactions by mooting the intermediaries such as banks and attorneys is widespread. For example, consider this recent article: How Lawyers will be Killed by the Blockchain and not Machine Learning (https://hackernoon.com/how-lawyers-will-be-killed-by-the-block-chain-and-not-machine-learning-bfbf77376c54).
I suspect development and adoption by the marketplace will be guided by these factors:
- Cost: whatever reduces transaction costs wins.
- Ease of flow: whatever reduces friction and restrictions wins.
- No substitute: whatever cannot be replaced with a substitute wins.
If it turns out an encrypted protocol using existing technologies can eliminate intermediaries as cheaply and efficiently as a blockchain smart contract, then there’s no compelling reason to use smart contracts. The marketplace will sort out if blockchain-based smart contracts fill business needs in ways that other applications can’t. If they do, then they will soon become ubiquitous.
But What if the Government Bans Cryptocurrencies?
Since decentralized cryptocurrencies are outside the direct control of states, many anticipate that governments will either limit or outlaw cryptocurrencies out of their own fear of losing control over capital flows in and out of their countries.
Ultimately, states fear cryptocurrencies because they cannot be devalued via inflation by government Elites. Why tolerate a currency that loses purchasing power every year by design, when you could own a currency that might increase its purchasing power over time?
States have a legitimate right—indeed, an obligation–to treat all taxpayers equally. How would it be fair to those using the state’s fiat currency if users of cryptocurrencies evaded taxes on their gains?
This is the reasoning behind the U.S. government’s treatment of bitcoin as a commodity, i.e. like silver, futures contracts, etc. The wallet outfit I use, Coinbase, already issues clients an annual statement of bitcoin trades, and I reported my $800 in gains on my 2016 tax returns and paid state and federal taxes on the income, just as I do with any other income.
Governments will require an accounting of cryptocurrency ownership and trading, and payment of taxes on any gains; that’s already baked in.
But capital controls, i.e. financial repression, is a different matter. There are already strict controls on moving more than $10,000 around the world, and legislation to include cryptocurrencies in this restriction is reportedly in the works. From the perspective of the government, why should cryptocurrencies be treated any differently than other forms of money?
That said, cryptocurrencies can be stored offline on a thumb drive. Just as someone can hike across the U.S./Canadian border wilderness with a gold bar in a backpack, someone can take bitcoin across any border on a thumb drive. If the drive is encrypted with readily available encryption (for example, Pretty Good Privacy–PGP), even the NSA can’t crack it without going to a lot of expense and trouble.
And how can anyone tell if there is bitcoin on a thumb drive? Will airport security have to scan every thumb drive? How about the delivery services that routinely ship millions of packages and letters overseas? Will they open each one looking for a thumb drive that might contain bitcoin?
My point is capital/currency controls only work if the currencies are flowing through centralized bottlenecks that the government can monitor. The government can certainly track my purchases of bitcoin with U.S. dollars, but they can’t track what I do with the bitcoin once it’s stored offline. As for what happens to my thumb drive with bitcoin stored on it—gee, officer, I lost it. My bad luck. There is no way anyone can track that it was shipped along with a used book to another country.
Any nation that outlaws blockchain technologies will be shooting themselves in the foot technologically, and that means financially. Economic stagnation is a high price to pay for attempting to outlaw what can’t be controlled.
If we look at the heavy-hitters in the Enterprise Ethereum Alliance, and consider reports that Goldman Sachs is busy applying for its own blockchain patents, we have to ask: why would the corporations which hold political sway in our pay-to-play “democracy” let some bureaucrats destroy or limit what might well be a technological gold mine of profits?
It has always made sense to follow what the super-wealthy are doing if you want to protect your assets from devaluation, inflation or confiscation. What if the super-wealthy (with corporations, the Elite class that controls the government’s policies) have concluded that cryptocurrencies may offer them some advantages above and beyond the alternatives? If cryptocurrencies serve the needs of financial Elites, they will remain legal.
The Inevitability of a Global Fiat Currency Crisis
Which brings us to the inevitability of a global fiat currency crisis. Creating currency in excess leads to the loss of purchasing power and related bad things. While we can’t predict which major fiat currency will slip into crisis, we can safely predict some fiat currency will do so in the near future: the buffers have all been eroded, the extremes piled ever higher, and the fixes to previous crises have been exhausted.
Are cryptocurrencies in a bubble? There is certainly a speculative boom in the space, and these kinds of booms end in busts. The market sorts the wheat from the chaff. What has utility and is scarce will gain value, what doesn’t will lose value.
I don’t think we will know the market value of bitcoin and the other major cryptocurrencies until a global fiat currency enters a crisis/meltdown. Only then will we see capital flowing into bitcoin and other cryptocurrencies in sufficient quantities to really move the needle.
Bitcoin enthusiast Tuur Demeester issued this projection of bitcoin valuations based on its adoption by various constituencies in 2013. This is a very speculative roadmap, but the point is worth taking: the wider the adoption of bitcoin et al., the larger the network effect, i.e. the greater the utility value of the network.
What if bitcoin is not just a non-state, inherently scarce currency, but it has characteristics of a network? The value could increase geometrically as the user base expands.
No guarantees, just an idea to keep in mind going forward.