Crypto currencies were one of the big stories of the now ending year 2017. These once geeky little software projects have truly hit the mainstream, and exploded in price. Bitcoin valuations are now featured in pretty much any major newspaper. Some believe that cryptos will take over the world monetary system, others think it is a fraud.
I myself have gone on record twice this year, arguing that cryptos are in a classic financial bubble, which will burst eventually. Given the popularity of crypto currencies, I got a lot of criticism for my opinion. A lot of smart people think that I got this one wrong. Getting critical feedback is always helpful. Ultimately, however, the critics have not convinced me. Of course, it is possible that I am missing something, but so far I have not heard any really convincing arguments for the case, that crypto valuations are justified.
Many of the arguments made against critics are ad hominem. These range from accusing critics of simply being jealous for having missed out, to having a special interest in preserving the currently rotten world monetary system. The most common rationalization, for not having to listen to critics, probably is the accusation that they simply do not understand blockchain technology.
While these arguments might be true for some people, simply attacking the integrity of a critic is a rather weak way of arguing. Either crypto currencies work or they don’t. Whatever the motivation of a critic, they are either right or wrong. The truth can only be settled looking at the actual arguments. If we want to understand what is going on, it is not helpful to start with the conclusion, and then cherry pick the evidence accordingly. This is never a pathway to truth, and particularly in finance, it may cost you a lot of money. I am talking from experience here!
Being an anarchist, the idea of an anarchic monetary system is actually very appealing to me. It would be awesome if we had a simple, technological solution to one of the most evil state monopolies. That is why I initially loved crypto currencies. But having examined the arguments, I simply cannot believe that cryptos will be able to establishing themselves as a true alternative to government money.
To me, the key argument against computer code functioning as money is the fact that it lacks any kind of use outside of trying to be money. In other words, it does not seem to have an intrinsic value. But crypto currencies believers have come up with two arguments why this is a false criticism.
Do Cryptos Have An Intrinsic Value?
The first one is to argue that cryptos do indeed have an intrinsic value. Blockchain is an incredible useful technology. It solves the problem of having to trust a human institution to enforce rules. With blockchain, we now do not have to trust potentially corrupt humans. Instead we can trust a mathematical algorithm, which seems a lot more solid.
I actually totally agree with that. This is indeed extremely valuable. Blockchain technology will change the world. But there is a problem with this argument. It is not clear how this use will give a monetary value to a crypto currency.
For something to have a monetary value, it needs to not just be useful, but also scarce. Air is a good example. For humans, air is incredibly useful. In fact, it is one of the most useful things I can think of. It is so useful that it is the absolute last thing I would want to live without. That is because, cutting me off from a constant air supply will kill me more quickly than cutting me off from anything else. And yet, despite this extreme usefulness, it is free of charge. In everyday life, it has no monetary value, because it is not scarce.
At this point, crypto advocates will say, but Nico, crypto currencies actually are scarce. With mathematical certainty, the number of Bitcoins is limited to 21 million. So there you have it. It is useful, and it is scarce. It therefore clearly needs to have a monetary value.
I don’t find this convincing. It is true, the number of Bitcoins is limited to 21 million. But this overlooks that Bitcoin is not the blockchain. It is merely an application of the blockchain. And there are many others. That means that one does not own the useful blockchain by owning a crypto currency.
The individual crypto currency unit in itself is useless. Pictures of Bitcoins tend to portray shiny gold coins with a big B on it. But in reality, a Bitcoin is just a bit of digital code. It has no other use than being a piece of information. So we are not dealing with something that is scarce and useful. Instead, we are dealing with something that is scarce, but useless. This combination tends to result in a monetary value of zero.
The useful blockchain technology, on the other hand, is not scarce. Luckily, it is open source, and in the public domain. Everyone can, and many people are using it in thousands of applications. There are even multiple Bitcoin applications at this point.
Crypto investors have one good defense to this objection. They argue that there is a network, and prime mover, effect which makes Bitcoin unique among crypto currencies. Bitcoin was the first crypto currency, and it currently is the most highly valued in dollar terms. This gives Bitcoin an edge over other blockchain currencies. So again, there you have it, now it is useful and scarce.
This is not a bad argument, but it ultimately fails to convince me. First of all, even if there is a network effect, it is not clear to me, why the prime mover will be the one that wins this competition. There are often problems with new technologies. Therefore, it is the second or x generation which makes the race. Only in later generations all the bugs from the beginning have been fixed. Google, for example, was not the first search engine, and Apple by far not the first computer company.
Basing hopes of owning the future crypto reserve currency on a network effect, is a risky gamble. Even if cryptos ultimately were to succeed, no one yet knows which one will eventually make the race. And as I write this, the technology of the Bitcoin application in particular does seem to have some problems. It is too slow for transactions, and the mining network uses too much electricity. That is why we have already seen multiple forks. Bitcoin, therefore, might turn out to be a terrible investment, independent of whether cryptos succeed or not.
The real problem with the network argument, however, is that it confuses cause and effect. In order for a crypto currency to profit from a network effect, it first needs to be used as a currency. But how can it be used as a currency first, if all that gives it value is the network effect?
Bitcoin believers will counter this by arguing that we are simply past that point. Yes, this might have been the problem when the currency started in 2009. But, for whatever reason, Bitcoin now undeniably has a monetary value. It therefore can now profit from the network effect. Superficially, this seems correct. Bitcoins clearly sell for lots of dollars. But if we look closer, the argument becomes rather unconvincing. To explain why, we need to look at the second argument made against the lack of intrinsic value criticism.
Cryptos Do Not Need An Intrinsic Value
Many people argue that cryptos do not need an intrinsic value to have a monetary value. That is because nothing really has an intrinsic value. The theory of intrinsic value died with the marginal revolution, and the insight that value is not objective. Each person decides for himself, how to value something. In other words, if someone is willing to pay 1 million dollars for a Bitcoin than that is its monetary value.
Intrinsic value, however, is not objective value. The objective value theory, which was falsified in the marginal revolution, was the idea that everything can be objectively valued according to the amount of labour that was needed to produce it. This theory is indeed completely false.
But intrinsic value refers to something else. Something has an intrinsic value if there are multiple uses for it. It can therefore be traded on different markets. That means it can still be sold, if its demand drops on one of the markets.
For example, a business usually has an intrinsic value in the from of all its assets. Let us say a computer store goes bankrupt. That means that all the computer equipment of that store has no further use for the business, as it is discontinued. But there are other people who will still have some use for all the assets of the shop. The amount, a potential liquidator could sell all these assets for, is the intrinsic value of the business.
This intrinsic value is not objective. It is not the same for everyone. Many people will have no use for these computers. Intrinsic value is merely the market value for which you would likely be able to find a buyer, assuming a big enough market. As such, the intrinsic value is not even a precise number, but varies within a range.
Accordingly, when it comes to currencies, intrinsic value means that if something fails to function as a currency, the owner can still sell it on a different market, or use it himself. This gives the potential currency trust, as it would need to loose its usefulness on all potential markets to become completely valueless.
And trust is really the key when it comes to the value of a currency. Prices are indeed subjective. If people do not consider a currency to be valuable, then it won’t be. On the other hand, if enough people do trust a currency, they will accept it for business. Therefore, there will be a constant demand for it, and the currency stays valuable.
Crypto currency advocates correctly object to gold bug critics that most of the monetary value of gold does currently not come from its intrinsic value. Yes, gold is an incredibly useful metal, but at current prices, it does not seem to be used for much in the industry. Most of the monetary value seems to come from its use as a store of value.
I completely agree that once trust has been established for a currency, the intrinsic value does not matter anymore. An established currency does not need to have a secondary market as a commodity. State currencies, like the dollar, are a good example. Once the currency enjoys trust, all it needs to do is to not blow it. That is why a lot of people around the world accept US dollars, even though the US government does not force them to do so. And they will continue to do that, as long as the US government does not do anything stupid to undermine the trust of the dollar. Historically, the way currencies have blown trust is through a too rapid increase of the currency units.
This is where crypto currencies get it exactly right. By limiting the units of the currency, they are designed to not blow the trust once they have established it. If they ever get that far, they will not need an intrinsic value anymore. But the problem is, how will they get there?
The only way I could see them getting there is by force. If a government declared a crypto currency as legal tender, and forced everyone to pay their taxes in it, then that would create an artificial high demand for the currency. This demand would quickly stabilize prices and would make people build trust in it. In other words, the government would have created a big, artificial network effect. In that case, even if the government were to withdraw its force, people would likely continue to trust the crypto currency.
But the problem is, how can a potential currency build trust on a free market? The only real solution for it seems to be, by having an intrinsic value. That is how Gold became a currency. Only with an intrinsic value can holders of a currency be secure that if the underlying commodity does not work as a currency they can always use it for something else. This puts a floor into the price.
I do not see crypto falsifying that theory. They are currently not being used as a currency. The volatility is way too high. People who buy crypto currencies perceive them to rapidly go up in value. And since Gresham’s law tells us that bad money drives out good, crypto currencies are not being spend. In addition to that, because of the volatility, and the fact that cryptos cannot be used to pay taxes, businesses do not account in them either.
People are not buying Bitcoins, because they are longing for a reliable payment system. There are a number of very well and cheap payment systems out there, which currently work better than crypto currencies. They also don’t really buy them because they mistrust government money. No, if we are honest, the reason why the vast majority of people currently flock into Bitcoin is pretty much exclusively, because they are hoping to be able to sell that same Bitcoin, in the relatively near future, for a significantly higher price to someone else. Any other conclusion seems delusional in my view.
And this is a big problem. It is an unhealthy economic phenomenon called greater fool investing. Ponzi scheme is another word for it. As long as cryptos get their monetary value from being a speculative asset, they cannot function as a currency. In order to gain trust as a currency, cryptos would need to be as stable as possible in price, ideally only going up with the increased productivity of the economy. But they cannot stabilize their monetary value as long as they are not a currency.
In other words, cryptos, currently, get their monetary value from the projected higher future prices. They get it from the perception that, in the future, there will be a greater fool who is going to buy Bitcoins for an even higher price. But if that is the only reason why crypto currencies have a monetary value, than they will lose this same value, once it becomes clear that the market has run out of greater fools. Once that happens, far from stabilizing prices on a high plateau, subjective value starts to work against the price. The very reason, why Bitcoin had a monetary value in the first place disappears. Everyone runs to the exits to cash in their profits. But there won’t be any buyers waiting for them at those exits. At that point the currencies will fall back to their intrinsic value.
This is the outcome of every greater fool investing scheme in history, and there are many. It is not clear how crypto currencies will be able to go from being a speculative asset to being an actual currency. This would be unprecedented. Greater fool investing schemes always, always! end in a collapse, in which the underlying asset goes back to its intrinsic value. I don’t know of any exceptions. As I explained in detail in my previous article, they always have to end this way, because there is a natural scarcity of greater fools. Someone will have to be the greatest fool.
The crypto mania very much reminds me of the dot com bubble at the end of the 90th. Back then the same two arguments were made, to justify the high valuations of internet companies. The first one was the argument that the internet was this great new technology which would completely change the world. Therefore, everyone wanted to own a piece of it.
This assessment was undoubtably correct. The internet has indeed changed the world, and it has done so far beyond what was even imaginable back then. But that did not stop the stocks of many dot com companies from going to zero. What investors did not realize was that, by owning an internet address, they did not own a part of the internet. They merely owned a few, often useless, information on the internet. The same mistake is now being made with the blockchain technology. Bitcoin owners simply do not own this technology. No one owns it. What crypto investors own is a piece of one application of the blockchain. One of a potentially unlimited amount.
The second argument in the 90th was, that since the internet was so new, old economic insights did not apply anymore. Trying to understand the ‘new economy’, as it was called, with old economics would fail. Old School investors like Warren Buffet were seen as dinosaur, who should better retire. Dot com companies did not have to have any intrinsic value. In the new economy, people were clearly valuing things differently.
This turned out to be an epic miscalculation, and dinosaurs like Warren Buffet had the last laugh. All the dot com stocks eventually fell back to their intrinsic value. That meant that a lot of them went to zero, as they only were useless internet addresses. The only reason why they had a monetary value in the first place was, because people thought that prices would continue to go up. The ones that survived had real businesses with real values behind them. In other words, they had an intrinsic value.
The same argument is now being made for cryptos. Apparently, the fact that they lack intrinsic value does not matter. Old economics does not apply. It is all so new and so great. But I am not convinced. Now does not look very different from back in the 90th. I see no reason why well tested economic theories are supposed to be falsified by crypto currencies. That is why, I predict that the monetary value of crypto currencies, like all other assets, will eventually go back to their intrinsic value, which is zero. It simply seems to be the only reasonable conclusion to draw. Nevertheless, given that I like the idea of an anarchic currency, I hope I will be proven wrong. But I won’t invest my money in pure hope against reason.