The Fair Price of a Bitcoin is Zero

By Eric Tymoigne

The virtual currency craze is on a tear, with new virtual currencies emerging every day. The New York Times just ran a series of articles about them last week. “Charles Ponzi would be so proud!” one person appropriately commented at the bottom of this article.

Before going any further, let’s learn a bit more about the bitcoin system (also here and here). There are three components to this system:

-       A unit of account—the Bitcoin (BTC)—in which all transactions are recorded and goods and services are priced.

-       A payment system, supposedly secured and anonymous.

-       A means of payment—bitcoins—that is needed to complete all transactions in the payment system (there are coins of several denominations and the coin with a face value of one BTC is called the “bitcoin”).

Given the craze over bitcoins, their price in US dollars (USD) has soared with a BTC 1 coin going for as much as USD 1200 at one point, leaving Business Insider’s Joe Weisenthal saying:

“At this point, I have zero idea what a ‘fair’ price for Bitcoin is.”

I have an answer to that question, but before I reveal it (pretend you did not read the title of this post), let’s spend a bit of time getting to know the Bitcoin, starting with its payment system.

All transactions that have occurred since the beginning of the bitcoin system are recorded on a ledger called the “blockchain.” The system is setup so that every ten minutes or so a new page—called a “transaction block,” or just “block”—is added to the ledger. This new page refers to all past transactions requests (by referring to the immediate previous block) and records all the new transactions requests.

The ledger is crucial to the system because it allows users to verify that a transaction request between two parties is not fraudulent. For example, Mr X. uses the bitcoin payment system to send a request to buy a pizza from Joe’s Pizza. Joe’s Pizza wants to make sure that this is a valid transaction. That requires verifying that Mr. X holds enough bitcoins to pay for the pizza (the ledger will tell from which past transactions he got his bitcoins), and that he is not trying to double spend the bitcoins. This verification process is done by the accountants of the system, who are called the “miners.” Usually Joe’s will wait for confirmation from several miners (the rule of thumb seems to be six confirmations) before agreeing to sell the pizza (“confirmation” means that a recorded transaction request is included in following blocks). Anybody can be a miner, you just need a computer.

Adding a page on the ledger is extremely difficult (more here) and requires time and CPU power. A miner can only add a page to the ledger after meeting a specific encryption requirement called the “proof of work.” The proof of work involves encrypting new transaction requests in the form of a 16-digit hexadecimal number—called “hash” or “digest”—that must be no greater than a target value set by the system. For example, to simplify, Mr. X’s transaction request with Joe’s Pizza will be combined with many other requests and encrypted as a number—say 16. But if the target value is 10, then the encryption failed to meet the requirement of the payment system, and encryption must be redone until it generates a random number below or equal to 10. This mathematical requirement is currently so difficult to satsify that it may take years for a miner using a standard computer to add a page. Indeed, the probability of finding a hexadecimal value that meets that requirement is virtually zero (3.82×10-19 last time I checked: check “Current probability of a winning a block per attempt” in “target” hyperlink above). A miner has much more chance to win the Powerball (5.71×10-9)! To speed up the process, miners can pool their CPU resources and can buy more powerful computers; however, the difficulty of adding a page to the ledger is adjusted over time to make sure that on average only one page can be added every ten minutes.

One may wonder why it is so difficult to add a page to the ledger. The main goal is to make the payment system more secure by preventing double spending of bitcoins. Another reason is to maintain the value of bitcoins by making sure that they are not put in circulation too quickly. We will come back to this second reason later and focus on the first.

If Mr. X is a miner, as an accountant he has direct access to the ledger so he may be tempted to temper it (“cook the book”). He can do so by adding to the ledger a transaction that is fraudulent in the sense that he is overspending his bitcoins (overdraft is prohibited). Given that all transaction requests are known, all other accountants could easily verify that this transaction is invalid by checking prior transactions of Mr. X. To be able to cheat the system, Mr. X has to create an entirely new (fraudulent) ledger with all past valid transactions and a new page that includes his fraudulent transaction. But he has to do it without anybody else knowing, so he has to solve a proof of work alone. In the meantime, every ten minutes a new page is created, so by the time Mr. X solves the problem many more pages will have been added to the non-fraudulent ledger. A rule in the bitcoin payment system is that accountants are only supposed to add pages to the ledger that contains the most proof of work—the “thickest” ledger (in bitcoin terminology, the accountants should add a block only to the “longest” blockchain, but the adjective “longest” is an unfortunate choice of word because what really matters is the amount of proof of work and this can result in a smaller ledger if difficulty is increased given everything else. As stated earlier difficulty is adjusted to make sure that a page is added to the ledger every 10 minutes or so in that case “longest” is an ok choice of word). So even if Mr. X succeeds in creating a new ledger that includes his transaction, all other accountants will know it is a fraudulent ledger because it won’t be the thickest. Of course all this assumes that there are only a few rogue accountants that do not pool their computer resources together to game the system by creating an invalid block in about 10 minutes.

You will notice that so far we have not described bitcoins themselves. We merely presented the architecture of a payment system with some security features. This payment system could technically use an existing unit of account (e.g., USD) and existing means of payments (one would just need to link his bank account to the payment system, like for PayPal). Is it secured and anonymous? I can’t tell you if it is safer than existing payment systems—it is not my expertise—but some past events clearly show that it is not a full-proof payment system.

Bitcoins and BTC come into the picture when one wonders how to reward the crucial work done by the miners. Being a miner, beyond being an extremely tedious activity, involves some upfront fixed costs (a computer) and some variable costs (electricity and computation time). But miners are crucial to the trustworthiness of the bitcoin payment system, so they should be rewarded. While paying miners in dollars could be done, the creator of the bitcoin payment system—who goes under the pseudonym Satoshi Nakamoto—wanted a system that runs on an independent unit of account with independent means of payment; hence the BTC and bitcoins. Each time a miner creates a new block by solving the proof of work, he currently gets 25 BTC in the form of bitcoins (over time this reward declines). The miner also receives a transaction fee paid in bitcoins. This transaction fee is provided by the persons involved in the transaction request (currently it seems to be paid by the buyer, Mr. X). The more transaction requests are included in a block, the more transaction fees will be collected by the miner who solves the proof of work.

In order to obtain bitcoins, one must first create a bitcoin wallet (or here). This wallet contains at least one bitcoin “address” or “public key” (think debit card number) with a corresponding “private key” (think debit card code). Addresses are public information but not the private key. When a miner is lucky enough to create a block, bitcoins are credited (out of thin air) to an address of his choosing. The creator of the payment system was frightened by this ex-nihilo creation of bitcoins, so he put constraints on the supply of bitcoins. The first one is the extreme difficulty to create a block, which makes sense in terms of security but also aims at creating an artificial scarcity of bitcoins. The second is that the maximum amount of bitcoins is set at BTC 21 million (at which time the reward for block creation will be BTC 0). Given the average rate of block creation (one every 10 minutes), the maximum should be reached by the year 2140. The hope is that accountants will be willing to earn their reward for creating blocks via transaction fees only.

Bitcoins can also take a physical form (or here, or here) that contains a hidden private key (think of the hidden code at the back of a gift card). These physical coins are representation of virtual coins and are funded via the income earned by the issuer of physical bitcoins. Thus, given the way they are created and used at the moment, they do not provide a means to bypass the BTC 21 million limit. They are just physical representations of virtual coins that are useful for people who are worried about leaving their private key online.

The creator of this system does not seem to see that this hard limit on bitcoin supply implies that, given transaction fees, the larger the number of transactions, the more bitcoins will go to the transaction payments and the less will be available for other purposes. One could avoid this by lowering the fee inversely with the amount of transactions, but that would reduce the incentive to be an accountant at the time when more are needed. A third possibility is for a Bitcoin deflation so that more goods and services can be bought with less bitcoins; thereby leaving more bitcoins to pay the accountants.

Okay, enough with the description. Let’s move to the analysis of the “moneyness” of bitcoins.

We are told that bitcoins are to be considered an alternative monetary instrument. Let’s take this proposition seriously and analyze it. Frankly, looking at the previous bitcoin creation mechanism, I see Easter egg hunting rather than mining. Gold only exists in a relevant quantity only in specific geological soil so you are not going to mine randomly. Mining also requires digging and here you are merely looking around for the coveted item.

It’s important to realize that block generation is […] like a lottery. Each hash basically gives you a random number between 0 and the maximum value of a 256-bit number (which is huge). If your hash is below the target, then you win. If not, you […] try again. (Here)

In addition, once you mine the gold nuggets they need much further processing before becoming coins whereas bitcoins are directly usable. But I digress.

Monetary instruments are financial instruments. Like all financial instruments, monetary instruments have an issuer who promises to do something in the future. There are one or two common promises embedded in monetary instruments. One is that they are convertible into something else, another is that the issuer will accept them as final means of payment from his debtors. Bank accounts contain both promises (conversion into cash on demand, and one can pay debts due to banks by using funds in a bank account). Federal Reserve notes currently only contain one promise, the government will take them in payment at anytime (either directly or through the banking system in case tractability and security of payments are required). Some Federal Reserve notes were convertible into gold coins in the past. Gold coins are also monetary instruments that contain only one promise, that of being accepted back by the issuer to settle debts due to him (usually a government). Gold coins have an extra feature, they are collateralized by the value of the gold content. Note that the gold content of the coin is not a monetary instrument, and it is not what makes the coin a monetary instrument. Gold bullions were never financial instruments (they contain no promise), they are real assets, i.e. commodities (payments made with them are payments in-kind).

Given the nature of monetary instruments, they have also other characteristics common to all financial instruments. First, all financial instruments are accounting creatures. They are the asset of the bearer and the liability of the issuer. Gold coins were the liability of, e.g., the King, Federal Reserve notes are liability of the Federal Reserve, and coins are the liability of the Treasury. Currency is their liability because they (at least) promise to take their currency from bearers in payments at any time; issuers owe that to the bearers. That is partly how their scarcity is controlled. Second, all financial instruments have a fair value that is defined as the discount value of future streams of monetary payments. 

Where the subscript t indicates the present time, Pt is the current fair value, Yn is the income at a future time n, FVN is the face value that will prevail at maturity, Et indicates current expectations about income and face value, dt is the current discount rate imposed by bearers, N is the time lapse until maturity (n = 0 is the issuance time). There is a wide variety of financial instruments using that formula. On one extreme are modern monetary instruments that, provide no income (Y = 0), have an instantaneous maturity (N = 0), and are widely expected to be taken back by their issuers at their initial face value at any time, Pt = FV0. On the other extreme are stocks and consols that have a positive expected income and an infinite maturity, Pt = Et(Y)/dt.

Given that bitcoins are supposed to be monetary instruments, they must follow the preceding basic rules of finance. We clearly know who the bearers are (the lucky Easter egg hunters and the persons to whom they get sold) but who is the issuer? In other words who put the eggs in the forest and is willing to accept them in payments due to him or her. I can tell you the answer for Easter eggs: none of the persons who put them in the forest promised to accept them in payments. Therefore, they are not a liability, therefore they are not a financial asset, and therefore, they are not monetary instruments. They are real assets, commodities. The same applies to bitcoins. There are commodities and people are basically involved in trading a commodity on a world scale; with much of the craze coming from China (see here for a link to world map of current bitcoins transactions). Think of international bilateral trade of Easter eggs for other commodities; it is barter on a grand scale (remember people in the past who would sell their farm for a tulip…).

We just established that bitcoins are not financial instrument, but let us, for the sake of argument, continue to assume that they are. This means that they must have a fair value. Now what is the fair value of a bitcoin? It does not provide any income (Y = 0), it has no maturity given that it is not a financial instrument. For the sake of argument, we might assume that their maturity is infinite because we are stuck with them forever once they are created. So their fair value as financial instrument is…A BIG FAT ZERO (you can use whatever unit of account you want). A BTC 1 coin should circulate at a 100% discount (BTC 0) if it was a monetary instrument, which means of course that it would not pass hands.

This would have been different if there had been an issuer who took back bitcoins at face value in payments. As bitcoins would have come back to the issuer, they would have been destroyed (like any pizza restaurant destroys free-pizza coupons that are returned to make sure they are not stolen and reused to get another pizza). Unfortunately, nobody issued them (and they are not edible like Easter eggs) and so we are stuck with them. This was actually a mistake made throughout history. Kings would issue coins and never promise to take back them in payment! Private banks issued notes that they would not accept in payments! Fair value fell and coins would disappear as people melted them down to extract the gold and sell it as bullion. Bitcoins have not intrinsic value so their fair value would dropped to zero.

The supply of monetary instruments needs to be elastic enough to change with the demand for them. They should be easy to create (bitcoins are) BUT ALSO easy to destroy if demand declines; that maintains the scarcity of the monetary instruments while making them responsive to the needs of the economy. Bitcoin supply fails on both sides, it is not demand driven; it is exogenous.

Currently, the only things that give bitcoins value as commodities is their utility and their scarcity. People love the beauty, spiritual meaning, and taste of Easter eggs and so are willing to pay for them. Is there anything to love about bitcoins? People involved in illegal activities and money laundering, who have a phobia of Big Brother or who just hate the federal government, find utility in this means of payment because bitcoins allow to access the anonymous payment system. Other people who loves gambling also find utility in bitcoins. Both categories of people will be willing to pay top dollar for them given their scarcity.

One may note that what gives value to bitcoins is not that there are redeemable in dollars. They are not redeemable (their quantity can’t be reduced by converting them into something else). What gives them value is that people are willing to pay a lot of dollars for them (or tulips if you see where I am going with this: people are trading virtual tulips that grow out of thin air and never die).

The structure of the payment system, not bitcoins, is actually what makes the bitcoin project so successful. It is supposedly so secretive that you can trade a bunch of illegal stuff and evade taxes. Think Easter eggs (or tulips) for coke, Easter eggs for guns, Easter eggs for prostitutes, the sky is the limit and everything is priced in an Easter egg unit of account (EE). A pound of coke EE1000. Of course, there is a slippery slope. You can write contracts in a EE unit of account that promise to deliver Easter eggs, you can securitize these contracts, you can write contracts that bet on when the supply of Easter eggs will exactly run out. Heck! You can write any contract you want because there is no regulation. Contracts can have the most stupid (and hidden) clauses in them as long as someone will swallow them in expectation of huge returns. (You did not know? They love Easter eggs on Mars!)

So there is a fixed supply of a commodity and a demand for that commodity (is it downward sloping? Probably not because speculation can easily overwhelm the use of bitcoins as anonymous payment method). A perfectly inelastic supply curve with a volatile demand curve is a recipe for wide price fluctuations of bitcoins in USD. If one takes chapter 17 of the General Theory, the bitcoin is an asset with no income (q = 0), no liquidity premium (l = 0), some carrying cost (c > 0, because one needs a computer and electricity to use them, even if in physical forms), and an expected capital gain or loss (a < > 0), so their expected rate of return is:

Rbc = abc – cbc

Put simply, Bitcoins are purely speculative assets. There are websites that help calculate if mining bitcoins is expected to be profitable, but, as one website notes: “Extrapolating bitcoin difficulty or price is pure voodoo.”

Happy searching! You could make a lot of money in dollars by speculating on Easter egg value (you won’t get rich as an Easter egg picker, i.e. miner)! But don’t get lost in the woods! By the way, just for full disclosure, those who organized the hunt collected a bunch of eggs before the forest opened to the public. They made a killing as many people were waiting for them when they came out of the forest to buy the eggs at a steep dollar price. After all, who wants to go into this stinky wet forest…just give me the dammed eggs so I can go watch TV…or sell my drugs and guns, hopefully in total anonymity and security.

 

*Footnote:  Is all this consistent with MMT? Yes. MMT does not state that all monetary instruments are government issued or that every unit of account must have its origin in a government declaration. Monetary instruments can be created by anybody but their capacity to be widely used will vary with the capacity of the issuer to make others (willingly or forcefully) indebted to him. The state usually determines the major unit of account used and what the legal tender is but anyone can issue promises and use any unit of account they want (Easter Egg, Buckaroo, etc.).

82 Responses to The Fair Price of a Bitcoin is Zero

  1. Bitcoin is an intangible commodity asset – like fine art, wine or patents or other intangible property licences.

    There’s nothing magical about it other than a very easy system of moving those assets between owners.

    The key point missing from the above analysis is that the amount of Bitcoins in circulation will likely decline over time – as people lose their access keys and the rate of mining slows down.

    Unlike normal cash, you can’t dig around down the side of the sofa to find those lost coins. If you lose your private key, your entire bit coin wallet becomes unusable.

    But certainly they are more akin to tulip bulbs than monetary instruments.

    • Eric Tymoigne

      That’s true Neil. People will probably lose them. Not an issue now because the amount of bitcoin supply grows, but losses will generate even more deflationary once the maximum of bitcoins has been created (provided that people are still using this payment system at the time; doubtful with the current setup)

    • > Bitcoin is an intangible commodity asset – like fine art
      ..and it’s highly fungible, infinitely divisible, pretty secure, seems to be getting more valuable over time, and growing numbers of retailers are accepting it as payment for their goods and services. Sure it’s a commodity, sort of like dollars, something you want to stash away for a rainy day. At $1000 per btc I’m not going to lose my wallet. :)

  2. This article would be a nice addition to the bitcoin discussion if it didn’t contain references to tulips and the black market. These both stand to discredit the backers of bitcoin by implying that they’re delusional maniacs (TULIPS!) and/or criminals (BLACK MARKET!). What seemed to be an insightful article on the hard economics of bitcoin turned out to be another thinly veiled attempt at condescension. Disappointing. I thought you had something useful for us.

    • Eric Tymoigne

      Tulips (or easter eggs) have to be in there because bitcoins are very similar to them. The article does explain how to make bitcoins sound monetary instruments.

  3. Guess on this one Eric… you’re not only swimming with the all fish in the stream—you’re doing your best keep the other fish from turning away. You justify a “system” of fiat currency where the Federal Reserve and Central Banks own all the “Easter Eggs” and we the people have all the debt. Great system… even the funny formula and ivory tower text does little to show that “your” currency isn’t anything but that which you describe… only run amok. A fiat-money currency generally loses value once the issuing government or central bank either loses the ability to or refuses to further guarantee its value. So besides the “promise” of backing the face value, dollars, euros or any coin can become zero as we’ve seen happen dozens of times in recent history. Nice try… but that which you profess to be safe, equitable and just is as flawed as you say Bitcoins are unsafe. Seems an even bet at least to give the old system a run for its money!

    • Eric Tymoigne

      Hey Colbydog,
      As it stands I can’t be for it. Too many flaws that probably result from thinking of money as equivalent to gold. We have been down that road before and it never ended well.
      I am not for a “easter egg” grab by the government. I am also not for or against bitcoins per se. I am just pointing at problem with the current set up of bitcoins (and Iam definitely against the system if it stays as it is). If one makes the bitcoin redeemable, if some regulations are included, if supply is made elastic, bitcoins will be a much more sound system. How widely it will be used is anybody’s guess.

  4. “coins are the liability of the Treasury”

    I thought they were counted as a form of equity? Are they liabilities in the sense that a share is a liability of the company that issues it? That’s an unusual form of liability as the owner of the share is also the (part) owner of the company.

    • Eric Tymoigne

      Yes coins are counted as equity. Some argue that equity is a form of liability, but even if you leave that aside clearly coins are clearly a debt instrument not an equity instrument. For example, your holding of coins do not give you voting power, and equity instruments have an infinite maturity (only redeemed at the wish of the issuer).

      • Right, thanks for that. That ‘equity’ question has been bugging me for some time.

        • US Coins are debt free money. Pennies, nickles, dimes, etc. Is that a fact? Bitcoin is a debt free entity object. Is that a fact?

      • How can coins simply be called equity? Isn’t equity what is left over after liabilities are subtracted from assets? That leftover is then a liability due to the owners. Payment of dividends is justified by that leftover.

  5. Interesting.
    Some speculation:
    1. What might occur if the USA accepted payment of taxes in x bitcoins or y dollars, where x and y are set by tax code and not by current market exchange rates?
    2. MMT has interesting implications about the capacity of the federal government to do more to improve economic conditions for the poor. However, one ill that is eroding the balance of power between federal and state governments is the ability of the federal government to use its currency powers to effect policy that states cannot match. State policies are restricted by their tax revenue and credit, and thus they come to depend on the revenues given by the federal government, but with strings attached. The result is an erosion of state power and independence. While some good has come from increased power at the federal level (i.e. human rights), other changes for good are stymied by a federal government that is too far from the People, that is willing to over-ride the will of the People of a state to instate certain laws.

    Thus, I have been entertaining the idea of state issued currencies, where the power to issue currency and tax that currency resides at the state level. This kind of approach, if allowed, would re-balance power back towards states, refocus politics to local government, and a number of other,probably healthy development.

    I am quite ignorant of the legality of such a power grab by the states, although slightly aware that there might past court decision that did not permit States this power. However, it seems strange to me that a person can issue a commodity/money (e.g. bitcoin), but states could not issue a currency, and accept tax payments in that currency, and adopt policies (e.g. tax breaks) for payment in the state currency.

    • Eric Tymoigne

      1- If the fed gov accepts bitcoins in tax payment, they will be more widely used and a floor price for bitcoins will be set in dollar (The price at which bitcoins are taken by the government). It would be a bit like during the gold standard when the government stood ready to buy gold at a given price.
      However, if the government accepts bitcoins in taxes, there is potential risk that the bitcoin supply would rapidly dwindle (if market price of bitcoins falls below the price set by the government, all bitcoins would flow to the government) unless the gov use bitcoins to make payments on the bitcoin system. If it does enters the bitcoins system, it will require regulation etc. Basically that would go against the purpose of the bitcoin system (“no gov please”)
      2- California was on the road to create its own currency during the crisis. In terms of economics though the role of state and local government has increased dramatically not decreased! Most spending on goods and services by the government is done by state and local government not the federal governments. They are actually responsible for too many things now and their budget is too small to deal with that burden (just check the crumbling infrastructures).

      • “Most spending on goods and services by the government is done by state and local government not the federal governments.”

        Interesting. If you mean to exclude transfer payments from the discussion, I suppose that might be correct. However, my experience, without researching 50 states worth of data, is that my state and local taxes have always been far lower than my Federal taxes.

        Rather than 50 separate currencies, the Feds should give dollars to states on a per capita basis, in order to relieve some of the constraints of their monetary non-sovereignty, and allow them to afford the federal mandates they are forced to fund.

        I suppose it is OK for California to pay employees with tax credit coupons in a crisis, but I wonder how spendable a Calidollar would be in Padukah? What confusion, with exchange rates and all? It would be like Europe before the Euro … oh … maybe not so bad after all.

        • That’s right golfer1, purely in terms of goods and services 60% of gov spending is done by states and local. Once one had total expenditures (i.e. includes transfers), 40% of gov expenditures is done by states and local. These are 2010 value (go to BEA to get more recent values). These proportions have been on a rising-to-stable trend from the mid 1950s and 2010 values were almost the highest after WWII (2000 was the peak year, 65% and 45% respectively). One has to go back before the great depression to find higher burden of government spending done by states and localities.

      • Hey, I just happened upon your blog. I’m interested in MMT and other economic perspectives, but at the same time I think it’s valid to point out that you’re shoehorning new types of currency into models that were designed to handle fiat money. The results you get may be wrong due to the inapplicability of the model to this case.

        I agree with you that bitcoins are commodity money, but I don’t think their value is zero. Let me make another comparison of bitcoins to gold. In the subjective theory of value, the “value” of gold to anybody may vary depending on what they can do with it, and whether that benefits them. The market value of gold is what the gold will fetch on the “gold market”, accounting for all the various costs of transacting on that market. So let’s look at the value of bitcoins in this context.

        If you read the whitepaper, you will see that bitcoins were designed to be the first method of payment online without trusting intermediaries. To pick one contrasting example, e-gold was backed by gold but had a single point of failure: the servers of “Gold & Silver Reserve Inc.” — in network theory, single point of failure is a risk that all communications are exposed to. If this central point went down — which it did — it killed the whole system. Now, the point does not have to be completely fail in order to jeopardize the system. Just a partial failure, or the risk that it can fail, introduces uncertainties. So the value of bitcoin is that sellers can accept payments without the uncertainty of:

        * chargebacks and other reversals
        * inflation and other fiat currency risks

        as well as enjoying low transaction fees. This is REAL VALUE for real people, and in aggregate represents a tremendous market cap. Here is another way to look at it: before bitcoins, there was NO WAY that I could purchase things online without trusting an intermediary, such as a bunch of credit card processors, banks, and governments. The transaction fees in addition were high, and I paid them for the convenience of easily making the payment online. With a bitcoin wallet, I can save those transaction fees and pay only one fee: to the miners.

        Think of bitcoin miners as full-reserve banks, which they will become roughly equivalent in the limit as the returns from mining are eclipsed by the fees. The fees are to cover running the system, they are in effect the cost of transacting, and instead of paying them to “your” bank you pay them to whatever bank happens to solve the block that includes your transaction. If that fee is too low, you’ll have to wait until some bank agrees to accept your transaction.

        So bitcoins are a commodity which has real value — something that guys like Peter Schiff don’t seem to get or acknowledge when they hawk gold. Sure, gold has “intrinsic value” as a metal. But bitcoins have the value that comes from having in place:

        1) A powerful open source software client
        2) A presumably secure network protocol
        3) A growing network of merchants ready to accept the currency
        4) Not to mention future applications of the “timestamp server” such as proof of copyright, proof of signing contract, etc.

        And by the way, #3 is the reason that new cryptocurrencies can’t just spring up and be worth the same amount as bitcoin. We have to consider here metcalfe’s law. Gresham’s law doesn’t really apply because no government is going to set the exchange rate between bitcoins and, say, litecoins.

        In short — the value of bitcoins may be in a bubble, but underlying that is Metcalfe’s law. Even after the novelty wears off, there is real value in this commodity that is increasing, and the difference between bitcoins’ intrinsic properties and gold’s intrinsic properties are things like easy online payments anywhere in the world, low transaction fees, and lower exposure to various types of risks.

        Here are my thoughts on the subject:
        http://magarshak.com/blog/?p=148

    • I am quite ignorant of the legality of such a power grab by the states, although slightly aware that there might past court decision that did not permit States this power. It’s not court decisions- the “power grab” is flatly forbidden by the US constitution. However, the trend of court decisions has been to “look the other way” and give states a lot of freedom , e.g. when the state owns a bank or does other things that come close to issuing money.

      • So it is. So it is. Back in colonial times it made sense to do so too. I am not sure that in today’s market places fueled by computing and telecommunications that a rapid and seamless translation of currencies could not be attained (e.g. Amazon will show the price in Calibucks, even if the seller is selling in greenbacks).

  6. I understand the above comparison between other “monetary instruments” and bitcoin but the Easter egg and tulip comparisons seem off.

    If someone gives me an Easter egg and I don’t consume it its still an Easter egg I can give to someone else. And tulips may have been extremely over valued at one point but they didnt end up being worth 0 when all was said and done; people still pay for them.

    Can’t bitcoin have value because its a more convenient form of exchange? Billions of dollars leaving the US (and other countries) as remittances every year are subject to large fees. Grocery stores and cab drivers pay 5% in credit card payment fees. Can’t Bitcoin be valued because people want to avoid these fees?

    • Eric Tymoigne

      Think gold coins. That type of coins as a face value and an instrinsic value (value of gold as commodity). If king stops accepting gold coins in payment, their price will fall to their intrinsic value. That instrinsic value is the market price of gold, which varies in function of the supply and demand for gold. Sometimes the intrinsic value went above the face value and coins would be melted down to extract the gold.
      Usually the gold price won’t be zero unless nobody wants them. Bitcoins are similar, as long as they have a utility they will have a non-zero price as a commodity given scarcity. They provide a service (access to bitcoin payment system) that people find valuable (and I am not judging those people for that unless they are involved in illegal activities).
      Put differently, with gold coins, if suddenly everybody hated gold (intrinsic value of coins goes to zero), one could always at least pay the king with them.

      • Eric Tymoigne

        And you would pay the king at a well known value: the face value.

      • “Bitcoins are similar, as long as they have a utility they will have a non-zero price as a commodity given scarcity.”

        Would you consider changing the title of your article to “The Fair Price of a Bitcoin is Non-zero as Long as They Have Utility”?

        The best comparison I’ve heard so far is with music media. The current payment systems are similar to compact discs while bitcoin is a peer-2-peer network. I guess iTunes would be credit credit/debit cards.

        Another good comparison is the tech bubble. Because of bitcoin’s results a lot of cryptocurrencies are popping up with prices sky rocketing based on speculation of similar results. A bubble may be forming but the idea of peer-2-peer currencies can still have utility after a crash. Going back to the late 90s AOL was a tech giant but after the crash google went on to dominate.

        • Remember here we are concern with moneyness of bitcoins. The point is that these are not monetary instruments, they are commodities. For the moment, they don’t follow the basic rule of finance and so can’t be a sound monetary system. That’s the point here.
          If virtual currency want to become more than just a fade they have to put their act together and restructure the system to work properly as monetary instrument. One needs to make bitcoin creation more responsive to the needs of of the payment: remove the BTC 21 million limit, block reward is like fiscal spending (miners are the system’s workers and are paid by it) we also need the taxing side (what about making the transaction fee payable to the system itself, would destroys bitcoins endogenously). Doing this would make the net creation of bitcoins move with desire net accumulation of bitcoins. We are getting somewhere with that. Block reward should vary with the difficulty.

          • More than just a “fad” not “fade”. Whoops! Writing too quickly here…

          • “One needs to make bitcoin creation more responsive to the needs of of the payment: remove the BTC 21 million limit, block reward is like fiscal spending (miners are the system’s workers and are paid by it) we also need the taxing side (what about making the transaction fee payable to the system itself, would destroys bitcoins endogenously). Doing this would make the net creation of bitcoins move with desire net accumulation of bitcoins.”

            The best of both worlds. I think we’ve just laid the groundwork for Modern Cryptocurrency Theory.

    • Billions of dollars leaving the US (and other countries) as remittances every year are subject to large fees

      Those fees are so bogus because US dollars can’t leave the US financial system, according to Frank Newman. They’re just keystrokes moving around the Fed.

  7. Kudos for actually investigating their mechanics instead of just looking at the price evolution and saying tulips.

    I’m a programmer/forex trader, so while I have a very good understanding of their technology, I only have a partial grasp on their economics or your arguments.

    To me, their practical value is obvious. Wire transfers to/from my forex broker take days or even a full week sometimes to settle, with costs between 1%-6%. Bitcoin transfers of same amount settle in hours with practically no commision ($cents). This opens up whole new dimensions. This is not even counting that they seem to be the first actually working micro-payment network. And like somebody said, instead of having 3 different networks (wire/western union/credit card) depending on the sum (tens thousands+/hundreds/tens), you now have a single payment network for all value sums, from pennies to billions.

    But this is not why I “invested” heavily in bitcoin. Indeed, I’m trying to make a buck here, but then again 98% of daily forex transactions are speculative too.

    I refer you to this paper, which argues that bitcoin is the most perfect form of “money” yet, and that it surpasses other monies on each measurement axis – scarcity, durability, divisibility, can’t be counterfeited, easy to store/transport (you can even memorize them – Johnny Mnemonic style) and a few others I don’t remember.

    To put it simple, marbles are better than eggs, gold is better than marbles, dollars are better than gold, and bitcoins are better than dollars – as value store/transmission mechanism. The paper arguments make sense to me, but since I’m not an economist, maybe they are wrong.

    http://konradsgraf.com/blog1/2013/10/23/on-the-origins-of-bitcoin-my-new-work-on-bitcoin-and-monetar.html

    Also, you seem to contradict your self. You say that their fair value is 0, but in a comment you say “Bitcoins are similar, as long as they have a utility they will have a non-zero price as a commodity given scarcity”. Are you saying that they won’t have a utility any longer sometime in the (near) future?

    • “Also, you seem to contradict your self. You say that their fair value is 0, but in a comment you say “Bitcoins are similar, as long as they have a utility they will have a non-zero price as a commodity given scarcity”. Are you saying that they won’t have a utility any longer sometime in the (near) future?”

      I think what he said was that as a financial asset, subject to the equations for financial assets, the value of bitcoins resolves to 0. And that as a commodity, they may continue to have utility (and thus, value) as long as the payments system remains intact.

    • Gigi, made be thinking about stamps would help.
      Face value is say $1.
      Intrinsic value is $0.
      As long as the post office accepts the stamp at face value it will circulate at $1 at least. fair value is $1 as a stamp. If the post office refuse to take the stamp, fair value as a stamp goes to $0.
      Now there are $1 (or other similar small face value) stamps that sell for millions of dollars. This is so even if their fair value as a stamp is $0. But this is their value as commodity, not as stamp. Their price as a commodity depends on the utility that people find in them (both intrinsic, like “beauty”, and speculative utility) and their scarcity.
      Regarding the paper you mention, it uses Menger’s theory. I (and everybody else on this website) reject this approach completely as ahistorical and no theoretically sound. Commodities have never been monetary instruments ever. Emergence of money was not based on market exchange but wergeld and then state. The story of money starts with the imposition of a unit of account and some financial instruments. This financial instruments were first uncollateralized unconvertible financial instruments (in Egypts and Mesopotamia via shubati), went to collateralized financial instruments (gold coins), then convertible financial instruments (convertible paper money) and then back to unconvertible financial instruments. Both states and private sector have issued monetary instruments.

  8. Thanks for writting this very clear and useful analysis!

    However I doubt that the use of bitcoins (and its technology) should be reduced to merely engaging in illicit/anonymous activities.
    An increasing number of worldwide service providers are accepting BTC as a means of payment, which have other advantages over the restrictions of national currencies in the globalized digital economy (to the same way cold cash can be preferred in real life over credit card, for instance). Even if most of the current bitcoin trade is pure speculation and clearly diverts and hinders its intended payment purpose, it does not cancel it! Besides, people will cash out their investment once the craze has stopped.

    If so many people started investing ‘real money’ in bitcoin, it was not necessarily to set up a new Ponzi scam: it might also have been because it answered real needs (not provided by national currencies) and they believed in the benefits the technology could bring (always the same story with digital economy…).
    Of course nobody can say if BTC and its crypto clones will last or not. It certainly depends to a large extent on how the national currencies will be able to address the consumer needs that triggered the initial adoption of BTC. But it might also survive its speculative phase and end up being widely adopted as a daily means of payment!

    One comment about the maturity of BTC: “we are stuck with them forever once they are created”…
    Maybe BTC is not a ‘financial instrument’ stricto sensu, but it can assume financial functions nonetheless (see, for instance : http://www.cryptostocks.com).
    BTC are neither paper nor copper… they are silicium! As such their existence depends ultimately on the hardware they are encrypted on and they will certainly not last ‘forever’. Not so sure that if humanity was wiped out tomorrow, we could retrieve any trace of BTC in 2000 years from now the same way we occasionally dig out some old Roman or Chinese coins. Not to mention the previous comment and the fact that private & public keys will be lost or forgotten along with the coins.
    Actually, the decision to take the BTC back belongs to its users – and not to the States like for national currencies. Since it is a means of payment, people can freely choose to use it or not -unlike national currencies. If it no longer suits their need, they will just cease to use it. I imagine the value they will loose in doing so will be the price paid for the service provided by this means of payment (instead of national tax for currencies).

    Beyond the narrow economic nature or value of BTC, I believe it is in its broader political and social dimension that its interest really stands: currencies are also means of power in the hand of states and big financial institutions…

    • Hi cardenio,
      I guess people focuses on that aspect of the article. I do mention other uses or reasons as well (pizza, hate gov, etc.). It looks like the finance world also find it useful as one of the fx trader commented (we had the shadow banking system, now we have the shadow payment system…). In fact I hope that there are many legal transactions done with it because given the amount of world wide transactions shown at Fiatleak.com it would be disturbing if all transactions were illegal.
      “the decision to take the BTC back belongs to its users.” See, that just not good enough. What if users don’t want the bitcoins anymore. Either they will try to spend it away (massive potential inflation) or they will throw them in the garbage (so to speak), value goes to BTC 0. We need a means to remove them from the user (like goverment removes its monetary instruments from its user by taxing, or bank remove bank money from their user through the need to repay loan and pay interest to banks).
      I am not against private monetary instruments, bitcoins is not novel in doing that. But bitcoin need to be structure properly to work as a monetary instrument.

  9. It’s true that BTC is inherently deflationary in the long run, but over the next several decades at least the BTC creation rates implies (all else equal) significantly higher rates of inflation than the official currencies of the world. For all practical time horizons (i.e., short ones) BTC won’t suffer because of built-in deflation.

    Which of course has no bearing on the suitability of BTC (or lack thereof). But the inherent deflationary bias in the long run is of no practical import. I doubt BTC will be in use in 2100.

  10. Bitcoin has an “issuer”, the miner and the issuer accepts bitcoin as payment for recording the transactions in bitcoin. Even when all possible bitcoins have been mined, the “miners” will continue to accept bitcoins as fees for recording bitcoin transactions (in fact that will be their only source of bitcoin revenue after that point of time purely from mining activity). Of course, nobody is forced to accumulate bitcoins, because payments to miners/record keepers arise only when one is transacting in bitcoin, but then it was intended to be a monertary unit free of any force.

    Right now it is behaving like an asset rather than a monetary instrument, but has all the qualities needed for a monetary unit.

    • GRP, it is lacking a few things to work properly (see reply go gigi above). There is no means to destroy it (think tax or repayment of debts so nobody that its quantity is reduced as needed), creation of bitcoins is too arbritrary (everybody complains that gov is spending too arbitrarily, should complain about block reward), limit of BTC21M is unnecessary (creator should embrace the ex-nihilo creation, very nice quality).

  11. Big fan of MMT and Bitcoin. I think in spite of the tone of this article, it is not (a) wrong nor (b) an indictment of Bitcoin (particularly the blockchain) as a valuable asset.

    Bitcoin has value outside of the equations above which could be considered a ‘transmissibility premium’ whereby I can send a bitcoin to a given address within a matter of hours. That’s faster than most money transfer mechanisms available to consumers. I think that alone creates a demand, even if people are mainly willing to pay that premium for illegal activities. I can still go to Gyft and redeem Bitcoins for amazon gift certificates or sell them on the open market for USD.

    As long as an actual market price exists, isn’t it incumbent upon modern monetary theorists to come up with an equation that explains it? I think you all have done amazingly well at explaining macro econ, I don’t see why MMT should settle for considering this speculative asset worth $0 by calculation when it is clearly >$0 in reality.

    • The difference is the nature of the asset. Financial assets can be priced according to the equations for financial assets. Real assets cannot. Real asset prices behave according to other factors not included in financial equations. Does your realtor have an equation that defines the price of housing from 2000-2010? Does your jeweler have equations for the price of gold?

  12. “Like all financial instruments, monetary instruments have an issuer who promises to do something in the future.” Cause the Federal Reserve has done so much for me…

  13. You are trying to use standard financial valuation to determine the value of a bitcoin. Then you completely miss the point of what makes a ‘currency asset’ different from other assets. A currency has value ‘in exchange’. Every day you can benefit from having them because it allows you to transfer value, hold value and heck, even give it away! The value of bitcoin is found in the network effect, others recognize it and accept it. (Hard to falsify and fungible are just some necessary conditions, nothing special about that.)

    Have you even tried to use it? So how far are you off in your valuation today then?

    • Eric Tymoigne

      Anything can allow you to transfer value. From a house to a car to gold necklace, etc. Not specific to monetary instrument.
      Here is an analogy for you. You can use a shoe to hammer nails, it does not make the shoe a hammer. If everybody thinks that shoes are hammers, first they are wrong (a shoe is a shoe and the lonely person who points this out will be right even though thought as stupid by all others), and, second, than I can guarantee that there will be many more work-related accidents and productivity will drop because shoe are not build properly to hammer nails.
      A monetary instrument is not defined by what people think money is or a commodity. it is a financial instrument. Use it carefully and properly.

      • OK, Eric, when Stephanie Kelton says that the US issues currency, what, then is she talking about? Just coins and dollars? Coins, dollars, and treasury securities? Anything the government issues that can be accepted in taxes? Just the unit of account?

        Thanks.

        • She is talking about coins, Federal Reserve notes, and reserve accounts (bank accounts of banks at the Fed).

          • Eric, thanks. Why aren’t treasury securities considered? They’re tradable. They’re denominated in US dollars, and they are dollar deposits at the Fed, aren’t they?

            Appreciate your time answering baby questions.

            • Yes they are tradable but their maturity is not instantaneous.
              They are not dollar deposits the fed; they are treasury securities. It seems you are thinking too much ahead. MMT indeed states that instead of bonds issued by the treasury, the fed could pay interest on savings deposits of different maturity.

              • [I think this got lost in software heaven before.]

                I got the expression from Warren Mosler. He said ‘basically treasury securities are just dollar deposits at the Fed’. Using his ‘CD at a local bank’ example, he said treasury securities are in savings accounts at the Fed.

                Can’t remember where he said it. Either his Columbia U. Modern Money seminar during Q&A? Or during his Soft Currencies talk in Europe last summer?

  14. My question about BTC is this – if BitCoin exists in the terrestrial world only as, in essence, a technique or process, what is to stop others from creating their own versions of BitCoin and subjecting BitCoin to Gresham’s law?

    • For now, the network effect. Lots of alternative distributed cryptocurrencies exist already, but people who haven’t been steeped in this stuff for a while only talk about Bitcoin.

      And strangely, Gresham’s Law hasn’t driven gold out of existence even though silver exists.

  15. When the bitcoin bubble gets big enough that its use gets in the way of the gov’t obtaining the real assets that it wants, that gov’t will decide it needs to find a way to tax it and regulate it. When that happens, bitcoin’s utility as a payment system disintegrates.

    • People who have income from bitcoins are already subject to income tax. And items sold for bitcoins are subject to the same excise and sales taxes as the same items sold for dollars. Bitcoin users may be under the impression that they don’t owe the taxes they would have owed if they used dollars, but if they are caught they will learn differently. They may be flying under the radar now, but if bitcoins become big enough the radar will begin to pick them up.

  16. Your post has appeared on Hacker News: https://news.ycombinator.com/item?id=6843676

    (Note that the commenters there have, as is usual with any articles that are critical of Bitcoin, rather failed to understand your point.)

  17. Nice review. I also think that Bitcoin has very little intrinsic value, however, it has some, such as time-stamping, document certification; decentralized DNS:
    http://apblog.imakescience.com/2013/11/bitcoin-true-vs-apparent-value.html

  18. Serious question: why does gold have “intrinsic value?” I’m not aware of any real use for gold before the industrial application of electricity. Its use in jewelry is mainly derived from the fact that it’s a conspicuous display of wealth, so that doesn’t count. It seems like people will trade goods and services for gold only because they expect others to trade gold for goods and services. Which is a tautology – “it is because it is” is not an argument with merit.

    I can’t discern what value gold has, other than the same “money” properties it shares with Bitcoin (plus physical tangibility, but minus instant worldwide transfer.) The author never seems to explain exactly what that intrinsic value is, and I can’t think of what it might be.

    • Well a big one was to be used to stamp coins. There was little trust in king’s promise so people wanted something to back the promise, hence gold that was a collateral. if king defaulted on promise, people could sell the gold content (at least they could melt it down, go back to the mint, and get new coins that king accepted). Others reasons for using a precious-metal to make coins was to limit forgery, to show prestige, to pay mercenaries. Note that gold was not the money, the coins made of gold was. As such the coin had a different (usually superior) value than the gold content.
      Then kings and his court wanted gold for everything. Jewelries is too small thinking. See you and I are not used to luxury. Reminds me of my students when I asked them what they would like to get if they were king. They always go for the small stuff: a big house, a nice car, jewelries, etc. Think big! Think casket of the size of pyramid, think gold plated walls in your palace, think chariots and thrones! Heck! even when they were dead they wanted gold (noooo! not just jewelries! the casket had to be made of solid gold!).
      They were so demanding about it that they exterminated and enslaved entire populations for that purpose.
      And you tell us that that demand “doesn’t count”???!!! That was a huge driver for the market for gold! (Just playing with you…don’t mind all the ? and !)
      In all seriousness, for bitcoins, the only use I can see is that it provides access to the payment system. That’s what some people find useful.

      • Vincent Huang

        Great article! But I am skeptical that bitcoins can even do a good job in providing an access to the payment system. Since its “purchasing power” stems from a speculative demand, it is highly unsuitable for making purchases. Its value is not in eliminating the “double coincidence of wants” problem, but in providing an apparent alternative that is supposed to be more “sound” than those government liabilities. Bitcoins are very much functioning like gold now. And behind bitcoins is a barter fantasy. I dare say that the demise of the bitcoins would be positively correlated with the spread of MMT.

      • You missed my point– I’m saying that 100% of the demand for gold as a display of wealth is because of the fact that gold is associated with wealth *in the first place*; but it doesn’t help us understand why gold was associated with wealth before people then started using it for jewelry and other conspicuous displays. I understand that B directly follows A; but I’m trying to understand what caused A, so defining A in terms of B is circular logic.

        • Eric Tymoigne

          Data Plumber, first remember there was a demand for the monetary system too beyond wealth (gold helped limit forgery of coins, increased acceptance of coins, etc.). Second, what creates a demand for something (why did the upper class want gold?) is not relevant for its pricing per se (unless related to speculative reasons: buying gold purely to bet on price direction). The point is that there is a demand (even if it may be for silly, conspicuous, wasteful reasons) and that allow prices to be positive.

    • >Serious question: why does gold have “intrinsic value?”

      Because it costs to “make/mine it”.
      This stays true until :
      - We mined the last bit of gold in the universe – so it becomes like any art work : unique and speculative
      - We can transform anything (lead?) to gold – then it becomes like food, a proxy for the cost meeded to make it.

      Bitcoins intrinsic value?
      While BTC mining is still possible, the cost (energy /capital) of mining it.
      Once all BTC have been mined: No idea

      An interesting question is: What will be the price of the 21M th BTC?

      • If your definition is correct, then the author’s assertion that Bitcoin has no intrinsic value is simply false, and since the article is pinned to that assertion, then the article’s conclusions are entirely without merit.

        Still, I would assert that the value of Bitcoin has nothing directly to do with the cost of mining, but rather in the security and utility of its network (which requires the poorly-named “mining” to occur. A better description would be “auditor”, but that lacks panache.) And that the value of gold has nothing to do with its cost of production (except insofar as that enforces scarcity), but rather its utility as a money. (Scarcity/divisibility/fungibility/transportability/ease of identification.) Oh, and of course the network effect: the association between gold ownership and wealth is so deeply ingrained in society that you have to concentrate to gain enough objectivity to figure out why.

        > What will be the price of the 21M th BTC?

        One could similarly ask what the price of the last ounce of gold mined would be? (While there will always be “more gold somewhere”, the marginal cost of mining another ounce will eventually be high enough that people will stop doing it.)

      • I think that’s backward. Gold is mined because there is demand for it. If the demand disappeared, there would be no “intrinsic” value, and nobody would waste the effort to mine it.

        Did people mine and sell pet rocks because they had intrinsic value?

        • Gold is/was 3 things: A currency, a rare metal and jewellery and their respective values are quite different.
          Jewellery has a clear premium (Artistic value, alloys …), as a metal for technical applications gold has another price (Because of purity …) , but as a currency.

          So the question what is the “fair value” of a currency?
          Do you think USD is stable because people want to have USD or because they trust Uncle Sam can manage an economy?
          To me the “demand” for a currency is just a proxy for the whole ecosystem behind it. It is close to a political vote.
          Now back to gold. If demand more or less equals offer what would be the “fair” price of gold as a currency?
          Since new gold must be created/mined the miner will never sell under its cost (for gold it is around 1200$) so you could say the fair price of gold as a currency is 1200$ + miner income.

          But if a new mining technology is found or if demand outstrips supply gold will fluctuate. Also it is impossible to destroy it. That makes gold a poor currency.

          The same cost of mining applies to BTC, a lucky miner will at least try to recoup its cost before selling a BTC. Parallel to gold, if you find a new technology to hash for less the price of BTC should decrease until the last BTC is mined.

          For me currently the price of BTC is related to demand as more and more people trust the BTC ecosystem to satisfy their specific needs. BTC is a bad reserve currency, for the now, as it fluctuates too much. But as a zero fee exchange system it is a wonderful tool.
          In 2140, when more exchanges will be carried in BTC, the “in-transit” amounts being orders of magnitude higher could earn it a reserve currency status.

  19. Russell O'Connor

    Thanks for the article. I really enjoyed it except for one last bit at the end where you wrote:

    “By the way, just for full disclosure, those who organized the hunt collected a bunch of eggs before the forest opened to the public.”

    I don’t know why you felt the need to throw that incorrect statement at the end. The genesis block, the first page of the ledger, contains a headline from the Jan 3rd, 2009 edition of the Financial Times. This is a standard way of establishing that the hunt could not possibly start before that day. The Bitcoin code was announced publicly on Jan 9th, 2009 @ http://www.mail-archive.com/[email protected]/msg10152.html which only gives the organizers at most a 6 day head start in egg hunting. That said being said, the second page in the ledger is dated Jan 9th, so in fact, the organizer only collected 50 bitcoins from the first block before the public announcement. Furthermore, it is my understanding that the protocol was configured so that these 50 bitcoins are unspendable. Therefore it is transparent that the organizers of the hunt did not collect a bunch of eggs before the forest opened to the public.

  20. Pingback: Interesting bits | Some Things Are Obvious

  21. Simply put, isn’t this a sort of online game that’s been taken a bit too seriously by the world?

  22. I want to know your opinion about the empiric difference between the “fair” and the “market” price and if that’s a problem or not.

    For example, the Black Scholes option pricing model it’s famous because it diverges from market prices at the tails, the so called “volatility smile”. So it’s “fair value” it’s acknowledged by academics/traders to not accurately represent the “market (real fair)” value of an option.

    As a result, there are a myriad of different option-pricing models, which try to more accurately compute the “fair” value, so that it is closer to the market value.

    Gold – the “fair” value of gold, counting it’s industrial/ornamental uses it’s probably much smaller than it’s current market price, probably accounting for less than 10%. Isn’t this a problem with the model used to price it?

    What I’m trying to say, it’s what is the utility of a model which gives a fair value hugely different from actual market prices, for long periods of time (10+ in case of gold, 4+ in case of bitcoin). Shouldn’t the model be improved? Maybe by using behavioral finance theories?

    In physics, if the model doesn’t agree with the experiment, people try to find a better model.

    Is it honest to wave that divergence away as “market speculation”, “mania” or “irrationality”? What about Warren Buffet which has an annual return of 19% over his entire career, contrary to what Efficient Market Hypothesis says it’s possible. It’s just only luck?

    Personally I have also made huge profits despite EMT, for example by trading the EUR/CHF peg that the Swiss Central Bank put into place in 2011. You could say that I just got lucky, but when a central bank says that it’s currency will go down and they will print unlimited amounts to that respect, don’t you believe it? Same with the ECB declaration that the Euro will be saved “no matter what”. Shouldn’t “fair values” theories take this kind of political statements into account?

  23. Eric Tymoigne

    I am with you on the rejection of the efficient market hypothesis. Markets are unstable, that’s minsky, and financial market participants now thrive on volatility.
    Regarding fair price, yes option pricing with BS as not work well given the underlying assumption and complexity of the factor influencing its pricing. Figuring out the fair price of a modern monetary instrument however is not rocket science. It is a (for all practical purpose) a zero-coupon security with instantaneous maturity so it is pretty straightforward to figure out the fair value: parity. Monetary instruments have traded at fair value for quite a while now. It used to not be the case in the past for complex reasons that I can’t go into detail here related to market structure, issuer screwing up, fraud, and influence of collateral value (gold value).

  24. Steven Arnold

    Merril Lynch says the current valuations of Bitcoin are not overly optimistic and pegs the fair-worth value of a single Bitcoin at $1300: http://arstechnica.com/tech-policy/2013/12/bitcoins-roller-coaster-ride-gets-wilder-as-wall-street-china-climb-on/

  25. A ponzi scheme…..like the US dollar. There is nothing backing the dollar as there is nothing backing bitcoin. Both solely have value based on their psychological value as a medium of exchange. At least the production of bitcoins is theoretically limited, therefore should be a greater value than the dollar. Ironically it is the United States government giving bitcoin its value. Its FATCA tyranny and NSA spying is driving people to find ways of finding ways of protecting their privacy. Bitcoin has value because the U.S. government has necessitated a mechanism such as bitcoin. If we saw the return of Swiss style privacy, for real, the value of bitcoin would disappear.

    • Both solely have value based on their psychological value as a medium of exchange.

      The USD has value ultimately because it is the only thing accepted by the US government as tax payments, nothing psychological about it.

      • Agreed, not only because it is accepted as tax payments but also because we trust the ecosystem to be willing and able pay those taxes.

      • Eric Tymoigne

        That’s right Erik. That’s part of the promise that government makes: it will accept its US dollar in payments. No need to back by anything as long as people expect that:
        1- they will have to pay the government
        2- the government will indeed accept its US dollars in payments

        Nice picture by the way…I trust you are one of those who hope to avoid requirement 1-…

  26. Eric Tymoigne:
    Your appraisal of the US dollar (and comparison of Bitcoin as lacking thereto) as having rational inherent value is missing all consideration of scale.
    .
    The US dollar could only inherently hold face value to the extent of any amount the recipient is lacking for expected future payments to the US government. Beyond that the face value must be discounted by the need to transact with others who do not yet have sufficient dollar to pay their expected future bills to the US government. Of course that is a discussion about rational inherent value, the current system reflects different realities because it is not rational and doesn’t require value to be inherent.
    .
    Being worth face value is apparently even less certain when you consider for a moment that the support offered by the US government accepting the US dollar as payment of debts is restricted to the gross receipts of the US government. With deficit spending gross receipts are not even lashed securely to gross expenditures.
    .
    The end result is that the de facto currency of the world is hinged on a guarantee that doesn’t actually cover the whole nut, yet it functions sufficiently well to have remained the dominant currency going on a century.
    .
    There are several reasons the US dollar maintains value. Inside the US, it has to do with prohibition of most other currency, the multitude of instances in which taxes must be paid, and a population thoroughly indoctrinated in valuing things with dollars. Outside the US, the hegemony of the dollar is the result of much effort; massive continual short positions in large derivative markets, formidable proactive stance taken against threats of competition by other currency in large markets such as petroleum, and the structure of deals by the likes of the IMC, IFC, military and non-military aid, trade agreements and large NGOs.
    .
    One possibility is that the reason BITCOIN was not crushed shortly after being noticed by the powers that be in the US government is because the powers that be are flirting with using it or something similar as the ship to jump to as the dollar ship is inflated away to worthlessness.