Why Bitcoin will continue to grow

My prediction for Bitcoin's future growth is not just exponential growth, but faster than exponential growth.

Text | Daniel Krawisz. Why Bitcoin Will Continue to Grow. 2014/2/1.

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The value of money is the value of community

Currencies are unusual in that their usefulness as money is a result of their demand. The more potential transactions that can be done with a currency, the better it is. A currency can be a good currency only indirectly because of its intrinsic properties. To an alien with no interest in human culture or technology, the dollar and the bitcoin are equally worthless, even though he can see that bitcoin is a superior medium of exchange.

In economics, this is often called a network effect, because it's the network of its users that makes everyone believe that the thing is valuable. This seems to lead to circular reasoning: everyone believes it's valuable because everyone else believes it's valuable because everyone else believes it's valuable... and so on. It's almost like a cartoon monkey picking itself up by its own tail!

However, a better physics metaphor might be the formation of crystals. A liquid can be supercooled to a state where it can support crystals, but no crystals will form because there are no initial crystals for the liquid particles to attach to. However, once a tiny impurity, or "seed," is introduced into the liquid, a crystal will form around it and grow rapidly until the liquid is completely absorbed.

In this metaphor, the supercooled liquid is the world a few years ago, ripe for a monetary revolution, and the seed is the initial Bitcoin purchase. Bitcoin’s successful transformation into something of value seems like a miracle. However, there is no miracle. It is the result of the dedication and belief of its community, whose members will not give up on their vision of Bitcoin’s future. Rather than using a metaphor like “bootstrapping” to describe a physical paradox, it might be better to describe the formation of the initial “seed” of a Bitcoin transaction with a word like “crystallization.” [Note 1]

So when people think Bitcoin is worthless and call every price increase a bubble, they really miss the point. An investment in Bitcoin is an investment in the Bitcoin community. It wasn’t until late 2012 that I realized how fanatical this community was, which convinced me that my Bitcoin was not simple speculation, but something with very real promise.

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The network effect of money

Social networks are a familiar and often cited example of network effects. Both Facebook and G+ have a lot of nice features, but what makes Facebook so much more useful is that all your friends are already on it. Therefore, it is the network of Facebook users that is truly valuable.

This example can be confusing when compared to currency. Facebook and G+ have properties that allow one to be used at a low opportunity cost. In other words, if I've already spent some time crafting the most narcissistic Facebook status update I can think of, it's almost no extra effort to post it on G+ as well. Facebook and Google both support chat protocols, so using a program like Jitsi to run both protocols and be logged into both services simultaneously is almost no extra effort. Therefore, it's possible for a social network to succeed without reducing the size of the other. It can expect to attract members without necessarily pulling them away from others.

However, with currencies, the situation is different. Owning any one currency comes with a high opportunity cost of owning any other currency. I cannot use the same money to buy an investment in Bitcoin, Silver, or Canadian dollars. If I want more of one currency, I must have less of another. If any one currency is considered a winner over the others, then there is no additional benefit for anyone to own the others.

While the two social networks can coexist, the world is not big enough for two currencies. Any initial difference between the two currencies, no matter how small, will positively reinforce itself, and there is no reason to expect that this effect will end before one currency is obsolete. As the price of currency A begins to rise relative to currency B, holders of currency B begin to see their investment becoming increasingly irrational. As more and more people flee currency B, its depreciation accelerates until it is effectively no longer a currency.

Our everyday experience with different national currencies within each independent country does not seem to bear out this conclusion. This is because these countries often have legislation such as legal tender laws and capital controls that artificially reduce the usefulness of other currencies within their respective borders. No jurisdiction has given Bitcoin legal privileges, so there is no group of people who need to treat it differently. Therefore, there is no reason to expect Bitcoin to maintain a stable balance with national currencies, the same way that these national currencies maintain a balance with each other.

From these considerations, the future of Bitcoin is an all-or-nothing proposition. If Bitcoin is good enough to compete with other currencies, despite their legal privileges, then it will surpass them. If not, then it is a bubble and ultimately no one wants it, except for a few true believers.

One could argue that Bitcoin can retain its uses in the illegal market, but if no one wants to use Bitcoin as a store of value or an investment, there is no reason for a drug dealer to accept Bitcoin as a means of payment. He must either want to keep it for himself or sell it to someone else in order to use it. Therefore, if Bitcoin fails as an investment, it fails as a payment system, even for the uses for which it is particularly well suited.

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The significance of Bitcoin’s upward trend

All things being equal, a larger network is better than a smaller one. This puts Bitcoin at a disadvantage relative to national currencies. Therefore, one would expect Bitcoin to fall relative to the dollar or the euro. The fact that this is not the case tells us that not all things are equal. It shows us that Bitcoin is still good enough compared to national currencies. Despite their advantages over it, it can grow regardless. The network effect means that the larger Bitcoin (the network) is, the better its prospects. The fact that Bitcoin has grown in the recent past is a strong proof that it will continue to grow in the near future.

One possible objection is that demand for Bitcoin is primarily investment demand, not demand as money. Therefore, the objection goes, demand for Bitcoin is no longer increasing on its own. However, a currency can become more useful due to any type of demand, not just demand as a currency. I would bet that most people investing in Bitcoin today would be happy to acquire more Bitcoin by trading it for goods and services. They would also be happy to act as facilitators for Bitcoin transactions through dollars, which is essentially what happens when a merchant accepts Bitcoin as payment and then immediately converts it to dollars. Therefore, their investment demand enables Bitcoin to be used more as money. By simply investing in Bitcoin, they enable more potential transactions and make Bitcoin a better currency.

What’s interesting here is that as Bitcoin grows, we should expect the advantage of national currencies over Bitcoin to decline and eventually turn into a disadvantage. So not only will Bitcoin’s expanding network further fuel its growth, but so will the decline of its competitor networks.

Based on this, my prediction for Bitcoin’s future growth is not just exponential growth, but faster than exponential growth. If successful, I predict Bitcoin will take over the world faster than anyone expected, including myself. This prediction has been borne out in my own case: I have always been surprised by Bitcoin’s success. Now, one of my biggest fears when writing about Bitcoin is that my predictions will come true before I publish them.

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The end of the trend

Predicting changes in Bitcoin's growth trend requires accounting for currently irrelevant effects. This makes things difficult because it's hard to say what will become relevant first. For example, Bitcoin's growth could outpace its technology, and the network would become congested enough to hinder adoption. If the world's governments work together to destroy Bitcoin, that could also significantly hinder Bitcoin's growth - but at this point, I doubt it would be stopped.

At least for now, Bitcoin’s current trend is self-reinforcing, with no equilibrium point in sight.

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Note 1: Crystallization implies a transition from liquid to solid, which is not appropriate for Bitcoin. A better physics metaphor is the more general concept of spontaneous symmetry breaking, which includes not only crystallization but all other processes that do not transition from liquid to solid. Unfortunately, however, not enough people understand that this is a good metaphor.