The original value of Bitcoin

Bitcoin is a puzzle to be solved, not an excuse to deny reality. It must have original value.

Text | Daniel Krawisz. The Original Value of Bitcoins. 2013/7/2.

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Regression Theorem

From the perspective of the Austrian School of Economics, the most puzzling aspect of the Bitcoin network is its relationship to the Regression Theorem, the Austrian economists’ explanation of the origin of money[1]. The Regression Theorem addresses two different issues: the emergence of a medium of exchange, and the evolution of a medium of exchange into money. A medium of exchange is defined as something that is purchased in order to later trade it for something else. Money is the most excellent of all media of exchange.

Bitcoin is not and never was money, so only the first question is relevant today. However, since the second question may be important for the future of Bitcoin, it is worth mentioning. The evolution of a medium of exchange into money can be explained by the observation that, all things being equal, a more marketable medium of exchange is more worth having than a less marketable one. Therefore, the medium of exchange that is the most marketable among several mediums will have an advantage over the others. As more people choose that medium because of its greater marketability, it becomes more marketable, while the others become less marketable. Thus, in the long run, one single medium can be expected to dominate the others.

Regarding the first question, the explanation depends on the observation that in order to sell something, both the buyer and the seller must view it as an economic good—meaning that they both want some, even if the price they are willing to pay is not the same. If the buyer does not view it as a good, then he will not be willing to pay for it, and if the seller does view it as a good, then he will be willing to give it up, and even willing to pay to give it up. Since a medium of exchange is something that is bought and then resold, both parties in both transactions must view it as an economic good.

Therefore, the first person who can use a commodity as a medium of exchange must buy it from someone who also considers it a commodity but does not use it as a medium of exchange. So there can be no other way for things to become a medium of exchange based on some other need.

To recap, the regression theorem says:

To become a medium of exchange, something must be desired for other reasons. Among a group of competing mediums of exchange, one will tend to become money.

Both are necessarily market phenomena, as they occur as people individually decide what they wish to trade with and with whom. Institutionalized coercion can influence this process, but it always comes from the outside: for example, a state can try to promote one medium of exchange over others by outlawing them. This can influence which medium of exchange becomes money, but they cannot directly make something a money or a medium of exchange by fiat.

On the other hand, the regression theorem does not say:

Something must be widely desired to become a medium of exchange. It must begin as a medium of exchange with those who demand it, but from there it can spread to more people. Something must be strongly desired to become a medium of exchange. Behavioral science cannot make such a statement, because subjective value theory does not allow for a distinction between strong and weak desires. Desires can be compared with one another, but they cannot be absolutely characterized. The future of a medium of exchange depends on its origins. Some origins are possible for a medium of exchange and some are not, but once it exists, its origins are not important: its future demand depends on its current demand and other current factors that affect it, not directly on anything that happened in the past. It is possible for a medium of exchange to not obey the regression theorem. Conversely, any medium of exchange that apparently does not obey the regression theorem will, on closer examination, be found to obey it perfectly. [2]

These fallacies underpin the negative reaction of many Austrian economists to the Bitcoin network’s currency, Bitcoin.

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The Bitcoin Paradox

Now it is possible to explain the paradox of Bitcoin and why it is often poorly analyzed by the Austrian School. To properly analyze Bitcoin, it is necessary to use only the cold hard logic of the regression theorem and not let the gold lovers interfere.

The Bitcoin paradox is that Bitcoin seems to have no use other than as a medium of exchange. Its technical features, while elegant, are lifeless as long as there is nothing Bitcoin can buy. Therefore, if Bitcoin becomes a medium of exchange, this would seem to violate the regression theorem.

There are two inherent fallacies in this apparently paradoxical statement. The first is derived from an unimaginative argument. Just because the nature of Bitcoin's original value is unclear, does not mean that there is none. The second is a violation of subjectivism, which is fundamental to Austrian methodology. Economists do not need to claim to understand why people value anything - demand is demonstrated by the fact that something has a price, not by the fact that economists understand why people pay for it. I do not deny that lottery tickets are an economic good, although I do not understand why anyone would buy them.

Bitcoin is known today as a medium of exchange. This proves that the regression theorem must apply to it, even though it is difficult to understand the original demand [3]. Empirically, they were sold for dollars before they were used as a medium of exchange [4]. This confirms that something must be true according to the regression theorem.

The correct approach should be clear to any Austrian economist, but until recently, the Austrian analysis of Bitcoin has been superficial. The Austrians have yet to generally understand that Bitcoin is fundamentally different from gold and fiat currencies, and therefore require a fundamental analysis, back to first principles. This may have to be reiterated several times before the Austrians are convinced.

Austrians who oppose Bitcoin have no plausible charges against it. They are convinced that there must be something wrong with Bitcoin, but when they try to articulate it, the conclusions they draw are either subjective or wrong.[5] The most common response is that the regression theorem means that Bitcoin cannot be money or is in some way unsustainable.[6] But this conclusion misunderstands the nature of praxeology. Praxeological arguments can only say that certain causal relationships are possible or impossible. Nothing in real life can violate praxeological laws—even temporarily.

I think this reaction has more to do with misattributing reasons why fiat currencies (and similarly Bitcoin) are unsustainable than reasons why gold is superior. Gold has obvious productive uses; the dollar and Bitcoin do not. Yet gold is not stable for those reasons, and neither is the dollar. Rather, the dollar is unstable because the organization that issues it is currently tampering with it. If the tampering should stop and the government should provide real evidence that it will manage the dollar responsibly, then there is no reason to expect the dollar to be unstable after that.

On the other hand, since gold has obvious and widespread productive uses, its price cannot go to zero as long as it has those uses. The same argument cannot be made for Bitcoin, but that does not mean that its value will or could go to zero: again, the best argument is provided by Šurda, who asks “If Bitcoin fails, what will replace it?”[7] As long as Bitcoin has uses that cannot be fulfilled by any other currency, and as long as it remains competitive with other currencies and payment systems, its value will not collapse completely.

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Explanation of attempt

Bitcoin is a puzzle to be solved, not an excuse to deny reality. It must have original value. The key moment for Bitcoin is when it is first sold. Why do people start paying dollars for additional Bitcoins beyond what they get for free? This is not a praxeological question, but it is definitely an interesting one, and it is at the heart of the Austrian puzzle over Bitcoin. It is clear that Bitcoin cannot be simply compared to gold, and some other story must be given before it will seem natural to people who are used to thinking of money in terms of gold and fiat currencies.

In general, people's desires are not always easy to explain because they are so subjective. However, a good deed can be explained as a means to an end, rather than as an intrinsic good. Human fashion cannot be explained, but given its existence, it is not difficult to explain fashion shows or designer clothes as means to push people to follow the latest trends. Therefore, it is not enough to simply say that they are "cool" or "mysterious". [8] This only explains what we already know. Usually, things are cool or mysterious for a reason, not because of a sudden mass delusion (although this is not impossible).

One explanation Graf offers is that the initial demand for Bitcoin was driven by admiration for Bitcoin’s engineering. A well-designed encryption scheme “may indeed be more valuable to some people, in some circumstances, than some ‘real’ economic object or a specific amount of fiat currency. Regardless of any potential future indirect exchange value, one can imagine people spending hundreds of hours creating and cracking encryption codes just because they enjoy it.”[9]

The problem with this explanation is that it does not distinguish between the Bitcoin program and the Bitcoin currency. An understanding of Bitcoin engineering explains why someone would download the program to play with it or peruse the code, but it does not explain why someone would pay for an immobile and arbitrary string of data. Any amount above a few satoshis is more than enough to try out everything Bitcoin can do. Indeed, why would an engineer prefer to use the Bitcoin blockchain when they could just spin up their own chain and own the entire system to experiment with?

I think the correct approach is as Šurda suggests when he indirectly states: “In my view, trade occurs when the rational expectations of potential buyers about the potential utility of Bitcoin exceed the price demanded by producers.”[10] Bitcoin has value to people with the right entrepreneurial mindset.

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Allegory of the Futurists

Two centuries ago, oil was worse than worthless. It was a harmful substance that people were willing to pay to have it removed from their land. However, suppose one day a mysterious stranger appeared, claiming to be a time traveler. He told everyone that one day oil would become the most valuable fuel in the world. It would be called "black gold." Wars would be fought over it, and huge machines would be built to collect every drop of oil.

Although no one knew if the so-called time traveler was telling the truth or how to develop the technology that would one day make oil valuable, some entrepreneurs believed him and began collecting oil in preparation for the day when it would turn into black gold. They built barrels to store it and then bought it by the ton. Because these entrepreneurs established a benchmark for the value of oil, others bought smaller amounts to speculate on the price in order to store their wealth outside of traditional banks.

After the financial panic, the U.S. dollar that people used to trade with became worthless. Needing something to trade with, and finding that oil was a widely in-demand commodity, people began trading and quoting with it. Soon, oil became their new currency, and no one figured out how to use it as a practical fuel. By the time the technology to use it as a fuel was understood, oil was too valuable to be burned.

In real life, there are no time travelers, but entrepreneurs can sometimes glimpse the future. When Bitcoin was first invented, Bitcoin had no exchange value and was given away for free only to generate interest. However, once the right entrepreneurs began to suspect that Bitcoin might actually be used as money one day, they were willing to pay dollars to get more than was freely available. They may not have understood exactly how it happened, but actually thinking it was certain was enough to give Bitcoin its mystique. Thankfully, there are enough people whose judgment is not clouded by an incomplete understanding of the regression theorem. Suspicion that Bitcoin might one day be a big thing explains everything about its original demand.

This explains how appreciation for Bitcoin’s engineering led to people wanting the coins themselves. Once it was known that Bitcoins could be sold, even for tiny amounts, new possibilities emerged. Second-generation entrepreneurs realized that the tiny baseline value provided by the first generation allowed for certain services that PayPal or credit cards could not. WikiLeaks, for example, could accept Bitcoin donations that no third party could block. The Silk Road website could be created to establish an anonymous and secure online black market.

At that point, Bitcoin had already established exchange value. Both groups of entrepreneurs were happy because they were both profitable. Bitcoin was still not money, but its potential was more accessible to others. As a result, new entrepreneurs entered the market as merchants and investors. This cycle repeats itself to this day, and there is no reason why it shouldn’t continue as long as there are people willing to invest in the vision of the Bitcoin economy.