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Bitcoin, the Greater Fool’s Gold

In a recent blog post, Bob Murphy succinctly asks a question that seems to get at the heart of the disagreements between Bitcoin proponents, and Bitcoin haters like me:

There are people claiming that Bitcoin’s non-monetary price is zero, and hence if it’s trading for anything at all, it is in a bubble. But by that logic, gold’s non-monetary price might be (say) $250, and so if it’s trading right now for $1,250, then $1,000 of that is clearly just due to a self-fulfilling prophecy, where people are willing to pay $1,250 for gold because they think that’s how much (at least) it will be worth in the future. If something were to shatter that expectation, then the price of gold would plummet back down to its fundamental value of $250

He similarly quotes a hypothetical proponent’s position, which I believe captures my point of view quite fairly. I would recommend reading his whole post, it’s not very long. I’ve touched on this particular argument before, but I think I should expound on it, given the opportunity to respond directly to Dr. Murphy’s careful layout of the proponent’s position. Murphy, at least for the purposes of this article, accepts the premise that bitcoin has no value as a consumer good, whereas gold has some. I will counter-argue with that premise as well. He also makes some of the same distinctions in categories of valuation that I like to make: consumption, store of value, and speculation. However, I think that Greater Fool speculation is a separate entity. But let’s start with the beginning.

He gives $250 as a hypothetical market value for gold in a pure consumer market today, and of course $0 for bitcoin. For simplicity, let’s suppose that this hypothetical $250 market price is absent any major lapses in knowledge on the part of vendors, so we can safely take as a given that there is no bubble in this market. In reality, a price of $250 doesn’t mean that all consumers are willing to buy at exactly $250, there will be a range of prices at which potential consumers are willing to buy. Suppose this range is between $100 and $1000. We arrive at the price of $250 because anybody only willing to spend $249 is out-bid by people willing to spend $250 or more. The number of people willing to pay $250 or more roughly matches the amount vendors are willing to sell at the same price (basic supply and demand).

Supposing then, that people start deciding to buy gold as a store of value. Many of them are willing to spend more than $250 an ounce, thus they outbid many of the potential consumers in the market, bringing the price up to, say, $300. In buying for a store of value, they expect the price to stay roughly the same, at worst. As such they are speculating on price stability (as Mises said, all action is speculative). Is this a bubble? Not necessarily, because we said that there are potential consumers going up all the way to the $1000 range. It might be a bubble, since these holders may be overestimating the demand at those higher prices, but not necessarily, because they might be right. In contrast, if the same is done with bitcoin (again, taking the $0 pure-consumer market assumption) they can’t possibly be right, so it must be a bubble.

Okay, so what brings gold all the way to $1200 today? It is probably the result of speculation, but the sort of longer-term speculation on effects of inflation of the dollar, in which the gold is priced. Is this a bubble? Again, not necessarily. If the feared outcome of inflation comes to fruition, consumer goods will skyrocket in price, and gold is a consumer good. The hypothetical pure-consumer market, may rise, say, to $1100. If we then account for the store-of-value speculators of that future date, those who speculate on price stability, perhaps the stable price post-inflation will be $1500. Now, the long-term speculators could be wrong that impending inflationary effects will increase the consumer + store-of-value price of gold to that degree, in which case this mentality and the resulting price would be a bubble. But in doing the same with bitcoin, taking the opening assumptions of no consumer market, they are surely wrong.

I’d like to note here that store-of-value speculation on price stability, alone, can increase the price of gold, but it cannot (without being a bubble) rise above the hypothetical price that the highest bidding consumer is willing to pay. That is, this cannot raise it above $1000 in the initial example. But speculating on price increase, as in the case of inflation speculators, the price can be well above today’s entire consumer market, without (necessarily) being a bubble. That said, this is not even the case today; gold-tipped RCA cables are still on the market. I like to point to this example because even jewelry can be a convenient store of value, whereas it seems implausible for RCA cables.

Finally, none of what I’ve described thus far is actually what I would consider “Greater Fool” speculation. All of the above forms of speculation, as I have described them, are based on the expectation, correct or not, of certain consumer prices at a certain point in the future. Greater Fool speculation, on the other hand, is speculation based on the assumption that another trader will always be around to keep the price afloat, in spite of the fact that there is no expectation of consumers. I don’t believe that it is correct to describe every price above the consumer price of gold to be a Greater Fool price. I’d gladly concede that some of gold’s price is due to it, maybe a whole lot of it, like in any market. But to say that everything holding gold so high above the hypothetical pure consumer market price is Greater Fool pricing is incorrect. A lot of speculation is quite legitimate, and as such, it is not necessarily a bubble (again, there could still be bad data). However if we assume that bitcoin has no potential for a consumer market, we must conclude that it is purely a bubble, either via bad data by those who believe bitcoin does have a consumer market, or of the Greater Fool variety for those who do not.

Original content by Dan, CC0 (attribution appreciated), tips welcome

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Going to bat for Peter Schiff

I’ve been kindly invited by Drew to guest write here, as an ambassador for Bitcoin haters everywhere. I thought it was good timing, as Peter Schiff’s video critiquing Bitcoin in terms of gold has made the rounds. I think Peter gets the point, but doesn’t anticipate all of the counter-arguments that the Bitcoin proponents have prepared. Here I will try to fill in the gaps a little for him.

I think it’s a bad sign for Bitcoin that proponents are so confident that it will survive, and yet can’t agree on what is keeping the price afloat. “You can make enormous trades around the world almost for free, that’s real value.” “Oh yeah? Well gold doesn’t have any ‘real value’ either. People just own gold to pass it on to someone else.” “You see, there’s value in the system.”

Of course it’s generally good not to be in lock-step with any group, but if Bitcoin is so important that it will save society from government, and you’ve got half your life savings in it, you’d better think carefully about what you think will continue to make it work.

“All value is subjective anyway”

I’ve learned not to use the term “intrinsic value” because the proponents correctly point out that there is no such thing; all value is subjective. However, people act because of a specific motivation, with a specific predicted outcome based on a logical premise. The nature of these logical premises matter.

Consumers and Traders

The nature of being a Consumer is that a person subjectively valuates a given good by speculating that it will make them happy. That’s it. In general, the opinions of other people do not matter. The nature of being an intermediary Trader of goods, however, is very different. The subjective valuation there is based on speculation on the actions of everybody else in the market, including other Traders, who in turn speculate on their actions.

So what about trading in gold? Well, you’re speculating on existence of two things: Consumers who still like the luxury good, and Traders who still believe in the existence of Consumers and other Traders. For Consumers to cease to exist, gold would have to independently fall out of favor for every individual actor. For Traders to cease to exist, they would have to lose faith in the existence of Consumers and other Traders, which can start to happen because Traders are interested in each other’s opinions. However, even if there was a panic, where every Trader momentarily scared each other out of the market, Consumers would still be around, which would eventually bring Traders back. In other words, in addition to the positive feedback loop of Traders anticipating Traders, there’s also a negative feedback loop of Consumers chasing a low price, regardless of who may buy later.

So what about bitcoin? There are no Consumers, only Traders speculating on the existence of other Traders. Right now, there are plenty of Traders entering the market, so it looks promising. This allows the positive feedback loop to continue in an upward direction. However, as Peter says, once the buyers stop coming in, people will want to spend, and then the fun starts.

“Gold is also inflated way above its ‘real price'”

Yes, gold is selling for quite a lot right now, and it’s probably not because people spontaneously developed a taste for jewelry. But that doesn’t mean it’s “overvalued.”

Having established the contribution to gold’s price due to valuation from Consumers, gold is a convenient way to store and transfer buying power. As such, Traders snatch it up, availability goes down, exchange rates go up. Then, especially in this economic climate, there is another source of valuation, which is speculation that in the future, prices will go up. Based on this phenomenon, the price of gold may be significantly higher than what it would be in a pure consumer market. But this is only because speculators believe that in the foreseeable future, Federal Reserve Notes will be devalued so much that someone will be willing to buy for jewelry at that higher rate (though I would note that gold-tipped headphone cords are still on the market).

Finally, there is another form of speculation, “Greater Fool” speculation. This is where Traders only anticipate other Traders. It adds a lot of volatility to the market. Greater Fool speculation does surely exist in the gold market, just as it does in any market. But again, the phenomena of Consumers, Traders following Consumers, and (mature) speculation, serve as a negative feedback loop keeping the price of gold above a certain point. For Bitcoin, Greater Fool speculation is all that exists.

Some believe that, given a big enough market, Greater Fool speculation is sufficient to keep Bitcoin alive indefinitely. It’s a hard one to argue definitively either way, but I’m still holding out in camp “no.”

“You can send large sums of money across the world almost for free, that’s real value”

Don’t fool yourself. If you find Bitcoin useful because it allows you to make cheap long distance payments, or conduct business anonymously (given the extra precautions), you are not being a Consumer of bitcoin, but a Trader, if in a roundabout way. You will not be trading with any Consumers, but other Greater Fool Traders. Bitcoin being easily transferable has the same economic behavior as gold being durable. It’s an added benefit assuming there are next buyers. If you argue that the next buyers of bitcoin are already established, this “usefulness” is superfluous, Greater Fool Speculation should be enough.

Erik Voorhees recently covered this point in an open letter to Peter Schiff as a followup to his appearance on the The Peter Schiff Show. He attempted to add some sophistication to the matter by making a distinction between bitcoins as currency and Bitcoin the system. Don’t let this line of thinking fool you. The payment system, for all its benefits, can afford you one thing, transferring of bitcoin. As Erik concedes, bitcoin in a vacuum are useless. But, bitcoin are useful because they’re your only ticket to this great system that allows a transfer of value without significant transaction fees or government interference. Isn’t that valuable? Well, what form does this value you are transferring take? It takes the form of bitcoin, and for that matter the very bitcoin that you paid into it. So ultimately, bitcoin is useful because you can give them to people. Think carefully, and you’ll find that this is all that this argument can say for bitcoin.

I recently wrote about this topic in some painful detail if you want to read more.

The technology

Old Man Peter Schiff, with his quaint, old fashioned attachment to “economics.” He simply doesn’t understand that this technology defies the laws of economics.

I will acknowledge that technology can create a unique economic environment, and Bitcoin does pull this off in some areas. Particularly important is the ability to enforce certain contracts algorithmically, removing some game theoretical problems. But they do not enforce an exchange rate with external commodities.

I will not say that it is impossible to technologically create some sort of value for Consumers. Other than a blow to my pride for being proven wrong on Bitcoin’s impending collapse, I would be glad to see it happen. As Peter Schiff said, Bitcoin is incredible cool, in every way, except the important one. If we can fix that, we’re golden (no pun intended. No, really).

It has to be something that leverages the system with an external benefit; i.e., not just facilitating transactions. Another requirement is that a certain balance of bitcoin be required to facilitate a certain amount of this benefit; it can’t depend purely on the exchange rate. As a partial concession, I will cite what I think are some cases that at least come close.

Software registration, or other signaling: One satoshi is arguably valuable because it can be used to send a verified signal. The problem with this is that it requires only one satoshi, which is not awfully scarce. If by chance this scheme did make satoshis very valuable, the developers of Bitcoin may still decide to increase the granularity of the currency, making a new lowest denomination which will be much less scarce.

Proof of work: On first glance I dismissed this as the Cost Theory of Value. However, proving that you did useless work could conceivably be useful as credentials to a spam filter. On the surface this meets the requirements. You can perform the work yourself. Or, you can buy it from others. It looks a lot like jewelry saving gold from collapse. One problem with this, though, is that a certain amount of bitcoin doesn’t represent a certain amount of work, but rather a rough percentage of all work recently done. If bitcoin’s price falls, miners will leave the market, creating a new equilibrium. There’s not a clear negative feedback loop. However, this is a complicated interplay, and it’s ultimately unclear to me how this plays out. I may give it some thought for a future post.

So to part on a positive note, if we can get on the same page, dispensing with the fallacious arguments for predicting Bitcoin’s long term success, and recognize the precarious position it is actually in, we have a chance to come up with something to save it. We can focus our attention in the right direction, accounting for the right pitfalls.

Original content by Dan, CC0 (attribution appreciated), tips welcome