Bitcoin Value Continues to Puzzle Economists

    January 1, 2014
    Brian Powell
    Comments are off for this post.

2013 will be a year remembered for many important reasons, with perhaps the most interesting being the rise of the digital currency, the bitcoin.

Bitcoins have been in existence for 4 years now, and over those four years the value of a bitcoin has fluctuated drastically. These intense changes in value make many people wonder what gives a bitcoin value and if they’re worth the investment. Several economists shed some light on the issue.

Nobel Prize winning economist and author of several bestselling books Paul Krugman warns consumers and businesses about the dangers of bitcoins, saying that he is “deeply unconvinced” that the whole bitcoin phenomenon will really work:

“So far almost all of the Bitcoin discussion has been positive economics — can this actually work? And I have to say that I’m still deeply unconvinced. To be successful, money must be both a medium of exchange and a reasonably stable store of value. And it remains completely unclear why BitCoin should be a stable store of value.”

In order to explain why the value of bitcoins are disputed, Krugman points us toward Brad DeLong, who ponders the question himself. DeLong points out that the intrinsic value of gold being used to make pretty things gives it its market value, while the value of the dollar comes from its ability to pay taxes and create transactions here in the US.

Considering bitcoins are a form of digital currency with no intrinsic value, then what gives them a stable, market value?

The answer to that question comes from Business Insider’s Joe Weisenthal, who sees bitcoins as a hybrid of 3 factors: currency, equity, and social network.

Bitcoins are obviously a form of currency due to their ability to complete transactions. While bitcoins were used almost entirely to complete online transactions at their inception, the acceptance of bitcoins as a form of currency in the physical marketplace has drastically increased over the past 4 years. Currently, there are 2,252 locations across the world that accept bitcoins as a form of currency, adding legitimacy to the argument that bitcoins are indeed a form of currency.

Bitcoins are also a form of equity in the fact that the more people who invest in bitcoins and use them as a form of currency, the more the bitcoins are worth. Thus, bitcoins act much like individual stock shares – the more people who invest in a company’s particular stock, the higher stock prices climb due to the increased perception of said company’s value.

However, bitcoins only act as equity as far as its social network exists and continues to grow. This is perhaps the biggest concern to consumers when pondering whether or not to make an investment in bitcoins.

As previously stated, bitcoins have no intrinsic value; they are simply 0’s and 1’s transmitted through the internet. The value of a bitcoin is derived from its use; i.e. bitcoins gain more value as more people use them, much like how Facebook gains value as more people use its service.

But that is where the problem lies. Recent research has shown that Facebook users are declining, especially in the younger generation. If Facebook users continue to decline, it could wind-up facing the same fate that befell MySpace.

Or, as Joe Weisenthal put it, “Without the network effects, the technology is nothing. It’s just a theoretical amusement.”

So, in the end, the value of a bitcoin will be ever-fluctuating as its numbers of users and businesses which accept payment continue to fluctuate. While one bitcoin is worth $750.99 today, its value could easily increase or decrease ten-fold overnight.

If you’re still questioning whether or not you should invest in bitcoins, ask yourself this: Do you have surplus cash that you don’t know what to do with? If that answer is yes, invest in some bitcoins, ride the bubble, and hope the gamble pays off (and if it does, send some of those excess bitcoins this way).

Image via Wikimedia Commons

  • MadMiner

    And now You should see Betacoin (BET).
    You will forget every other cryptocurrency :)

  • Jackson

    You cannot use bitcoins to pay mortgage, rent, groceries, utilities, etc.

    They have no real value. They’re an imaginary item whose only worth is in what people are willing to do for them.

    They are the beanie babies of this generation. Remember all those people hoarding beanie babies thinking that, when they were ready to retire, they could sell them for huge profits, and retire off that income?

    Yeah, good luck with your bitcoins.

    • http://economicsjunkie.com EconomicsJunkie

      “You cannot use bitcoins to pay mortgage, rent, groceries, utilities, etc.”

      Next time you comment on something that you are completely clueless about, try to spend at least 30 seconds on researching the claims you make before spewing such unbelievably embarrassing mental garbage into the stratosphere.

    • Stuart

      I understand your point of view as btc are hard to grasp, it’s like trying to teach a cat why gold has value, you’ll have better luck with notes as at least these can be made into kitty litter.

      My turning point was realizing it’s just a very pure limited resource, more pure than gold since they’ll only be 21 million units in existence. This is why it’s nothing like bennie baby or tulips or any other inaccurate simile. Do I think btc will replace cash? No. Do I think it will replace gold as a store of value? Yes, it may well do as it’s far easier to trade/subdivide/store.

      It’s also worth pointing out that most currency doesn’t ‘exist’ either, I believe over 90% of fiat currency is held as numbers in a bank account, there are no physical notes or coins for it… Really bitcoin is identical to this except no one organization owns it and it can’t be diluted unlike fiat… this is why it has many interesting properties and is being taken seriously by many people now.

    • David

      Thanks! I’m up 1600%!

    • David

      I quit reading after your first sentence. Why comment if you’re clueless? Seriously I would love an answer. You said something as fact and now we all know you haven’t even researched what you’re commenting in. Like 99% of Bitcoin bashers. Get well soon!

    • Dave

      But beanie babies were never easy to send across the globe instantly. I tried shoving them into fiber optic cable, but no luck.

      I’ll issue my usual challenge whenever I read the beanie baby/tulip argument.

      If you can send me 2 cents over the internet using something other than crypto-currency I’ll send you a couple hundred bucks in Bitcoin. I promise.

  • AlanX

    Gold’s primary intrinsic value is to sit in the dark in a vault.

    It has no intrinsic value in making pretty things. At least, no unique value. You can make pretty things out of a huge array of materials, of which Gold holds no intrinsic advantage.

    As a conductor, there are many, many options as well. Of which gold isn’t necessarily the best option.

    What we can do, and what we actually do, is make bars of gold, and jewelry from gold that we then lock up.

    Here we could make bars out of ash, and jewelry out of ash, and lock them up just as easily.

    Bitcoin on the other hand is not just a currency, but a payment system that allows anyone to pay anyone else a Bitcoin and not worry about 1) counterfeiting (Bitcoin cannot be counterfeited, or 2) the security of the transaction (in minutes with a single confirmation, a bitcoin can be spent).

    That is true intrinsic value. When something can be done with a thing that cannot be done with anything else. Only cryptocurrencies have the advantages that Bitcoin have, and of them, only Bitcoin has the network effect to make it useful.

  • Richard

    Bit coins are, at best, a method of transferring wealth from one
    place to another. Kind of like a check. Unlike a check, however,
    the value can fluctuate widely relative to normal currencies.

    Bitcoins are backed by NOTHING. Now I know people can pretty much
    say the same thing about most currency, except governments have the
    ability to force you and others to accept that currency as payment
    for debts. More importantly, they can demand taxes/fines/tariffs to
    be paid to them in their own currency. This has the function of always ensuring some level of demand to prop up its market value.

    More importantly, if enough of the right governments forbid bitcoins
    usage,the value immediately collapses.

    • David

      When I accept Bitcoin I get paper fiat of the value at the time of the exchange. I don’t care if it’s 709 or 800. Go read some more and come back.

    • David

      Then I kept reading and you’re a slave that defends your bosses. Amazing! Seriously seek help and get well soon. Good luck with your boss and their force when no one is using their dollars to pay for it, go fight for your bosses!!!

    • Anonymous

      hmm, drugs are illegal yet they cost a lot… So, with this being said, your remark is wrong 😛

    • Rassah

      Bitcoins are backed by nothing, and that is a good thing. Backing is a liability – an IOU – which requires you to trust someone, and is thus based on nothing but hopes and promises. What backs a house, a bar of gold, a barrel of oil, or a bag of sugar? That’s the same thing that backs bitcoin.

  • Bob

    More importantly, if enough of the right governments forbid bitcoins
    usage,the value immediately skyrockets.

  • http://opentransactions.org fellowtraveler

    Regarding Bitcoins and gold, it’s important to keep in mind that neither has “intrinsic” value.
    Rather, both are valued by men for their unique properties.

    Gold is:
    — Divisible.
    — Fungible.
    — Value dense. (Scarce.)
    — Recognizable.
    — Durable.
    — Zero counter-party risk.
    — Stable in supply, yet minable.
    — Liquid.
    — International.
    — Non-manipulatable. (Non-centralized.)

    By comparison:
    — Diamonds, while valuable, are NOT divisible, nor are they fungible.
    — Water, while valuable and divisible, is not value-dense enough to compete with gold as a form of money, on the free market.
    — Food, while valuable, is not durable.
    — Dollars, while liquid, do not represent zero-counter-party-risk (rather, they are debt-based.)
    — Dollars, while recognizable, are not stable in supply (inflation is a worry).
    — Dollars are also not minable. (Production is available only to a monopoly cartel, versus gold, which anyone can produce.)
    — Food, which anyone can produce, is not liquid, especially in comparison to dollars or gold.
    — Dollars, while you can hold them in your pocket, a board of bankers still has the power to reach into your pocket and manipulate its value. (This is not the case with gold.)

    Soon it becomes very clear that gold was never “declared” to be a form of money by any “authorities” but rather, became money due to natural market forces.

    If gold became money strictly due to natural market forces (as a result of its unique properties) then clearly the only reason it has been supplanted by dollars is due to artificial restraints imposed on the market by government force. (Such as legal tender “laws”, tax “laws”, money laundering “laws”, etc.)

    Such forces must be constantly active, otherwise, natural market forces would immediately resolve back to gold again as they have for thousands of years.

    Now let’s consider Bitcoin’s unique properties:
    — Divisible.
    — Fungible.
    — Value dense.
    — Recognizable.
    — Durable.
    — Zero counter-party risk.
    — Stable in supply, yet minable.
    — Liquid.
    — International.
    — Non-manipulatable. (Non-centralized.)

    — Non-confiscatable.
    — Accounts cannot be frozen.
    — Anonymity is possible.
    — Electronically transferrable.

    As you can see, Bitcoin’s unique properties are similar to those of gold, although it adds new properties due to its ethereal nature.

    Those new properties (non-confiscatable, non-freezable, pseudonymous, transferrable electronically) all serve to route-around the artificial forces that are currently being used to supplant gold with the dollar. After all, the various immoral, legal-tender legislation in place today uses the force of a gun to impose fiat money onto an economy that would otherwise resolve to gold by natural forces. That artificial force depends on the government’s collusion with banks and their collective monopoly on the ability to issue, store, freeze, confiscate, track, and transfer dollars.

  • tim

    The up side:
    1 – bitcoin does not need a backer, it backs itself so long as people believe it has value.
    2 – people will always believe bitcoin has value if it is secure and people offer goods and services in exchange for bitcoins.
    3 – thousands of businesses and people accept bitcoin, more everyday, and you could be the next!
    4 – bitcoin has had its hiccups but has been analyzed by the best and brightest to be technically sound.
    5 – bitcoins’ price volitility is just a more amplified version of the volitility of any new and old currency (not counting government controlled prices/wages) and can be avoided.

    The down side:
    1 – keeping your funds in bitcoin form subjects your wealth to the raw volitility that has been purely present since , but it will likely average on the positive.
    2 – bitcoins can be permanently locked, over time bitcoins will become too rare to use as everyday currency ( unless we find a way to spend .0000000000001 bitcoins.
    3 – as hundredsn of other cryptos come to market, bitcoin could get phased out by a superior.
    4 – if the US outlaws bitcoin, your funds could potentially be frozen or tracked.
    5 – bitcoin will continue to have growing pains until they become easier to get (credit card online) and spend (bitcoin card in your physical wallet).

    Nature will take it’s course, choose your side!


    • Anonymous

      if the US outlaws bitcoins, how do they freeze your bitcoins??? i’d love to hear this one!

      • Dave

        They can’t. It really is that simple.

  • http://free-bitcoin.neocities.org/ Jesse

    I think 2014 will be an interesting year for crypto currencies. If you want to give Bitcoin a try without spending money, have a look at http://free-bitcoin.neocities.org/

  • vadoff

    Economists didn’t predict the housing bubble or recession. It’s a good thing they aren’t in charge of Bitcoins.

  • mementori

    “the intrinsic value of gold being used to make pretty things gives it its market value, while the value of the dollar comes from its ability to pay taxes and create transactions here in the US.

    Considering bitcoins are a form of digital currency with no intrinsic value, then what gives them a stable, market value?”

    I believe that bitcoin’s intrinsic value is in the decentralized public ledger that cannot be counterfeited or falsified – The Blockchain. This system could pave the way towards a more open democracy if implemented for voting, towards the distribution of digital proof of ownership (think deeds/titles/stocks/domain names), and towards various other projects that we are only beginning to see the use of.

    This has never been able to be created before and solves a huge issue of computer science. That gives bitcoin a metric shit-ton of value.

  • Dan

    Go back and read Krugman’s article about the internet having an effect about as much as the fax machine and you will understand why we ignore him. It might also be due to his poorly researched articles, like those about bitcoin. This author here uses straw men. What a joke. This is journalism? Learn to write without using fallacies while we change the world.

  • Zac

    You forgot to mention the value of inclusion. The vast majority of Americans have no stock holdings; the barrier to entry is too high. Trading altcoins (smaller startup alternatives to Bitcoin) is the new stock market for the 99%. With a hundred dollars or so you can own ‘stock’ in your own emerging currency. Kinda neat. In the past week I’ve made nearly 100% profit on my initial small investment just trading arbitrage between two of these alternatives to bitcoin, dogecoin and catcoin on Cryptsy.com. Sounds ridiculous I know. But so was the internet (yeah…I read the Krugman article). Day laborers doing currency arbitrage with virtual cash in their spare time – inclusion – that’s what the folks in charge are really afraid of.

  • http://www.myotherdrive.com John DeRegnaucourt

    Although a simple question, “What gives Bitcoin value?”, the answer is not as simple as the question. What gives Bitcoin it’s value, can best be answer by the formula

    PB = (SW + TX) / BC

    The value of a Bitcoin is derived from the total value of the Bitcoin used for storage of wealth (SW) plus the total amount of the Bitcoin required for concurrently transacting in it (TX). The sum of these two numbers divided by the amount of Bitcoins in circulation (BC) (currently 12.2 million, ultimately 21 million), will give you the price of Bitcoin (PB).

    There are estimates of the total amount of gold in existence (mined) in the $10-13 Trillion range. If $1 Trillion (10%) of the amount of wealth that would have gone into gold, instead lands in Bitcoin, that would increase the price of Bitcoin to ($1Trillion + TX) / 12.2 million, or by $83,000 per Bitcoin. Remember, this leaves out the TX component, which will further increase the price of Bitcoin. Over time, funds will shift from other asset classes being used for wealth storage to Bitcoin.

    There are many advantages to storing wealth in Bitcoin as opposed to specifically gold, for example, as you can divide Bitcoin into very tiny pieces (difficult with gold) and you can send Bitcoin to someone on the other side of the planet within minutes (impossible with physical gold). These use cases illustrate why Bitcoin is a good alternative for gold (and other assets) for storage of wealth.

    From a transaction perspective, as more citizens, businesses, and governments transact in Bitcoin, the amount of ‘wealth’ that must be placed into Bitcoin must be large enough to allow these transactions to happen.

    For example, if it becomes common place for real-estate purchase payments to be processed via Bitcoin, then the amount of value in Bitcoin required to allow this to happen will need to be as large as the current working set of real estate transactions in progress. This logic applies to online sales and brick and mortar sales. If, on a daily basis, $250 Billion is required to allow all Bitcoin transactions to occur, the Bitcoin price only in terms of TX requirements, is $20,500.

    The price of Bitcoin (PB) = (SW + TX) / BC. SW and TX will both change as time passes. In geek terms, SW, TX, and BC are functions of time f(t). Therefore to more accurately predict the price of Bitcoin, you need to estimate these two components for a given time, and then divide by the number of Bitcoins in circulation. BC can easily be obtained from many websites and is updated live.

    Bitcoin works well as a storage of value and for financial transactions, therefore it will often be used as a substitute for both currency as well as common wealth storage assets (e.g., gold). Bitcoins utility (global register – the block chain) is what makes this possible. The worth of Bitcoin comes into play because of this utility, wealth storage and transactions will happen ontop of this platform. And using the formula above, the price of Bitcoin (PB) can be computed by estimates of these two quantities.