One approach to pricing Bitcoin [and similar] has to been try to ask oneself what the fundamental value might be in terms of its enduring use and appeal to the community wishing to store value or make payments outside the reach of regulatory and tax authorities.
John Cochrane’s recent post has an element of this, attempting to distinguish between “speculative” and “fundamental” values for Bitcoin.
Bitcoin’s current high cost of individual payments make it unappealing for small and legal payments. For small payments, the payment fee is a large fraction or multiple of the actual payment, and so highly inefficient. For legal payments, there are cheaper alternatives and no obvious benefit, yet to using Bitcoin. However, for those seeking to keep their wealth hidden, and move it around without the knowledge of the authorities, or being taxed, Bitcoin may still be useful.
However, there are no laws enforcing the use of crypto-currency in the illicit communities imagined here. No law of legal tender. The value of a medium of exchange in that community depends just as much on trust as it does for conventional monies in the overground communities. That is, whether I accept Bitcoin for the drugs or guns that I sell illegally is going to depend on what I think others will think about taking Bitcoin from me when I try to turn the proceeds of my arms and drugs dealing into something I need myself. [Readers will note that I am talking hypothetically at all points here]. And that, as always, will involve me thinking about what a putative future holder of Bitcoin will imagine that the next holder might think of it. And so on.
This point – that there is no real fundamental value for the currency – is all the more important because the illicit and legal communities are intertwined. For many of the illicit activities, of course, the whole point is to extract resources from the legal community and they are entirely parasitical in that respect. For others, we can think of illicits trading contraband for legal goods. And of course for that to happen, the reverse goes on: those working in the legal economy trade the legally gotten gains of their labour for something under the counter. Therefore, amongst the potential future holders’ beliefs that illicit agents have to factor in when they are assessing what the future value of Bitcoin might be are those of the legal agents [agents who earn legally].
Just as the quantity equation for conventional money does not provide useful guidance about its price when real central bank money demand is fluctuating a lot, so here the size of the illicit economy is not sufficient to say much about the floor to Bitcoin. The complex judgements about how others think others think others think…. the exchangeability of Bitcoin will proceed have to be made by Bitcoin users, and changes in these judgements will cause girations in the value of Bitcoin. There may be a fundamental demand for illicit goods, but that need not generate much restraint on the price of Bitcoin either way.
Misbehaviour by governments and central banks has in the past resulted in rapid coordination by private agents in economies on the rejection of the local currency in favour of the dollar, or commodities. Although Bitcoin itself can’t be over-issued in the same way, it is easy to think of other events, like further forks, sudden regulatory interventions, exchange fraud, that could lead the illicit community to coordinate on rejecting Bitcoin [and similar] too.
A related phenomenon is the history of technological standards that emerged that were not necessarily optimal. The econ 101 example of this was the Sony Betamax video recording format, which was dropped in favour of VHS despite being technologically superior. The relevance is that the ‘fundamental’ characteristics of the thing were less important than whether others used the thing and were expected to use it in the future.
I think it’s a mistake to think of Bitcoin’s value, therefore, as underpinned by a reliable long term demand from badly behaved or private people; that community may be as fickle in coordinating on a currency as our own, and as responsive to what they think we will do as we are to them.