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The Value of Bitcoin

My goal here is to determine the value of bitcoin from first principles. When I say bitcoin I am referring to the digital asset, not the underlying technology, software, or protocols.

I will start with establishing what money is, and how bitcoin is like money. Then I will describe how to determine the value of money and apply that same process to bitcoin. Afterwards we’ll discuss what that means for people who have bought or are considering buying bitcoin. And finally, what this means for other blockchain currencies.

What is money?

Money, by definition, has three characteristics. It is a store of value, a medium of exchange, and a unit of account.

A unit of account is something that is useful to measure the value (or cost) of other items. In the same way we use inches to measure length, we use money, (like dollars) to measure value.

A medium of exchange is something that is useful in trade. I write software and eat bananas. It’s hard to trade bananas for software labor, so instead I trade my labor for money, which I can then trade for bananas.

A store of value is something that is useful because it can be saved and it retains its value. Bananas are a poor thing to save. They take up a lot of space and lose all their value after about a week. Money, in contrast, is worth about the same as it was last week or month.

Types of money

Money can be categorized into three different types, commodity money, representative money, and fiat money.

Commodity money

A commodity is an economic good that is completely interchangeable. A pound of coal is indistinguishable from every other pound of coal. An ounce of copper is equal to every other ounce of copper.

Not all commodities are suitable as money. Barrels of crude oil are too heavy to carry to the store. Pork bellies rot if they are not kept frozen.

Gold and silver are commodities that have been used as money throughout most of the world.

Representative currency

Something that represents commodity money can be used as money in its place.

Copper is heavy and difficult to ship, so around 800 BC the Tang Dynasty began to pay merchants with pieces of paper that could be exchanged for copper in the capital.

As recently as 1933 the US Government created representative currency in the form of gold certificates. Each certificate could be exchanged for a fixed amount of gold.

Fiat money

Fiat is Latin for “let it be done” and means an authoritative or arbitrary order.1 Fiat money is not an economic good like commodity money, nor does it represent one like representative money. It is called fiat because something, usually a government, declares it to be money.

Bitcoin as money

The increasing pace and geographic scope of trade has demanded increasingly fast and efficient mediums of exchange. By now, most money doesn’t exist as physical objects, but as accounts in computerized ledgers. Instead of exchanging bills and coins we make debits and credits with banks, credit card companies, and payment processors.

Bitcoin works the same way, except instead of a private ledger held by a trusted party, it uses a distributed ledger that can be verified by anyone in the world. And instead of an account that is tied to some identity, it use an address tied to a secret key.

Because the ledger is distributed, transfers can be made without needed to trust any third-party. Because there is no need to tie an account to an identity, there is the potential for pseudo- or actual anonymity.

Underlying value of money

Commodity and representative money

The underlying value of commodity money comes from the utility that the commodity provides. For instance, gold is extremely inert, malleable, and conductive. Because of that there is a lot demand for it in electronics and other uses.

Representative currencies add a layer of indirection. The value of a gold certificate is the same as the value of the gold it represents, plus the value of the convenience the certificate provides, minus the cost of converting it to gold and the risk of not being able to convert it.

In 1800’s America banks were not permitted to have satellite branches, so the value (and thus the price) of a gold certificate would decrease based on its distance from the bank that issued it.

Fiat money

The value of fiat money comes from the demands of the government that supports it.

The U.S. Government has declared US Dollars to be legal tender, which means that it is accepted for all debts, public charges, taxes, and dues.2. As long as the US government demands US dollars, it has value to people who need to pay.

In theory, a government’s demand for their own currency could end at any time. However, the benefits of being able to create your own money are so great that as long as the government is capable of operating in its own best interest it will maintain the value of its currency.

Secondary demand for money

Much of the demand for money come from people who do not want it for its underlying value.

Investors don’t buy gold coins to make circuit boards. I want dollars so I can pay taxes, but also so I can buy bananas from the grocer. The grocer wants dollars so he can pay his suppliers and landlord and clerks. And they all want dollars so they can buy a myriad of things.

And even though much of the trade in dollars is not to immediately satisfy the demand from the government, that demand is why the dollars have value and why we are all willing to trade valuable things for them. If the underlying demand disappears, the value of the dollar would disappear with it.

We see this every time a government falls. Once the government no longer provides the underlying demand for its currency, nobody wants it and the value of the currency drops to zero.

The value of bitcoin

Bitcoin does not have utility like a commodity money. It does not represent a commodity with utility. And it does not have any underlying source of demand like fiat money. Bitcoin has no value.

This is notwithstanding the amazing features of public blockchain technologies. Fast and cheap transfers, facilitated without trusted intermediaries, is worthless if the thing being transferred is worthless.

Value versus price

Up until now I have written a lot about value but I haven’t talked about price. The value of something is what it is worth. The price is what people pay for it. This distinction makes it possible for me to say that bitcoin has no value even though the current price is thousands of dollars.

Value investing versus speculation

Value investing is the process of identifying and purchasing assets that are worth more than their price.3 When a value investor pays $70 to buy an asset that is worth $100, they make $30 in profit.

Because bitcoin has no value, it cannot be a value investment.

Speculation is the process of speculating on which assets people will pay more for in the future and buying those assets with the intent of selling them when the price goes up.

Bitcoin’s meteoric rise in price has created astonishing returns for speculators and it may continue to do so. Because the price is limited only by what people believe other people will pay for bitcoin in the future there is no limit to how high it can go.

However, like all speculative bubbles, the price of bitcoin is unstable. A sufficiently large shock to the confidence of speculators that the price will continue to go up will cause it to crash all the way to zero. Over time the odds of such a shock happening approach 100%. Eventually the price of bitcoin will fall to effectively zero.

Unfortunately, it is impossible to identify when this crash will happen, only that it will.

It is possible to make a lot of money on speculation buy either being lucky or predicting investor sentiment. There is no known way to reliably and ethically generate either of those conditions.

  1. Merriam-Webster 

  2. 31 U.S.C. § 5103 

  3. The seminal work on value investing is The Intelligent Investor by Benjamin Graham. I highly recommend it.