In the aftermath of the Mt. Gox meltdown and subsequent bankruptcy filing, I have been reading a lot of commentary on Bitcoin. Even Paul Krugman has weighed in (against Bitcoin). Much of the criticism of Bitcoin centers around the idea that it has no ‘Intrinsic Value.’ While I have no particular opinion on whether or not Bitcoin is over or undervalued or whether it has long term viability, the Intrinsic Value criticisms are unfounded and based on a misunderstanding of Intrinsic Value, value and currency mechanisms.
A quick review of economic and financial principles will reveal that Bitcoin could have Intrinsic Value and be sustainable despite the fact that it is not backed by gold or a government’s power to tax.
What is Intrinsic Value?
Intrinsic Value is a concept in finance that attempts to value an asset (usually a financial asset like a stock or bond) based on a mathematical analysis of the (usually cash) value derived from that asset over time. Usually, discounted cash flows are used. So, for example, if a company is expected to pay dividends of $1 per year forever and an investor applies a discount rate of 10% to those dividends, the stock will be worth $10 per share ($1/.1).
This approach can be applied to assets that do not throw off streams of cash. For example, if I own a right to have dinner for two at a restaurant once a year and I value that at $100 with a discount rate of 10%, that right is worth $1,000 ($100/.1).
It should be pointed out that many assets with Intrinsic Value are not entirely backed by another asset (like gold) and the vast majority are not backed by a government’s right to use force to collect taxes.
As we will see in a bit, using the standard definition of Intrinsic Value, Bitcoin may very well have Intrinsic Value even though it is not backed by something with established value (e.g. gold) or a government’s right of taxation. All that is necessary to use Intrinsic Value analysis is for the asset in question to have tangible benefits that accrue to the owner over time.
Are All Values Intrinsic?
Most items with monetary value do not have Intrinsic Value. In other words, they do not throw off cash flow or other measurable benefits over time. For an item to have monetary value it needs to have two things and two things only: scarcity and demand. That’s it. Economics is about understanding human behavior, not judgement. If a lot of people want a baseball card and are willing to pay $80,000 for it, it’s worth $80,000. Period, end of story. If people are willing to pay $1,000 for an ounce of gold, that is what it is worth.
It should be pointed out that gold is not valued by Intrinsic Value analysis. It’s good old (scarce) supply and demand, econ 101, day 1. Gold certainly has a more established value based on a long history of it being a store of value but that’s it.
Why Are Currencies Useful?
Switching gears a bit, let’s talk about currencies. There are two potential uses of currencies. They can be used 1) as a store of value and 2) as a medium of exchange. The store of value is obviously needed for it to be a useful medium of exchange over the short term because if you have $3,000 in your checking account that you need to pay the rent, you need to know that it will be worth roughly that when the rent comes due next week.
Having said that, currency values change daily in relation to each other and over longer periods in their own country. If the federal reserve doubles the money supply, it will cause inflation and my rent will go up as the US dollar will be worth less to my landlord (it will buy less).
The point of all of this is that just because Bitcoin’s value has been and will continue to be volatile, that does not mean that it has no use as a medium of exchange.
Taking another step, there are many factors that impact the utility of a currency as a medium of exchange. Let’s look at three of them.
Acceptance. Clearly if no one will accept a currency as payment, it is useless as a medium of exchange. The more entities that accept it, the more useful and valuable it is.
Transaction Costs. The less that it costs the buyer and seller to transact in a currency, the more useful it is. This is a major consideration and US dollar transaction costs can be significant. Credit card companies charge 2.5% or more to process a transaction.
Anonymity. For certain sectors of society, anonymity is highly valuable. Some people simply do not want their transactions traceable. Some of this demand may come from mere paranoia and certainly a significant portion of it relates to criminal activity.
Is Bitcoin Potentially Useful?
The answer, quite clearly, based on 1, 2 and 3 above is yes. While Bitcoin does not have the broad acceptance of the US Dollar at present and it is tricky to buy Bitcoin with PayPal, broad acceptance is not a requirement for it to have value. All that is required is for a meaningful subset of users to see value in using the currency for them to use it. Clearly transaction costs are lower and Bitcoin’s anonymity is very attractive.
Could Bitcoin Have Intrinsic Value?
The answer, according to finance theory, is a clear yes. Let’s recall that Intrinsic Value has nothing to do with something being backed by gold or the power of taxation. Again, all that is necessary to use Intrinsic Value analysis is for the asset in question to have tangible benefits that accrue to the owner over time.
Just looking at the transaction costs, we can measure the value of Bitcoin as the sum of the net present value of money saved over time by using it as compared to currencies with higher associated transaction costs. To create a simplistic example, let’s say that I keep a $3,000 worth of Bitcoins to use for a certain number of transactions per year. Think of it like a checking account. Let’s say that I do $15,000 worth of transactions a year and save 2%, on average, on each transaction for a total of $300 per year. Assuming a discount rate of 10%, the Bitcoins are worth $3,000 to me ($300/.1). It is actually quite possible to save 2% per year or more and $15,000 of annual transactions on a $3,000 account is very do-able as well.
The fact that the Bitcoins are not backed by gold or the power to tax is no more relevant to me than the fact that I have my retirement savings invested in General Electric Stock (which is neither backed by gold nor the power to tax). The Bitcoins have $3,000 worth of value (Intrinsic Value) because they deliver $300 per year of tangible benefits to me as an owner. If had a magic wand or totem that saved me $300 per year on transaction costs, that would be worth $3,000 to me as well using the same analysis.
The benefits for criminal activity are even greater as money launderers charge substantially more than 2% (at least according to my favorite television shows). And the IMF estimates that 2-5% of global economic activity involves money laundering ($1.4 – $3.5 trillion per year). Bitcoin is not a complete solution for criminals as it does not yield a stable asset post-transaction but criminals may be willing to take some Bitcoin volatility risk for a portion of their portfolios in order to save on transaction costs.
Now I may have some value risk or piracy risk on my Bitcoins but that is something that I may be willing to take to save money on transaction costs and/or to achieve anonymity.
I’ve never used Bitcoin and have no plans to do so. Having said that, as a business owner, I am well aware that transaction costs are material and a new transaction mechanism (that may or may not include a new currency) could have value and gain adoption. Bitcoin, or other digital currency like it, could certainly be that mechanism. Whether it will succeed or not, I have no idea. But focusing on a misunderstanding of both Intrinsic Value and why currencies are useful will certainly not shed any light on the subject.