Bitcoin Series 12: Krugman and bitcoin

I think it will be helpful to clarify where Krugman is right about bitcoin and one subtle but very important point he and his uber-nerd friend might be missing.

(1) First, let's accept that Krugman forgets more about economics while having his morning coffee than most of the rest of us will ever know in our whole lives.   He fully deserves to be taken seriously on economic issues.

(2) I think most of his reaction to bitcoin is based on the fact that there is a vocal subset of the bitcoin community that says things like:  (a) bitcoin will replace fiat currency or (b) bitcoin is better than the dollar because there is no 'money printing' or (c) bitcoin will replace the dollar some day.

This is all patently nonsense.   Krugman is right to slap it down and he will be particularly sensitive to it because he has spent his whole life fighting austerians/gold standardians and so on.

So far, so good.   

(3) In the last 24 hours however, Krugman has:

(a) Accepted that bitcoin is a technological breakthrough but also made a price / valuation call (aka it is a 'bubble' aka it is overvalued).   My guess is that he would have made the same valuation call if / when bitcoin was valued at $10 (aka, it has no intrinsic value, it can't be a store of value and the price will fall) so it is not like he is saying it should be $100/coin vs $700/coin.   He is effectively saying that it is intrinsically worth very little.

(b) He then got a lot of flack for his 1998 prediction that the internet would have no more impact than the fax machine, something that he is downplaying today with the fair justification that he is not a technologist, he is an economist. 

So, in aggregate, he is saying:   

(c) Bitcoin is, in fact, a nifty technology

(d) But it is overvalued (in a bubble)

Unfortunately, there is no way you can make the case that it is overvalued or undervalued or correctly valued without having an opinion about what its ultimate adoption rate would be.  

This is the part he is missing: Since there is no way to use bitcoin-the-technology without buying bitcoins-the-coins, so long as there is demand for bitcoin-the-technology, people who want to use it will need to buy bitcoins from people who already have bitcoins and those people will demand some non-zero price for them.  

This is a bit counter-intuitive, but it is counter-intuitive in more or less the exact same way that it was counter-intuitive that the internet network would have a lot of value in 1998, which is why it keeps getting brought up as a possible 'blind spot' in his thinking. Even hyper-smart, Nobel prize winners can't be expected to keep the whole set of human knowledge in their brains at once!

In summary, you can't figure out what a bitcoin is worth without knowing (a) the future adoption rate and demand for bitcoins, (b) discounted to the present.   Given this is an almost impossible thing to predict, this is not much different than Krugman calling Instagram overvalued at a $1B valuation.   And if he is making those types of calls, I am not sure how much value his macro expertise adds - he is just another technology prognosticator at that point.

(4) So, to conclude:

(a) Bitcoin would be a terrible national currency.  Krugman is correct.

(b) Bitcoin has not invented anything new in monetary economics. Krugman is correct.

(c) Bitcoin is a significant technical innovation.  Krugman is correct.

(d) Bitcoin will have a non-zero value because of the value of its network and Krugman seems to be missing this part altogether.    If he does accept this and is simply making a valuation call on bitcoin, well, he is a better man than me because I don't know how one could do that at this stage.

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Bitcoin Series 11: Digital currency will be a winner-take-all game

Digital currency is a 'network effects' business and, more specifically, it is a two-sided market.

In other words, it means that it is a type of market that requires two distinct types of participants to be useful (most often merchants and consumers).   A classified ads market is a two sided market - you need sellers providing listings and buyers who want to purchase from the sellers.   A social network, on the other hand, is not a two-sided market as users are all of the same type.  Social networks have great network effects but they are still not as strong as those of 2-sided markets.

Two sided markets are notoriously difficult to kick-start and then notoriously difficult to displace once they become established.   What we have seen in the last fifteen years with the internet confirms this.    The first 2-sided internet marketplaces to achieve scale (eBay, Craigslist) have proved remarkably resilient to new competitors even when, in the case of Craigslist, their feature set seems mired in 1999.    Whereas 1-sided markets (like social networks), while having serious network effect stickiness, are displaceable (MySpace, Friendster, etc).

Digital currency is a classic 2-sided market.    If no merchants accept, say, bitcoins, it is not particularly useful for consumers to have a bitcoin wallet.   If no consumers have bitcoin wallets, then it is not particularly enticing for merchants to accept bitcoins.   So something has to happen to get the first group on board in order to get the second group on board.

Given this, what are the conclusions that one could draw about bitcoin and digital currencies in general:

(1) Bitcoin has probably achieved escape velocity relative to its clones, in terms of usage, money supply and public awareness of its brand.   It has a good chance of becoming the generic word for digital currency.

By the end of 2014, there will be millions, if not tens of millions, of consumer wallets and hundreds of thousands of merchants who directly or indirectly accept bitcoin.

That is probably enough to end the 'competition' for which cryptocurrency will be broadly adopted.

(2) Given this, it is going to be extraordinarily difficult for any 'alt-coin' (alternative digital currency) to displace bitcoin.   Even if a certain alt-coin has certain feature X that is superior to bitcoin (and I am not convinced that any alt-coins do have any meaningful advantages at this point), that will not be sufficient to dislodge bitcoin.   Getting consumers and merchants to use/accept bitcoins is already a huge adoption/branding challenge that requires a few hundred million dollars, if not a few billion dollars, of free / editorial publicity to solve.   Minor technical improvements (if they are not co-opted by bitcoin itself) are not going to cause a rush of users to a second, third or fourth digital currency.

(3) With this lens in place, the speculative excitement around the 'asset value' of bitcoin isn't a bad thing.   It is probably in fact a necessary condition to generate interest, generate publicity and induce the first million consumers to open a bitcoin wallet.   Bitcoin is truly in the stage where all publicity is good publicity.  The fact that some people now hold bitcoins, for speculation or just curiosity, is what is now drawing in the merchants.   

The biggest risk to a new digital currency is not that it is volatile in the beginning (something that will calm down over time), but that nobody knows or cares that it exists. By accident or by extremely savvy design, bitcoin has solved the awareness problem in spades.

Caveats:

(1) By 'winner-take-all', I mean 80%+ market share.

(2) What could keep bitcoin from achieving that level of market share in digital currencies?  Only two things I can imagine

(a) Regulatory decrees in specific countries:  E.g. if Brazil banned bitcoin exchanges but allowed "brazilcoin" exchanges, that would probably move the market share needle in Brazil (though that would inevitably create a brazilcoin-bitcoin black market).

(b) Government-backed coins:  An officially backed digital currency would take market share.   Though hardly imminent, this is something we will discuss in a later post.

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The bitcoin series - Table of Contents

This is a marker page to hold all our bitcoin blog posts.   Follow on twitter at @polemitis.

Part 1:  Background and some fallacies that repeat in the media.

1.       Bitcoin is a major technical achievement

2.       Decentralization is the key characteristic of bitcoin

3.       Bitcoin would be a terrible national currency (and why that doesn’t matter)

4.       Is bitcoin a currency or an asset?

5.       What are the elements of valuing bitcoin?

6.       Intrinsic value - It is not that simple

7.       How is bitcoin a store of value?

8.       Who is investing in bitcoin today?

9.       Five reasons bitcoin is currently volatile and why it does not matter

10.   Why the $7M pizza does not matter (aka how to transact in bitcoin)

Part 2 and beyond will deal with future and potential applications of bitcoin and will be more open in approach.

11.  Digital currency will be a winner-take-all game

12.  Sideshow:  Krugman and bitcoin

13. Only the Fed can make a Dollarcoin

14. Our robot overlords will use bitcoin

15. The discontinuity that is bitcoin (aka the day bitcoin moved my cheese)

16. So you want a bitcoin, eh? (with really pathetic PPT graphics)

17. Bitcoin loves our freedoms

18. Why bitcoin miners aren't incented to 51% attack

19. Bizarre shadowy paper-based payments system to be rolled out worldwide (or how cash would be described in the press if invented today)

20. The Full-Proof Press Release Kit for [Your Country]

21.  Retirement Plan and IRA Investment in Bitcoin and other Cryptocurrencies

22. Bitcoin valuation for dummies

23. Bitcoin disclaimer

24. The Mega-Master Blockchain List

25. IRS Tax Guidance - Transacting With Commodity Money

26. The 'Polemitis Impossible Trinity'

27. Bitcoin - A 6-Sided Market and Network Effect

28. Sidechains

29. Why Do We Mine Bitcoins?

30. Hashing Power and Difficulty

31. Cost of a 51% attack against Bitcoin vs. a traditional ledger

32. I rented a NYC apartment with Bitcoin and I liked it

33. FedCoin, revisited

34. Oracles, Oracles, Oracles and Oracles again

35. How I Learned To Stop Worrying and Love Hashing Rates

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Disclaimer:  ledracapital.com/disclaimer
 

Bitcoin Series 10: Why the $7M pizza does not matter (aka how to transact in bitcoin)

One of the central fallacies in the media about bitcoin is that volatility will hinder transactions.   This is usually expressed in one of two ways:

(1)    Bitcoin is going to soar to the moon so why should anyone spend their bitcoins? 

This is usually illustrated with the story of how Laszlo Hanyecz paid 10,000 for 2 pizzas in the first documented bitcoin transaction.    The theory being that if Laszlo had kept his 10,000 bitcoins they would be worth $7M today and makes those pizzas the priciest pizzas in world history.

While a great story, the conclusions drawn from it are usually dead-wrong.    After those pizzas were eaten, 10,000 bitcoins were still worth $30.    Laszlo could have trivially replenished his 10,000 bitcoins for $30, not $7M dollars.

This is a more general principle.   Whether or not you want to maintain a ‘long’ position in bitcoin (for investment purposes) is completely irrelevant to whether you want make a purchase in bitcoin (for convenience’s sake).

Imagine I have 10 bitcoins worth $7,200 as of this afternoon because I have decided that is how much investment exposure I want to bitcoin.   And I want to order 6 pizzas for $72 because football is on, my buddies are drinking all my beer and if we don’t get some food in us bad things are likely to happen.

I can either: (a) pay $72 with my credit card in US dollars and still have 10 bitcoins and 72 fewer dollars or (b) buy the pizzas with 0.01 bitcoins and then press one more button and replenish those 0.01 bitcoins with $72 from my bank account.    At which point I would have 10 bitcoins and 72 fewer dollars.

If I instead buy the pizza with bitcoins and do not replace them, then I have made two decisions: (a) to spend $72 for pizza and (b) to reduce my long exposure to bitcoin by 1% (0.01 bitcoins).   But decision (b) has nothing to do with decision (a).

(2)    The volatility of bitcoin creates uncertainty for merchants.    This is just factually inaccurate.   Both major US payment processors (Coinbase and Bitpay) offer vendors the option to convert  bitcoins received back to US dollars as they receive them and take on no bitcoin ‘currency’ risk.  When I read articles in serious publications worrying about this, then I know who hasn’t done their basic homework.

I tested this whole concept in practice a couple of weeks ago when I paid our IT consultant’s latest invoice with 4 bitcoins or so.   I paid him 4 bitcoins, bought 4 more bitcoins 3 seconds later and he made a decision later about when he wanted dollars for his bitcoins.    It was trivially easy and no different than any business that transacts cross-borders deciding to accept money in a second currency.  The only difference I could note is that it took a few seconds to deal with instead of several days.

For the full bitcoin series: ledracapital.com/bitcoin
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