This is Part 2. I recommend reading Part 1 first.
BTC as a network
BTC, like everything that either is money or seeks to become money, is an economic network. I have been interested in the intersection of money and networks since before BTC existed. In fact, my business, Stinson Analytical, is devoted to the idea that both the economics of networks and their wide implications for what are presently considered to be other areas of economics are not even remotely well understood. I have devoted years of effort to developing a new framework that will remedy these shortcomings.
Under my framework, the source of value in any network, monetary or otherwise, is its “homogeneity”. Homogeneity, as I define it, is a characteristic determined not only by network size or, equivalently, by adoption or acceptance, but by other measures of network quality as well. “Money” is the term that society uses for a particular set of network goods that either have, or seek to attain, a high level of homogeneity.
It is essentially the definition of a network good that its fundamental or real value is positively related to network size or adoption. Where price is mostly demand-determined, such as in the case of constrained supply (there are other cases), price can be an indicator or signal of network adoption. Thus, notwithstanding the tendency to mock BTC in certain circles, a network’s current price can legitimately be a fundamental element in establishing expectations of future value, in a manner that is analogous to future cash flows being fundamental to the valuation of a stock.
A question to ponder though: if holdings of BTC become concentrated in transaction aggregators, as discussed in Part 1 (link), then what happens to the incentive to run a full node (as we are continually being urged to do by Bitcoin evangelists) and consequently to the potential for maintaining a highly decentralized network consensus?
But BTC isn’t backed by anything!!
Superficially true, but substantially false.
As discussed in Part 1, BTC does not represent, either directly or indirectly (the latter via backing assets on a balance sheet, for example), a claim on another asset or cash flow.
The same thing can be said about gold under the gold standard. Indeed, the lack of a counterparty is normally considered to be one of gold’s advantages.
The absence of a backing asset is the very strength of emergent base money, once it is widely-enough adopted. The “money network” should be the most stable economic network. It would therefore be counterproductive to base its value and stability on an inherently less stable and less valuable network (i.e., anything else).
What confuses people is that BTC, like gold, comes into existence by production, not by being sold into existence (what central banks do when they purchase assets — they sell fiat currency) or borrowed/lent into existence (what commercial banks do when they create bank money).
Emergent base money is backed, like any network, by the current and expected future path of network adoption (and other aspects of network homogeneity) and by characteristics of the network good that align with user preferences. This is what backed gold under the gold standard and it is what backs BTC now.
BTC and Mises’ Regression Theorem
To simplify, Mises’ regression theorem implies that non-state or free-market money emerges from a commodity that has non-money uses (or as I would prefer to generalize, “non-network” uses). It is these non-network uses that generate the initial widespread demand (and relative price) for the commodity. Its use as money follows. Because BTC has no non-network uses (again, as I would formulate it), there has been some fretting in the Austro-libertarian world about whether BTC violates the regression theorem and is therefore perhaps not money after all (or something like that).
In my view, the regression theorem is a special case of how a free-market “base money network” might be coordinated in a very highly decentralized environment, such as that existing before widespread literacy and mass communications, where individuals are isolated and where no competing “money network” currently exists. The process envisioned by the regression theorem should not be viewed as an absolute requirement for modern network formation. For example, it requires no great imagination, given the history of central banking, to recognize that it might be possible to improve upon fiat currency as a store of value and that there might ultimately be a significant demand for an improved base money. Thus, initial demand for the network good can be justified on the basis of the potentially superior characteristics of the new good as a network good. Modern communications also aids in expectation formation.
The regression theorem is similar to the view, common in non-monetary circumstances, that a network must be “seeded”, in effect, with a non-network use. Non-network use forms the initial user set, at which point the network effect can potentially take over. My perspective is that this may be necessary in some cases but not in others, depending on the network. My own work also implies that reliance on a non-network use can create instability.
Is BTC a bubble?
Momentum-driven growth in the price does not require that BTC be a bubble. It is sufficient that BTC be a network good with largely demand-determined price. As noted above, the fundamental value of a network good is positively related to network size or adoption (this is the “network effect”). Because price can be a valid indication of network adoption and thus of network quality, it is not irrational for price to inform or confirm expectations of network adoption. A rising price, by signalling greater adoption and increased quality, can therefore lead more individuals to consider joining the network.
In my framework, a bubble is a subset of unstable networks. I have not yet fully settled in my own mind what distinguishes a bubble from other unstable networks. However, to be a useful distinction, it makes sense to view bubbles as anomalies or distortions and thus, as a cluster of error, as the Austrian school does.
From an immediate practical perspective, it matters less whether BTC is a bubble than whether it is unstable. In other words, even if BTC is not strictly speaking a bubble, it may still be an unstable network. An unstable network has poorly anchored expectations of current and future adoption. Unstable networks, whether bubbles or not, are susceptible to the network effect operating in reverse to unravel the network and thus also susceptible to precipitous declines in price.
Whether BTC is stable will be determined by the market. If it survives, we will know that it is/was stable. However, it is possible to identify features that predispose it to stability or instability. At this point, I would simply say that BTC has features that may be less than ideal from a long-term monetary network perspective. However, some of these features may be inherent to the highly pre-determined aspect of crypto-currencies, which in general is a source of stability. And while BTC competes not against the “ideal” but against central bank monetary policy and what so far appear to be other inferior crypto-currency networks, one must also consider the potential for new entry. For example, gold has physical properties that are uniquely suited to its previous emergence as base money. Regardless of what one thinks about the relative merits of “commodity” money vs. fiat money, it is unlikely that, in the world of non-virtual commodity currencies, gold could be improved upon. Those physical constraints do not exist in the virtual world. Just as BTC emerged, it is conceivable that an improved version could also emerge.
Continued in Part 3.
19 December 2017