On the Fair Value of Bitcoin and its implications

Humanity is unprepared for a pure speculative asset with no intrinsic value or connection to physical reality

“Bitcoin has no intrinsic value”

”Bitcoin isn’t backed by anything”

“Bitcoin doesn’t generate any returns”

“Bitcoin’s value is from pure speculation”

“Bitcoin is a bubble”

Those of us who have been following bitcoin for a while will feel a rosy glow of nostalgia to hear the mainstream economic establishment again wheeling out these facile tropes in their increasingly desperate-looking attempts to convince the plebs that bitcoin is just a Ponzi scheme that will collapse any day, and to instead trust their banking system which has never tried to screw them.

But the Rubicon has been crossed now. The Trojan Horse has entered and the gates of the citadel locked behind. With the approval of the US spot bitcoin ETFs - in particular by BlackRock, who are (one imagines) at the absolute power centre of Wall Street - humanity has passed, almost silently, over the event horizon beyond which the gravitational attraction of bitcoin is probably inescapable.

And a large part of the reason for this is that the mainstream quotes above are essentially correct. Their authors think they mean bitcoin will fail, but anyone who thinks objectively can see that the opposite is true - and the implications for humanity are huge.

The essence of these critiques is that the price of bitcoin is determined by pure speculation, and not connected to any physical or economic reality. This is exactly right. If mainstream economists did what they are supposed to, and actually consider what it means, they’d quickly realize we are in uncharted territory. Because no such asset has ever existed before.

To be specific: bitcoin is the first and only asset whose supply is not affected by its price. This means it is not subject to the natural constraint on all assets humanity has ever known, whose supply will increase in response to price rises, thereby choking them off.

Without that constraint, the known laws of supply and demand just don’t apply.

So what does determine bitcoin’s ultimate “fair value”? This post shows how, without any physical or economic reality to limit bitcoin’s price, it will be driven up by a positive feedback loop of self-fulfilling expectation that only stops when the entire world is “all in”. At that point, everyone still thinks the price of bitcoin is going up, but they don’t buy any more because they have nothing left to buy it with.

If this happens - and after many years pondering this question, I can’t see anything likely to stop it - it’ll pretty much be The End of the World As We Know It.

All assets before bitcoin have prices connected to physical or economic reality

Before bitcoin, anything you could own - stocks, bonds, gold, $$$, property, commodities, cans of beans, ammo - has some notion of value that is connected to activities in the real world.

For things you can inhabit, eat, burn or shoot, this connection is obvious - they will be valued in the market according to how much people want to inhabit, eat, burn or shoot them, and how hard it is to make more of them.

Things get more interesting with gold. Industrial demand for gold cannot possibly explain its market price, which clearly resides in something else: its utility as a store of value per se. This begins part of the logical circuit we will see in bitcoin: the higher the price of gold, the better it has performed as a store of value.. ..so the more highly demanded it will be for people seeking a store of value and the higher its price.. All else equal this loop would lead to a price that spirals off towards infinity.

But the price of gold is not infinity - for the same reason the price of tulips and south sea stock and any other (traditional) asset is not infinity: supply responds to price. When the price of something goes up, it increases the returns available to anyone who produces more of it - so more is produced. When this additional supply comes to market, it suppresses the price.

That economic tether is present for all assets before bitcoin. Known gold deposits are everywhere - but they are too costly to mine at current prices. If the gold price goes up, they become economic to extract so they will be extracted. We have only mined a vanishingly small proportion of the gold available even in the Earth’s crust - let alone that buried deeper, or in asteroids. So its easy to see that the price of gold will always be connected to, and limited by, the cost of generating new gold.

When you look for it, this connection between price and supply is present everywhere. If a stock price increases it incentivizes more stock to be issued, either of that same company or of new entrants deploying capital in its market. If interest rates rise it incentivizes more supply of loans (bonds) by creditors. If land prices rise it incentivizes more development, regeneration, reclamation or even ultimately planetary exploration.

This connection is deeply engrained in our consciousness, and implicitly determines our initial attitude to anything you can buy (or sell). It is the reason all speculative bubbles have ultimately burst.

All bubbles until bitcoin, that is - because for bitcoin, that connection simply does not exist.

A brief introduction to Bitcoin supply

Everyone probably knows by now that the bitcoin supply is “fixed”. That’s not to say there will never be any new bitcoins produced, but the schedule of their production is predetermined. There are currently about 19 million in circulation. After April 2024’s “halving” event, the rate of production will fall from ~900 per day to ~450 per day. Four years later it will halve again, and so on. In the year 2140 the last fraction of a bitcoin will be produced, for a grand total of 21 million.

The precise schedule doesn’t matter. The key fact is that it is completely* independent of price.

(*for nit-pickers, there is technically a way that price changes can have a slight effect on how fast the 21 million cap is reached, but this can be ignored).

For the first time, an asset exists without any supply-side price constraint. To use the jargon, bitcoin is the first and only instance of perfect price-inelasticity of supply.

Market valuation with price-inelastic supply

We are all accustomed, unconsciously at least, to the behaviour of markets under normal conditions of price-elastic supply. Demand fluctuates, causing prices to increase or decrease initially, before supply of the asset adjusts to bring price into line. It is the persistent interaction of the forces of demand and supply which determines the price and its trajectory.

So what happens when demand is the only variable influence on price? For a consumption good, such as a foodstuff, this wouldn’t be that big a deal. Price would go up and down with demand, but demand would be based on peoples desire to consume the good - its “utility” to them - which is independent of price.

But for an asset that is used as a store of value, like gold or bitcoin, utility is not independent of price. The more an asset appreciates over time, the more useful and attractive it is as a store of value. That increases demand for the asset, whose price rises further, making it more attractive. This is the bubble logic of tulips and dotcoms and all speculative manias.

It’s worth noting that this can work both ways: the expectation of higher prices in future means greater demand now, which makes the price rise a self-fulfilling prophecy. But if at some point expectations were for lower prices, demand would fall and the prophecy would be fulfilled in the other direction.

In the short term you’d expect uncontrolled spirals in both directions, as control swapped between the alternate forces of greed and fear. But if you zoom out, one of these must win. It’s a question of pure human psychology - left to itself will people tend to drive the price of a pure speculative asset to zero or not?

This leads us to the two possible answers for the question of the ultimate fair value of bitcoin:

• $0, if downward speculation dominates in the long term

• $effectively infinity, if upward speculation dominates in the long term

Downward speculation cannot dominate

The $0 outcome seems fairly easy to rule out. For example, I promise hereby to buy any and all bitcoin at a price of $(1/21million) - thereby ensuring it will not reach zero while I’m alive and have $1.

(You could argue that if I owned all bitcoins it would be dead, and the market price would be $0. But it would only take one other diehard trading against me to produce a permanent nonzero price).

If downward speculative pressure stops at any price above zero it fails definitively - as the only force left will be upward.

In practice I’d think it is obvious to everyone that market forces alone are not going to drive the price of bitcoin to zero, and that upward speculation dominates.

Of course it could go to zero for other reasons - eg if some attack against it were to succeed, and it was effectively destroyed. This seems a more serious concern (and of course would itself be self-fulfilling if the market thought it likely). I may post separately about the incredible resistance of bitcoin to interference and attack, but here I’ll just say this possibility now seems very unlikely to me, especially now Wall St seems to be fully on board (here, here).

Its worth noting that bitcoin is unique in this property of durability. Other cryptocurrencies are not comparable in terms of their resistance to attack and government interference. That is why, to me, bitcoin can reasonably be described as the only asset ever to exist with price-inelastic supply - because that requires the asset to continue to exist..!

Where does net upward speculation take us?

If downward speculation cannot dominate, and take the price to zero, what then will be the effect of dominant upward speculation? What $ price level is too high?

Here it is important to remember: the price of bitcoin has no connection to any physical or economic reality. That means that the actual $ price of bitcoin is entirely arbitrary.

There is nothing special about any price level, be it $0.01 or $10bn. There is no number you can pick and say, for any reason based in reality, that it is too high. All that matters is the expectation of future prices and the resultant speculative pressure to move the price.

If the price level is arbitrary, then changes in the price level will not exhaust upward speculative pressure. In fact, as successive examples are made of the dominance of upward speculative pressure, one would expect its dominance to increase in ever tighter feedback.

This leads to the theorized event known in bitcoin circles as hyperbitcoinization, where a tipping point is passed and all other assets degrade in value against bitcoin at an accelerating rate. It is analogous to the compression of a collapsing star as the force of gravity it exerts on itself increases in a positive feedback loop until it becomes a black hole, or singularity, with infinite density.

OK but the price will not actually be infinity - it will be constrained by global liquidity

The absence of supply response means the price of bitcoin cannot be constrained to the kind of normal equilibrium seen in other goods. But that doesn’t mean no other constraints would ever be encountered - and indeed one will certainly intervene to stop unlimited eternal price appreciation.

To see this, consider the case of an OG bitcoiner. They may have taken the orange pill in 2012 and bought a few thousand bitcoin at $1. They agree with my arguments here, and believe the price in future will be significantly higher than its current level of ~$70k.

Under naive economic assumptions you’d expect them to continue to buy bitcoin - because everyone always wants more money, right?

This kind of unlimited profit seeking assumption holds pretty well at the level of whole economies - and ensures that all opportunities for making money will be taken by someone. But at an individual level it obviously breaks down. The OG bitcoiner will be very rich now, and might have 95% of their wealth in bitcoin already. They aren’t going to sell other assets to chase more wealth. In other words, they are already effectively “all-in”.

And this is the only constraint I can see. Dominant upward speculative forces will continue to push the price of bitcoin up, probably catastrophically, as everyone realizes that the price is driven purely by expectation, and that everyone else is expecting it to rise. Individuals will exit the mania only at the point when they consider themselves already “all-in”- that is, they are:

• aware of bitcoin’s properties and understand that it is a bubble with nothing to pop it, a one-way bet

• already so exposed in bitcoin that they decide to forgo further investment

The price will rise until everyone with assets is at this point. Everyone looks at their portfolio and says: “OK I think bitcoin is still going to pump but I’ve got enough now”.

What is the equilibrium price at the global liquidity limit?

We can now start to think analytically about this outcome. When will it be reached, and what will it look like? What would the price be?

For example, suppose people consider themselves to be “all in” when bitcoin is 50% of their financial worth. At this point they will stop buying more even though they believe they’d be likely to make money.

A quick search suggests the total global value of financial assets is around $250 tn. This just includes stocks, bonds and other financial instruments - and omits “real” assets, which could also be sold for bitcoin.

Say bitcoin just cannibalizes this $250tn in a zero-sum exchange - and the mania stops when the whole world has 50% of their assets in bitcoin. Everyone considers themselves “all in”. This implies a bitcoin price of about $6m - about 100x higher than we are now.

This has to be a gross under-estimate. For one thing, the 50% would only apply to the investor “at the margin” - that is, the last person to consider themselves all-in. At that point our OG would have a far higher proportion, and everyone in between would be >50%. There are also lots games likely to be played that ensure a much wilder ride up and a consequently higher equilibrium price. For example it would be rational for central banks to print money without limit, to buy as much bitcoin as possible - which could lead to far higher overall transfers of wealth, even though the marginal investor was still only at 50%.

Any further quantification effort seems a bit futile, but it’s worth noting that a simple description of the world this equilibrium produces is one in which, by definition most wealth is in bitcoin.

The end of upward price speculation should lead to stability

When everyone is “all in” the upward speculative pressure will dry up. This may cause the price to fall, but that would break the equilibrium condition - and we’d be back to where we started, with people sooner or later driving the price back up until they are back at their liquidity constraint.

Over time, this equilibrium should become apparent to everyone, and form a kind of “Schelling point” that everyone subconsciously coordinates around, leading to increasing stability - and marking the end of the era of active speculative bubbles. Bitcoin will have matured.

What will the world look like at bitcoin equlibrium?

There’s a lot more analysis that could (and I expect will) be done of this global liquidity equilibrium, but it feels like it is probably pointless at the moment. Long before it is reached, the world will have been completely transformed.

Here are a few of the more obvious changes we can expect in a world where most wealth resides in bitcoin:

• Bitcoin mining will dominate industry and power supply. Already bitcoin mining uses a non-insignificant fraction of global energy. As the price explodes under hyperbitcoinization, its energy usage will increase commensurately. Its not hard to imagine a situation in which >20% of the world’s economic activity and power use is in bitcoin mining - perhaps a lot more.

• Bitcoiners will rule the world. At a price of just $1m, Satoshi Nakamoto - if he’s alive - will be the world’s first trillionaire. As most wealth drains into bitcoin, economic and political power will no longer reside with the military-industrial complex, but it will be in the hands of OG bitcoiners. Who knows what the effect of this will be, but it has to be better than the constant warmongering and abuse of government power on which western society is currently based. Of course bitcoiners will also have incentives to do things to increase the price of bitcoin.

• Investment will drain out of productive capital. Many bitcoiners will hate me for saying this but even if you think (as I do) that bitcoin provides the hope of freedom for a world population whose alternative is digital enslavement - due to its property, which I haven’t discussed here, of enabling censorship resistant economic activity - its economic design means that it will provide significantly greater returns than other investments which society needs. Owners of capital will see they can make more money from bitcoin, and so will sell their factories and equipment. Only investments projecting higher returns than bitcoin will gain funding. Less capital employed reduces wages and overall welfare. It is possible that this problem would be solved by a new model of governance - based, necessarily, on bitcoin - but this is beyond my ability to foresee.

Before closing its worth noting: it’s not hard to see reasons to expect that bitcoin would be net bad for humanity - and possibly catastrophic. But even if we were all to agree that bitcoin should be stopped, it would be impossible for us to do anything about it. The game theoretic design of bitcoin is inescapable, it seems to me. Humanity cannot control bitcoin, it is something that is happening to us, and we will just have to go along for the ride.

Meanwhile, as satoshi said:

It might make sense just to get some in case it catches on.

Caution

This post is not investment advice.. If you do decide to buy bitcoin, know that:

• you don’t own it unless you hold your own private keys. Even owning a bitcoin ETF means you just have an IOU and are depending on the kindness of your counterparty not to keep it. I expect the temptation to keep it will become irresistible.

• there is no regulation or central control, by definition - and if you type “buy bitcoin” probably most results will be pure scams

• there’s no substitute for educating yourself. The information is all out there but you need to develop a good bullshit detector, and work out what information is trustworthy. This is a good place to start looking for resources. You can also try to meet knowledgeable and trustworthy people in real life who can help you, eg through bitcoin meetups.