The value of cryptocurrencies

Got an email from “Xiao” about the cryptocurrency podcast a couple days ago:

At  16:49 David is talking about more people is using something makes that thing more valuable. I don’t agree with that. This is my argument. I don’t mean I don’t agree David, It’s just mean I don’t agree with the above assertion.

More people become to use it doesn’t mean it’s more valuable. Just take the value of US dollar as an example, I don’t think there are more people using US dollars than those using RMB. But still US dollars are still more valuable than RMB. ($1=Y6.3) I think that’s because the trading using US dollars are more valuable than those which are using RMB. If that example is not very clear, we think about the British pound, the people who are using British pound is much fewer than those who are using US dollars just because there are not as many Britons as US people. But still one pound values more than more dollar.

I think the value of any currency doesn’t depend on how many people are using that.
Even the facebook phenomenon is kind of suspicious. For me, even if all the people
literally using facebook everyday doesn’t mean facebook itself  is valuable. That’s the
advertisement profit that can be collected from the amount of visiting. By that I mean
it’s trading, people buying, selling stuff making facebook valuable. If facebook can find
another way to get monetary benefit from visiting of all the users, it could be more
valuable. Let’s look into another example, Chinese the language, it’s been used for a
very long time, dating back to 5000 years, I guess (maybe longer than the history of
English). And there are more than 1.6billion people using it. And does it make Chinese
the language more valuable than English? No. Why? Because the trading, the business conducted in English has more value than those using Chinese. The exchange of much more valuable services, goods, assets is being made in English. That makes English more valuable than Chinese.

Let’s get back to the currency and my point that one currency is more valuable than
another only if the exchange using that currency is more valuable than that using
another. That’s what I think. And it fits the hamburger theory, purchase power of a
currency. In China, a McDonald hamburger costs 6 yuan, and the exactly same burger in America costs 1 dollar. It’s proved again, dollar is more valuable than yuan just because the same amount of dollar can buy more goods and services.

Worth at least yi jiao…

So there are at least three things at play here: network effect, diamond-water paradox and the subjective theory of value.

The network effect in essence means the more users of a good or service, the more value it is worth. This doesn’t mean that the service will remain on top forever, as consumer behavior or preferences can change. A recent example of this is Myspace, which quickly grew out of LA underground music scene to become — for around three years — the largest social networking site globally. Its dominance was replaced by Facebook and perhaps one day it too will be replaced. But in both cases, the network effect is illustrated: the more of your friends, family and colleagues used the sites, the more uses it could potentially have for you. A book that discusses the “power” of interconnectedness (e.g., building and maintaining your social rolodex or guanxi) is Linked by Albert-Laszlo Barabas.

The example of the British pound you noted is interesting because it was at one point the dominant global currency a hundred years ago. Before it various other currencies including those from Spain held dominance for periods of time prior to Napoleonic conquests in part because of political hegemony and in part because of business, trade and commercial links. I recommend checking out Paper Money Collapse by Detlev Schlicter who goes through the history of numerous paper (fiat) currencies and Good Money by George Selgin who looks at a longer historical backdrop for minting coinage.

Another example of the time delay that takes place been introduction and widespread adoption are credit cards. Diners Club was introduced in 1950 yet it took decades before charge cards were commonly found in the average bill fold. And who is to say, perhaps other competing digital alternatives like Litecoin or Terracoin will — for some reason(s) — replace BTC as the dominate currency as American Express and Visa overtook Diners Card. Thus it may be too early to declare the cryptocurrency experiment stillborn or DOA since it has been around a mere four years.

T-shirts in Antarctica

The diamond-water paradox in a nutshell means that despite it covering most of the globe, water can command a high price, higher than diamonds even, depending on the location — such as deserts. At the time this paradox was formalized, the prevailing view was that something was valuable because of the amount of labor inputs — the labor theory of value. But this became anachronistic (for all but the ardent socialists) and was replaced following the marginal revolution, with the subjective theory of value — something is valuable based on each individuals’ preferences. Or in other words, one man’s trash is another man’s treasure.

What David mentioned in terms of fiat currencies, prior to the 1970s, all notes in circulation were redeemable on demand for some portion of a commodity (usually metals like gold and silver). For several decades this monetary order was called the Bretton Woods system, however the link was severed officially in 1971.

Today consumers (and just about everyone for that matter) hold currencies and trade currencies with the expectation that they will receive some good or service in return. Thus, while paper notes are technically a “worthless” fiat currency (e.g., there is little utility, no industrial uses for the actual physical content of the bills themselves), the fact that merchants, vendors, institutions and individuals continue using them for transactions and as a medium of exchange would by definition constitute money. For those claiming it is not money, feel free to exchange and trade all of your “worthless money” to David or I via Bitcoins/Litecoins…

What does this have to do with the subjective theory of value?

Again, something, whether it is a good or service is valuable solely based on the preferences and tastes of an individual. Those preferences and tastes can change, there is nothing bedrock or ironclad about them. They can change over time (temporal), they can change based on location (geographic) and they can change based on any number of variables (climate, culture, who won the Super Bowl). Thus the criticism that cryptocurrencies are “worthless,” “valueless” and “not money” is invalid because of the simple fact that today Bitcoins, Litecoins and others are actually being traded by individuals in exchanges for goods, services and foreign exchange (see Mt. Gox and BTC-e). But that is besides the point — a priori, just about anything has the potential to become money. To predetermine what is or is not money is a fallacious exercise as it solely depends, again, on the counterparty, what do they value — are they willing to accept the currency?

Lastly, the discussion about hamburgers is in reference to purchasing power parity and the Big Mac Index devised by The Economist. It is probably only tangentially relevant, because for determining the purposes over whether or not cryptocurrencies are money, PPP has not been a front and center issue for adoption.

Digital currencies like Bitcoin may fail, perhaps they are a bubble propped up by nerd euphoria, but these experiments can and will follow the same laws of supply, demand and subjective preferences. Furthermore, the more vendors and merchants accept them, the more consumers demand to hold them, the more useful and potential valuable they may become.

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