"Our view is that if it is viewed scientifically and rationally that money should have the function of a standard of measurement and thus that it should become comparable to the watt or the hour or a degree of temperature.”
Introduction
Bitcoin has had a short, but incredible history since its inception in 2009. There has been much debate about both the technology and the economics of Bitcoin. Many have made compelling arguments about the technological innovations that enabled Bitcoin to be successful. There has been somewhat less discussion on the economics of Bitcoin. I’d like to share a few economic thoughts in this post.
Bitcoin as Money
Bitcoin has many great qualities as a money. As a digital money it’s durable, easily divisible and easy to transport. The core functions of money is that it is used as a store of value, medium of exchange and unit of account. The primary function for Bitcoin currently is as a store of value and it’s especially attractive for that when compared to weak government currencies such as the Bolivar in Venezuela. Bitcoin may be preferable to major currencies like the dollar/Euro/Yen for people that prefer not to have any form of quantitative easing, currency management or manipulation. Bitcoin currently is only used sparingly as a medium of exchange. That may not be a reason for alarm because Gresham’s law essentially dictates that bad money circulates while good money gets hoarded. The last function of money is as a unit of account. This is where at first glance Bitcoin, like fiat currencies, may seem to have a problem.
Money’s Unit of Account
Ludwig von Mises spoke about the unit of account problem when discussing fiat currency in his book “Theory of Money and Credit”. How can anyone distinguish between 1 fiat paper dollar and 1,000 fiat paper dollars if there is no intrinsic value in it? If the world had amnesia one day and had to determine the fiat paper dollar price of a good, how can anyone achieve that with no reference to some base reference value of money. Based on the Austrian economic school and subjective value theory people each should compare any one good they own with all the other goods they own. Hence an individual would first consider the use-value of gold as jewelry, a collectible or an industrial metal as a reference point before he/she could compare it to other goods and before that person can assign some additional value to gold as a money. A money does however need to have some original base reference value, otherwise how does any individual even begin to assign a fiat paper dollar amount to it? Hence with the gold standard there was a precise measurement of gold that fiat money referred to. The US dollar was based on a certain weight/measure of silver based on the Spanish silver dollar that commonly circulated in the eighteenth century. Hence because there was a historical link of paper dollars to silver and people could reference past prices, they are able to use fiat paper dollars as a unit of account. This idea is called Mise’s regression theorem and the main idea is that there needs to be some originating intrinsic value of a commodity before it can become money. If people measure and compare all goods with each other, they can only initially compare the commodity value of a good to others. Hence people compare a certain weight/measure of gold to other items subjectively before adding an additional ‘objective’ value component to the value when that commodity is also used as a medium of exchange. So what does one Bitcoin represent? How can anyone distinguish between 1,000 Bitcoins, one Bitcoin or a tiny fraction thereof?
Intrinsic Value of Bitcoin
The primary value of Bitcoin is based on its utility as a money. Some describe it as being an immutable digital ledger. There is an underlying tangible software & hardware network underlying Bitcoin that makes it sustainable, secure, reliable and resilient. Bitcoin is as difficult to shut down as the Internet. As long as the Bitcoin network is useful to some people and bitcoins are scarce they will have some nontrivial value. The more users that use the Bitcoin network, the more valuable it becomes. Whether one views Bitcoin as an immutable digital ledger or a resilient software network with hardware infrastructure, Bitcoin can be described to have a ‘commodity’ component of value.
von Mises describes in “Theory of Money and Credit” that there is an ‘objective’ value component of money that is added to the value of any commodity when it becomes used as money. In other words a commodity becomes more valuable the more it’s used as a money. Bitcoin just so happens to inherently have the qualities that make it a good money and its primary role is to serve as a money. Hence it is even more valuable with this additional ‘objective’ value component of money when it’s used for that purpose.
Furthermore the earliest forms of money had characteristics of value that differed from typical commodity money. Nick Szabo, the godfather of Bitcoin, writes extensively about the origins of money. One of his theories is that the earliest forms of money had certain qualities as ‘collectibles’ as opposed to commodities that arose from barter. According to Szabo, early money such as beads & necklaces and jewelry had certain characteristics such as being secure from accidental loss/theft (eg. worn as necklace and secured closely to the body), having unforgeable costliness (eg. required unique human labor) and also having easily observable measurements of value (eg. jewelry that had rings or chains). Bitcoin also has these characteristics as a ‘collectible’ form of money.
Bitcoin’s Cost of Production
The intrinsic value of bitcoin rewards incentivizes Bitcoin miners to buy hardware and consume electricity similar to how gold mining companies set up operations to produce gold. The increased utility of bitcoins drives its value up and subsequently attracts Bitcoin miners to invest more capital. The utility value drives the price of Bitcoin first and foremost.
Secondarily, the cost of production can be a good proxy of value in general. Szabo discusses this idea in his post "Of wages and money: cost as a proxy measure of value" Time-rate wages (eg. $/hr) are still used today as a proxy for a measure of sacrifice. Likewise the unforgeable costliness of bitcoin may instill a similar measure of sacrifice that can strengthen its perceived value.
In the long run Bitcoin mining resembles a purely competitive market because there are very few barriers to entry and it is a globally accessible market. Hence profit margins for the mining industry should be expected to trend towards zero. In theory, the marginal costs to produce bitcoin should eventually equal marginal product in a purely competitive market. These economic details are described by Hayes in "A Cost of Production Model for Bitcoin". Hence the price of bitcoin should approximate the cost to produce it.
The Watt As A Unit of Account
Ultimately the marginal costs for bitcoin are primarily driven by electricity consumption. Hence electricity consumption in Watt-hrs can be used as a proxy to represent the cost of producing bitcoin as well as approximate its price & value. Energy consumption is estimated to be 60% of the total cost of Bitcoin mining. The remaining 40% is the cost for purchasing mining equipment. Bitcoin users can ascribe a real world resource value to each bitcoin by using the energy consumption measured in Watt-hrs used to produce it. Using the current energy consumption estimates at Digiconomist, we can calculate each bitcoin generated to use about 35 Megawatt-hrs of electricity (60% of cost) plus the cost of equipment (40%). If we simplify the total cost of bitcoin production to an equivalent amount of energy we can estimate each bitcoin to be worth about 58 Megawatts-hrs of electricity.
Relating to the Real World
Bitcoin’s relation to electricity can be useful for everyone. In the past, societies used ‘grains’ as a precise weight and measure of gold and silver to enable common folk to easily compare the commodity value of gold/silver money to a roughly equivalent size of agriculture grains they farmed or bought. Today, people can use Watt-hours as a measure of electricity and unit of account that allows them to easily compare bitcoin money with electricity needs. In the modern world, electricity is probably a better and more useful measure of utility than a grain of wheat or rice. People can subjectively compare the amount of electricity required to power their car, home, appliances or computing needs to decide if and when they want to spend or hold bitcoin.
Conclusion
Bitcoin has all the qualities of a good money. It can serve as a store of value, medium of exchange and as a unit of account based on a measure of electricity, namely the Watt-hour.
Updated:
I was informed Joules or Watt-Hour is the appropriate measure for electricity consumption, not the Watt.
Corrected title and some content to reflect that.
