Supply and Demand: The price of bread

This whole section is to get warmed up on basic supply / demand mechanics. Feel free to skip if you’re comfortable with that.

Let’s start with the first economic principle of them all: In a competitive market, prices of a good move to the point at which the quantity supplied meets the quantity demanded.

Think of an old-time market, a town square where bakers bring their loaves to auction and village people go shopping.

On this particular Monday, the bakers brought 100 loaves to sell as they always do. Unbeknownst to them over the weekend there was an article claiming to prove bread is the fountain of youth and a lot more buyers showed up than expected. At the morning auction people start outbidding each other. The first loaf goes for 50% more than normal. The trend continues and as there are fewer and fewer loaves people start to get desperate. The price continues to climb.

Mechanic 1: When demand increases, but supply is fixed, prices go up.

The other vendors notice the bread frenzy and want to get some of the profits. So the next weekend, a couple of of the vegetables sellers learn to bake and on Monday morning they bring loaves to the market alongside their carrots and brussel sprouts.

Bad news for them. Once they added their loaves to the market, there was more than enough to fulfill all the buyers. No one had to outbid each other anymore. On this sad Monday the bakers and vegetable sellers alike have to auction their surplus loaves off at a low price.

Mechanic 2: When demand is fixed, but supply increases, prices go down.

Supply and Demand as applied to currency: The price of money

Next let’s think about how this applies to money. We usually price goods in terms of money, but now we have to do the opposite. We’re going to price money in terms of goods.

First we need to note that currency — let’s consider US Dollars or USD — can be framed as a good just as easily as loaves of bread. There’s one single “baker” that controls the supply, the Federal Reserve (The Fed). They can bake (or print) as much of it as they like.

What determines the demand for currency? Everyone wants more money. So isn’t the demand for currency infinite?

Not quite. Currency isn’t wealth. Every time you’ve bought anything, you’ve shown this. At the moment of trade, your demand for the currency was lower than it was for whatever you purchased. It certainly wasn’t infinite. When you exchange a $1 dollar bill for a loaf of bread you are saying “my demand for bread is greater than my demand for this $1 dollar bill”.

Literal cash can’t keep you warm at night, you can’t eat it, it can’t fly you to the Maldives, it can’t fight a war. As its naked, shivering self, currency is worthless. This might seem self-evident, but it holds the key insight to understanding the correct price of Bitcoin: the demand for a currency is determined by what you can buy with that currency. All demand for currency is transitive — it’s a proxy for demand of something else. You only value it because you trust that it can be exchanged for something you *actually *want in the future.

Anyway, back to the town square. Most people go to the market to buy final goods like bread and carrots. But not the vendors. The vendors go to the market to buy money.

Imagine the price of a loaf of bread is $1. When the consumer goes to the market and trades with the baker, the consumer buys one loaf and sells $1, which means the baker buys $1 and sells one loaf. Both parties benefit from this trade since their relative demand is different. The baker does this all day and buys as much money as possible.

Now we have a price for money: 1 dollar (USD) = 1 loaf (LF).

Now pretend that overnight The Fed decided to print a bunch of money and distribute it evenly to every household. In fact, they double the money supply.

The next morning at the bread auction people are all of a sudden willing to bid higher for the bread, everyone’s feeling pretty flush and the bids start creeping up. They want to make sure they can get their bread. Pretty soon the price is quite a bit above 1 USD.

Isn’t this strange? The supply of bread hasn’t changed. The bread has the same intrinsic value as before: the same caloric content, the same shelf life. There aren’t any more people buying bread than normal, and the bakers didn’t bring more to the market. In other words, the bread market is unchanged. But the price of bread, in terms of USD, has increased. How’s this possible?

The currency market changed. Supply of money has increased while demand stayed the same — so the price of money dropped. This is inflation. Bread loaves are just as valuable as as they were the day before. But now USDs are worth less than 1 LF.

Mechanic 2 applies to currency just as well as bread; when supply increases and demand is fixed the price goes down.

Now let’s look at the demand side of the currency market. To do this, I will make the Canadian dollar worthless (sorry Mom).

Imagine every business and exporter in Canada suddenly decided to stop accepting CAD and instead required all payments to be in USD. Anyone who wants to eat, put gas in their car, or pay their bills — everyone in Canada — would rush out to sell their CAD and buy USD. And no one would want to buy CAD, since it’s useless. With all these sellers of CAD and no buyers, the value of a CAD would drop like a rock, which means the price of a USD in terms of CAD would skyrocket.

The price of a USD in terms of other currency would increase a bit too since there’s more total demand for USD and the USD now has more purchasing power. Remember the demand for a currency is determined by what you can buy with that currency, and now you can buy all the bread and beavertails in Canada with USD.

So mechanic 1 applies to currency too: When supply is fixed and demand increases, prices go up.

Now that’s we’ve looked at how supply and demand determine the price of currency, let’s look at Bitcoin.

The Supply of Bitcoin

One of the things that makes Bitcoin so interesting is that its supply is entirely predictable. No government or corporation can decide to print more overnight. In fact, I can tell you exactly how many Bitcoin will exist in 2040: just shy of 21 million.

Regardless of how many people adopt Bitcoin, or how many people start mining, there will never be more coins than what is given by this graph.

Supply increases every year until it hits a limit at 21 million BTC in circulation. This growth equation is baked into the core of the software running on every miner in the world.

With such a straightforward supply story, let’s look at the other side of the equation: demand.

The Demand for Bitcoin

Why would someone want a Bitcoin? Here are a few relevant properties of BTC:

1. It has a fixed supply, can be traded for dollars, and has a narrative for why its price may increase in the future.

2. Bitcoin can be stored and transacted anonymously.

3. It is not controlled by a nation state and can quickly be transferred anywhere in the world.

These properties have been true since Bitcoin first traded in 2009 and they lead to the four drivers of Bitcoin demand:

1. Speculation & Investment

2. Crime & Paranoia

3. Currency flight

4. Network effect

1. Speculation & Investment

Bitcoin has a fixed supply, can be traded for dollars, and has a narrative for why its price may increase in the future.

Speculation is demand to buy Bitcoin purely in the hopes of its value increasing. Truthfully, so is investment. The only real difference is time horizon, level of conviction, and (to some degree) value. If you put $50 on a hope that a penny stock is going to 10x in the next month, that’s speculation. If you put $50,000 into an exchange traded index you aren’t going to touch for five years, that’s investment.

Speculation and investing has been part of Bitcoin since the beginning. I remember it being a big story on Hacker News when Bitcoin passed $1 and the long discussion of its money making potential. And I probably don’t need to convince you that speculation is adding to demand for Bitcoin — most people think speculation is the *only *source of demand for Bitcoin. Coinbase didn’t suddenly hit #1 in the App Store after the price run up in early December 2017 for any reason other than people hoping to make some money:

Speculation has negative connotations, while investment doesn’t. This is because the short time horizons of speculators make them prone to trading on emotional whims, leading to bubbles and crashes that hurt everyone.

But the negative connotations aren’t entirely fair. Speculative risk takers are the entrepreneurs that breathed life (value, and demand) into crazy ideas like Bitcoin. They lifted it off the ground and gave it some value, and that value was enough to bootstrap all other forms of demand, “investment” included. The early Bitcoin speculators were the prime mover that set this whole cryptocurrency wheel into motion.

2. Crime & Paranoia

Bitcoin can be stored and transacted anonymously online.

Bitcoin’s first major non-speculative use was as a way to buy illegal drugs online. Silk Road launched in 2011, was the first modern darknet black market. Bitcoin was the official currency. Here’s how it worked, courtesy of Wikipedia and the FBI:

This works because while all transactions on the blockchain are public, they are anonymous. Your wallet is identified by a string of 26–35 alphanumeric characters that have no connection with any real-world identify, for example “167NcGmpEcTRTFANQrBjxtV3szyAtDX4dA”. If someone wants to send someone else money, that address is all they need.

Anyone can get an address anonymously. Just download Bitcoin Core and click the ‘new address’ button. Now you’ll have a wallet on your computer and an address like the one above you can use to receive any size payment from anyone in the world. And no one needs to know who you are.

Because of this anonymity, Bitcoin is clearly attractive to criminals generally and retailers of illegal goods, money launderers, tax evaders especially. It also makes it attractive to mostly law-abiding Libertarians who don’t like the idea of the government having control over their currency. For more on this, listen to This American Life “237: Regime Change” which visits the “Free State Project”, a free-market Libertarian festival where Bitcoin has become the de facto currency.

The ‘Bitcoinization’ of all these markets — criminal and libertarian — increases the purchasing power of Bitcoin. Crime contributes real, non-speculative, consumer demand to the market for Bitcoin. Albeit unsavory real demand.

3. Currency flight

Bitcoin is not controlled by a national government and can quickly be transferred anywhere in the world.

The price of every national currency is largely controlled by that nation’s government. Like we discussed above the central bank could print as much money as it likes, for example to pay off all the government debts denominated in that currency. This would rapidly devalue the currency, steal wealth from all people holding the currency — all of its citizens — and transfer it to the government.

Another thing the government can do: declare the paper tender being used as currency illegal overnight, as India did on November 8 2016. In an apparent effort to punish counterfeiters, all medium and large bills (₹500 and ₹1000) were invalidated without warning.

I was in India at the time and here are some things I remember:

• Day-long line ups at every bank as people seeked to exchange their money for the new bills.

• The remaining small bills becoming more valuable as they were all that people could use to buy basics like food and fuel.

• The price of Bitcoin jumped.

From “India’s Demonetization Is Causing Bitcoin To Surge Inside The Country” (Forbes, link):

in a mere 18 days after the demonetization speech of Prime Minister Narendra Modi, the price of bitcoins on Zebpay [An Indian Bitcoin Exchange], which claims to have over 130,000 users, had surged from $757 to $1,020 (per bitcoin), whereas in the U.S. (the benchmark market for most cryptocurrencies), bitcoins are trending at $770 apiece, marking a clear premium on the Indian bitcoin exchanges.

Fast forward a year to Zimbabwe November 2017. There’s a military coup, Robert Mugabe is put under house arrest, and domestic Bitcoin prices spike. As reported by CNN Money

Political turmoil and an apparent coup have pushed the price of Bitcoin as high as $13,000 on a digital currency exchange in Zimbabwe — nearly twice the going rate in global markets. Bitcoin was trading on international exchanges for roughly $7,500 on Thursday.

One more example: Throughout 2016 and early 2017, much of the growth in Bitcoin was attributed to capital flight from the Chinese Yuan. In 2016 China was responsible for over 80% of Bitcoin transactions worldwide. The Yuan is tightly controlled by the PRC, only limited amounts are able to be exchanged into USD or any other foreign currency by private citizens. But if you could change your Yuan to Bitcoin and send them to a wallet you (or a friend, relative) controlled abroad, those limitations could be easily circumvented.

Whether it was due to fear of artificial currency manipulation by the government, a way to lock in and diversify the gains from the rapid recent economic growth in China, or general pent-up demand for international commerce — a lot of Chinese people wanted use Bitcoin as a vehicle to get their wealth out of Yuan. In September 2017 Beijing tried to regain control, closing all domestic Bitcoin markets.

Currency flight is not new and Bitcoin is a clear jump forward in the technology to accomplish it. No suitcases of cash to get through an airport, no gold bars to smuggle. No shady alleys or physically threatening situations. No Western Union or other central authority tracking you.

This too is real, non-speculative demand.

“Bitcoin: Send your wealth anywhere in the world, in 15 minutes, for less than the price of a wire transfer.”

4. Network Effect

Currency only works because we all agree on it. I wouldn’t accept dollars as my salary if I could only buy apples with it. It is because I can buy oranges, and pants, and cars, houses, and even other currencies that I accept dollars as my salary. And the dollars get more valuable the more things I can buy with it. This makes the currency system a classic network effect: Every actor who joins the system, or is willing to transact in the currency, grows the number of trading opportunities for everyone already using the currency and thereby the overall value of the system.

Systems with network effects naturally converge to a single solution. There’s only one phone system. There’s only one email protocol. There’s only one world wide web. If we’re all on the same system it maximizes everyone’s value. It’s the cost-minimizing optimal situation.

So why hasn’t this happened with currency? Why haven’t we already converged to a global currency? Because of trust and sovereignty.

Imagine if the world standardized on the US Dollar. The US Federal Reserve has unilateral control over the supply — and therefore price — of that particular currency. This undermines the sovereignty of every other State. A bad decision by some American policymakers, would send the whole world into inflation and turmoil.

As a global community, we have not been able to agree to trust a single body with control over the global money supply. We trust our domestic governments, where as citizens we have ability to exert political will more than foreign bodies that have no obligation to hear our opinions. Correctly so. But this being the current situation, we find ourselves stuck with an inefficient global system of fiat currencies.

Cryptocurrency is an attempt at changing that reality. No trust in any single body controlling supply is required. Trust is distributed and supply is transparent and predictable. And the network effect is still there.

I am more willing to demand Bitcoin because I know that I can sell it to speculators and investors not only in the United States, but also Russia, Germany, and Japan. Criminals are more likely to transact and hold in Bitcoin because not only their furtive endeavors are enabled by Bitcoin, but those of their entire criminal network. People have more confidence using Bitcoin to flee economic instability because it is used in this way not only in India, but also in Zimbabwe, Venezuela, Greece, and Brazil.

As Bitcoin comes out of the shadows and into the sunlight, becoming directly exchangeable for more and more of the world’s GDP, these network effects will continue to strengthen exponentially.

The Price of Bitcoin

Trust

What the conquistadors failed to understand is that money is a matter of belief, even faith: belief in the person paying us; belief in the person issuing the money he uses or the institution that honours his cheques or transfers. Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display. Anything can serve as money, from the cowrie shells of the Maldives to the huge stone discs used on the Pacific islands of Yap.

• Niall Ferguson, The Ascent of Money, emphasis mine

The great innovation of Bitcoin and cryptocurrency is that it allows you to shift your sources of trust away from any single actor. On the supply side it replaces a system that asks you to trust politicians and central bankers with a system that only requires you to trust mathematics and a highly distributed community of miners; algorithms implemented in the open and verifiable by anyone with the skill to do so. On the demand side it requires you to believe that people will want to buy Bitcoins to acquire other things they want, as described in the last section.

While in fiat currency there is risk and trust on both sides, cryptocurrency virtually eliminates supply risk and instead asks for much more faith in demand.

Fitting demand

All the goods and services produced in a society have some inherent value. We make something that some other people want and are willing to trade for. This value is completely independent of whatever currency it is denominated in. It is simply aggregated fulfillment of human desire. All of this value combined, the total of all our output, is a country’s GDP (Gross Domestic Product). And because we all agree to accept currency in exchange for that value, we give the currency itself value.

So the question of “How much will Bitcoin be worth in 10 years?” could be rephrased as “How much of the world’s productive output of goods and services will I be able to purchase with Bitcoin in 10 years?”. If the answer is “nothing”, then correct value of a Bitcoin is, of course, 0. On the other hand, Global GDP or GWP (Gross World Product) is over $78 trillion USD.

To get our heads around this and at some numbers let’s try to “fit” varying quantities of GWP into Bitcoin’s fixed supply.

Take a look at that table. It seems to imply there is still a lot of headroom for Bitcoin to grow. If Crime alone was to fully shift to Bitcoin, there would almost be another 10x growth, not counting any other demand.

As a sanity check, let’s use another approach and look at gold.

Comparable: Gold

Probably the closest established comparable for Bitcoin is gold. Like Bitcoin, gold

• Has no intrinsic rate of return. Gold pays no dividends.

• It not particularly useful on its own (jewelry notwithstanding).

• Is valued almost entirely because we believe other people will continue to want it and value it.

• Is not controlled by a single state or actor.

Gold was, of course, even used as currency in many societies throughout history. Bitcoin has some advantages over gold: it’s much cheaper and faster to transfer, as example. Gold has some advantages over Bitcoin: it’s shiny and has a long history.

The current market cap of gold is approximately $7.07 Trillion. If Bitcoin reaches the equivalent capitalization, each coin would be worth at least $336,667.

Conclusion

There are still many risks associated with Bitcoin. There’s been a ton of speculation. Its trading value versus the USD could easily fall to 10% – or less — of its current price. As I’ve repeated throughout this essay, long-term value will be driven by real usage to acquire real demand. So here are a few closing words on the biggest question marks at time of publishing (December 2017).

**Slow transactions. **Bitcoin transactions takes around 15 minutes to be verified as legitimate by the network. No one is going to wait 15 minutes at the coffee shop waiting for their payment to clear. This is a major hurdle to widespread adoption as Bitcoin in place of cash for high-volume low-value consumer transactions.

But those are just the surface-level visible transactions. Big money moves invisibly, and a lot slower. There is a strong inverse correlation between transaction size and speed in the real world.

I remember the day I made the biggest purchase I ever made, my house. On the day the wire was supposed to ‘arrive’ we waited anxiously for hours until it finally did right before the day ended. Fifteen minutes isn’t practical for buying a coffee but it’s way faster than a wire transfer or waiting for a cheque to clear — or a shipment of gold bars. Bitcoin could become a high-value reserve currency, adding efficiency to that (large) portion of the world’s money flow, even if it never becomes day-to-day cash.

**Blockchain size scalability and transaction costs: **Two words: Moore’s law. But seriously, I think the ongoing development of Bitcoin Core paired with hardware improvements and network growth will solve these issues.

**Accessibility and usability: **Bitcoin is still nerdy and esoteric, but much less than it was 5 years ago. Today anyone in the US can download Coinbase from their app store and safely buy Bitcoin with a friendly user experience. I think startups will continue to fill these gaps and bring Bitcoin into the mainstream.

**Energy & Environment: **This is a tough one. Switching from proof-of-work to proof-of-stake might work and would certainly help.

**Legal & Regulatory: **This has been the bogeyman for Bitcoin for years now. In some cases it has come true, like when China outlawed Bitcoin exchanges in September 2017. The SEC’s recent statement on Cryptocurrencies was surprisingly supportive:

*“We at the SEC are committed to promoting capital formation. The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing. I am confident that developments in fintech will help facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike.” *(source, accessed 12–17–2017).

Ultimately I don’t think any of these hurdles are showstoppers. Bitcoin could very well prove to be the most significant financial innovation in the past 100 years and the biggest technological innovation since the internet.

My personal opinion — and this is not financial advice (nor is any of this article) — is that buying Bitcoin today in December 2017 is going to be like buying Amazon in 2000. Smart in the long-term, but painful over the next couple years. It wouldn’t surprise me to see Bitcoin valued at over $300,000 USD in 2027.

I know it sounds a bit crazy, but people are very bad at thinking nonlinearly. Writing this article proved this to me, as I explain in the backstory below.

Whatever you do, don’t risk more than you can afford to lose and try to enjoy the ride.

Thank you Todd Sherman and Sonia Lebofsky for providing draft feedback.

The Backstory

What is this graph? Guess.

What a bubble! Did you guess? If you said “the price of Bitcoin” you would be partially correct.

If you said “the price of Bitcoin in 2013” you would be entirely correct.

I wrote this article almost exactly four years ago, in December 2013, during the height of the first Bitcoin craze. I wanted to prove to myself it was a bubble. The graph above was the state of affairs when I wrote this. I had been following Bitcoin closely since 2011 and this rapid growth kind of blew my mind.

Here’s how the 2013 draft started:

Consider this graph. You have probably seen it, or something similar, in the press.

The value of Bitcoin has grown over 1000X in the past few years. Any rational person who thinks this ‘Bitcoin thing’ might be a bubble is showing good judgement: at first glance it certainly looks that way. (..)

I just updated the rest of the article to bring it up to speed for today, I didn’t have to change that much.

Here’s the same slice of the year, but brought forward to 2017. Much more steady and stable.

How wrong was that 2013 “obvious bubble”? Here are the last five years of Bitcoin prices, since January 2012.

Do you see it? That crazy bubble? It’s obvious, no?

We humans are very bad nonlinear thinkers.

Just because something has accelerated exponentially doesn’t mean it won’t in the future. Don’t let a few million years of evolution trick you into thinking that gravity applies to prices the way it applies to falling rocks.

And for a bit more perspective, here’s the conclusion from the 2013 article, entirely unmodified:

Conclusion from 2013 (Unmodified)

I started writing this article as a way to form a cohesive argument as to why Bitcoin was bound to fail. Its rapid rise just felt like a bubble and I was prejudiced against it .

But over the course of writing and researching this article, I realized I was wrong. I’ve actually convinced myself that the opposite is true: Cryptocurrencies are destined to become a major new platform for trust and thereby finance. This may be the biggest technology platform we’ve seen since the internet. Bitcoin might do to money & contracts what the internet did to communication & publishing.

Like anyone else, I can’t predict the future. Bitcoin and cryptocurrencies might be a bubble. Perhaps they will be laughably worthless in 5 years. Perhaps there is some major security flaw that some clever hackers will discover in the next few years that will completely undermine the system. Please do not take anything I say here as financial advice.

But I can tell you this: if you want to know if you can get rich from the cryptocurrency gold rush you need to answer two questions:

1. Are cryptocurrencies of any kind going to establish a substantial foothold in the real economy? and;

2. Which cryptocurrency will be the Facebook and which will go the way of Friendster?

Personally, for (1) I believe the answer is yes. There are too many real advantages to cryptocurrency for it to not find any use. Groundbreaking technologies solve long-standing problems and create great leaps forward in efficiency. I believe that a trust rooted in independently verifiable math is a great leap forward over trust rooted in the actions of human political actors — and that cryptocurrencies have shown how this can become a reality.

For (2) I think BTC will be the winner, but I am less confident here than with (1). BTC has first-mover advantage and nearly all adoption of cryptocurrency today in the real economy is BTC. The technical advantages of new coins so far are only small iterative improvements, not disruptive innovations. Many of these improvements will be able to be brought back to retrofit the BTC protocol itself. And I believe the other advantages will be bridged by new services and technologies which will further entrench BTC and erode any current advantage of LTC and co.

If I am correct, at today’s price of $900 USD, Bitcoin is massively undervalued.