Why Is Bitcoin So Valuable?

The price of bitcoin has soared from a mere $759 a year ago to an astounding $11,760 today. Naturally, many are left scratching their heads. Why is bitcoin so valuable? In what follows, I consider two common views before offering my own.

1. It’s costly to produce.

Many in the bitcoin community claim that bitcoin is valuable because it is costly to produce. Each bitcoin represents the computing power used to produce it, they say. Computing power is valuable. Therefore, bitcoin is valuable, too. Is that right?

There is a grain of truth there. But, ultimately, this explanation doesn't work. Let's start with what is correct: it is costly to produce bitcoin.

Bitcoin is a distributed ledger technology. The blockchain, or ledger, at bitcoin's core must be updated when a transaction is made. If you buy a burger with bitcoin, your account has to be debited and the diner's account credited. To accomplish this without relying on a central clearinghouse, all of the computers running the protocol race to complete a complicated computing problem that processes the transactionor, more precisely, a block of transactions. Of course, it is costly to solve this computing problem. To encourage folks to incur those costs, the first computer to solve the problem is rewarded with new bitcoinbitcoin that no one owned previously. That’s mining. You run the program and, with some luck, acquire some new bitcoin.

So, where does this explanation go wrong? Basically, it gets the causation backwards. It is true that individuals incur costs to mine bitcoin. But that doesn’t make bitcoin valuable. Rather, individuals choose to incur the costs of mining because bitcoin is valuable.

Think of it like this: no one digs for gold in my backyard. Why? It is costly to dig for gold and, presumably, they do not believe the gold they could expect to discover would cover the costs of digging there. Incurring the costs of digging in my backyard would not make the project more valuable.

Or, like this: an hour at the doctor’s office is not expensive because the doctor has spent a lot of years in school. Rather, a doctor spends a lot of years in school because an hour at a doctor’s office is so expensive. Doctors incur the costs necessary to offer medical services because they believe those services will be valued sufficiently. Incurring similar costs to learn how to thread a needle or mow grass would not make threading a needle or mowing grass more valuable. It would just make you an idiot for wasting so much time learning how to do something that isn’t worth much.

Remember kids: never reason from cost to value. Individuals choose to incur costs based on their expectations of value.

2. It’s just a bubble.

Another common explanation for the huge run up in bitcoin’s price is speculation. I find claims of speculation unsatisfying. The future is uncertain. Everything is an act of speculation. Going to college? You are speculating that the job you can get once you earn that degree will be worth the time and money spent on education. Starting a pizza shop? You are speculating that enough individuals will be willing to hand over their hard-earned cash for your oven-fresh pies. It is hard to think of anything that isn’t an act of speculation. We should be asking: what is the basis for the speculation?

Of course, most who say that bitcoin’s price is driven by speculation really mean that it is a bubble; that the price of bitcoin is greater than its fundamental value. But they don’t observe the fundamental value. They only observe the price. So, how can they be so sure? If pressed, they usually say that bitcoin must be overvalued because there is no way its value could have risen so quickly. Perhaps they are right. Or, perhaps bitcoin was undervalued before. Since we do not observe bitcoin’s fundamental value, it is difficult to adjudicate between those two views.

3. It's useful; or, might be in the future.

So, what’s my preferred explanation? It’s simple: some people believe bitcoin serves a useful purposeor, has the potential to serve a useful purpose in the future. That’s it. The price goes up. The price goes down. And the fluctuation in bitcoin’s price merely reflects the extent to which people think bitcoin will serve a useful role from now on into the future.

It is a little more complicated than that, of course. As a medium of exchange, bitcoin is subject to network effects. That means individuals must form expectations about the future network size, which might be difficult. It is also subject to regulatory shocks or outright bans, both of which might affect network size in hard-to-predict ways. So, not surprisingly, the price bounces around a bit.

But isn’t the price too high to be based on bitcoin’s usefulness? I don’t think so. The market capitalization of bitcoin is around $200 billion at the moment. For comparison, the market capitalization of Visa is just over $245 billion. The market capitalization of MasterCard is roughly $154 billion. The market capitalization of Western Union is around $9 billion. And we could go on down the list. Is it so hard to believe—or to accept that others believe—that bitcoin might one day capture a third of the global payments market?

Some look at bitcoin’s price and see a bubble. I see a lot of people betting on bitcoin.

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William J. Luther

William J. Luther is the Director of AIER's Sound Money Project and an Assistant Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular works have appeared in The Economist, Forbes, and U.S. News & World Report. He has been cited by major media outlets, including NPR, VICE News, Al Jazeera, The Christian Science Monitor, and New Scientist.

Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.