The Price and Future of Bitcoin

Guest post by Evan Jenkins.

It’s time for some Real Talk about Bitcoin.

This past month’s Bitcoin boom has brought out the usual derp from both the True Believers and the Cryptoskeptics. The True Believers point to rising prices as evidence of the impending Fiatpocalypse, while the Cryptoskeptics point to the same rising prices as evidence that Bitcoin is a mere faddish bubble, destined to pop as soon as its so-called investors get kicked out of their parents’ basements and need to pay for food and shelter.

What we haven’t seen enough of is analysis of Bitcoin as an asset. Whatever you may think of Bitcoin, it's an actual commodity with an actual price, and we can use that price to make inferences about its future. You’re welcome to unskew my analysis using whatever set of Bayesian priors you hold, but I hope this will at least give a basis for some actual dialog about the future of Bitcoin. 

Bitcoin is a purely speculative asset (that is, you will never be paid anything just for holding it), which makes its pricing model particularly simple. To further simplify things, we’ll make the not entirely realistic assumptions of a zero risk-free rate and risk-neutral investors, or equivalently, a discount factor of 1. What this means is that the price of Bitcoin now is equal to the expected price of Bitcoin at any time in the future.

As I write this, the price of a Bitcoin is hovering around $300. Does this mean that twenty years from now, the price of a Bitcoin should still be around $300? Of course not! Twenty years from now, either the True Believers or the Cryptoskeptics will be proved right. If the Cryptoskeptics are right, Bitcoins will be worthless in twenty years.

If the True Believers are right, they’ll be worth a lot more than they are now. Determining exactly how much more is a tricky issue. The chart in Guan’s post shows several potential implied values for Bitcoin, based on the total value of all Bitcoins in existence growing to various levels. These values are possibly reasonable short-term goals for the True Believers, but I can’t imagine the Bitcoin hype stopping at any of those levels. In order for Bitcoin to really reach a stable value level that can reliably be used worldwide for online transactions, it’s going to need to become a sizable portion of the world’s currency. One estimate puts the current total value of currency in the world at $58.9 trillion. Let’s say that in the long run, Bitcoin will need to become 1% of that, or $589 billion. This corresponds to a price of about $28,000. (This is a larger value but lower price than the last entry in the table: I’m having this take place in the future, when there will be more total Bitcoins.)

All right, we have our setup. Right now, the price of a Bitcoin is $320. There are two possible futures: in the Cryptoskeptic future, a Bitcoin will be worth $0. In the True Believer future, a Bitcoin will be worth $28,000. What is the probability of each future? If we let \(q\) be the probability of the True Believer future, then \[300 = P_{\operatorname{now}} = E(P_{\operatorname{future}}) = 28000 q,\] so \[q = \frac{300}{28000} \approx 0.01.\] Thus, our model tells us that there’s only a 1% chance that the True Believers are right! The higher you think the future value of Bitcoin is, the less likely that that future will actually happen. (This is what makes the chart in Guan’s post so amusing!)

To finish up, I want to bring up two confounding factors, one of which is bad news for the future of Bitcoin, and one of which is good news for the future of Bitcoin but possibly bad news for the True Believers.

The first confounding factor is that the Bitcoin market, as it exists now, probably does a pretty bad job of pricing correctly. The problem is that it is very difficult for somebody who does not already hold Bitcoins to make a bet against the future of Bitcoin. The only people with the power to move the Bitcoin market down are those who have already bought into the Bitcoin market, and they likely have rosier visions of the future of Bitcoin than the rest of us. This, in my opinion, is the biggest piece of evidence in favor of calling Bitcoin a bubble. In order for the Bitcoin market to price Bitcoin correctly, there needs to be a good way to short Bitcoins. But until there is a reliable way to lend and borrow in Bitcoins, that won’t happen.

The second confounding factor is that if Bitcoin really does establish itself as a legitimate currency, we will need to throw our assumptions of how many Bitcoins there are out the window. In principle, there should be no more than 21 million Bitcoins ever produced. In fact, since Bitcoins can be irreversibly lost, we should actually expect the number of extant Bitcoins to start decreasing at some point. But, as much as the True Believers like to rail against fractional reserve banking, the truth is that once Bitcoins become a real currency, it will start being banked and invested like a real currency, which will effectively increase the number of Bitcoins in existence. Depending on how we measure total “amount of money” in US dollars is anywhere from 10 to 20 times the amount of physical currency in circulation. But there is reason to think that for Bitcoin, the mulitplier could be even higher, as Bitbanks would lack, at least initially, any sort of reserve requirement. This lowers the future price, and thus raises the probability, of the True Believer future. But is this the future that the True Believers want? Not really.

So, what conclusions do I choose to draw from this analysis? First, Bitcoin is in a massive bubble that will in all likelihood eventually pop. Second, even if I’m wrong and Bitcoin does manage to establish itself, it will end up looking a lot more like a traditional currency than the True Believers envision. Indeed, it’s possible that Bitcoin will succeed but still settle at a significantly lower price than it’s at now, due to the power of fractional reserve banking. But it’s hard to imagine a path from here to there. The True Believers are likely to resist any attempts to turn Bitcoin into a stable store of value precisely because the means to do so are antithetical to their cause. A Bitcoin future will require a concordance between the True Believers and the Cryptoskeptics, and right now, the cultural gap just seems too large to bridge. Some sort of cryptocurrency may indeed establish itself, but the signs right now do not point to Bitcoin.

Evan Jenkins is a Visiting Fellow at the Pinion Institute for Econotrolling. He occasionally rants about provincial urban development issues at his blog, Let the Midway Bloom. Follow him on Twitter at ejenk.