Why Bitcoin Will Continue to Grow

Why Bitcoin Will Continue to Grow

The Value of Money is the Value of a Community

Currencies are unusual in that their usefulness as currencies is a result of their demand. The more deals that can potentially be made with one, the better it is. It is only indirectly because of a currency’s inherent properties that it can turn into a good currency. To an alien with no interest in human culture or technology, both dollars and bitcoins would be equally worthless, even though he would be able to see that bitcoins are a superior medium of exchange.

In economics, this is often called the network effect because it is the network of people using it that convinces everyone that the good has value. This can appear to lead to circular reasoning: everyone believes it has value because everyone else believes it has value because everyone else believes it has value… and so on. It is almost like a cartoon monkey that picks itself up by the end of its own tail!

However, a better physical metaphor might be the formation of crystals. A liquid can be supercooled into a state that can support crystals, but no crystals form because there are no initial crystals that the liquid particles can attach to. However, once a tiny impurity, or “seed” is introduced into the liquid, a crystal will form around it and grow quickly until the liquid has been absorbed.

By this metaphor, the supercooled liquid is the world as of a few years ago, ripe for a monetary revolution, and the seed is the initial bitcoin purchase. The fact that Bitcoin successfully transformed into something with value seems like a miracle. However, it was no miracle. It was a result of the dedication and faith of its community, whose members will not let go of the beautiful vision of a Bitcoin future. It might be better to use a word like “crystallization” to describe the formation of the initial “seed” of Bitcoin trading rather than a metaphor like “bootstrapping”, which depicts a physical paradox.1

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Crystal bit persuasion

Thus, when people dismiss Bitcoin as valueless and call every upward price movement a bubble, they are really missing the point. An investment in bitcoins is an investment in the Bitcoin community. It was in late 2012 that I came to realize just how wonderfully fanatical this community was, and this was what convinced me to treat my bitcoins not as simply an utter speculation, but as something with very real prospects.

The Network Effect for Currencies

Social networks are a familiar and often-cited example of the network effect. Facebook and G+ both have a lot of nice features, but the feature that makes Facebook so much more useful is that all your friends are already on it. Thus, it is really the network that uses Facebook that makes it valuable.

This example can be confusing when analogized to currencies. Facebook and G+ have the property that either can be used at a low opportunity cost of using another. In other words, if I am already spending some time crafting the most narcissistic Facebook status update that I can think of, there is little additional effort to posting it on G+ too. Both Facebook and Google support chat protocols, so there is little additional effort to using a program such as Jitsi that can run both protocols and log me in to both services simultaneously. Thus, it is possible for a social network to succeed without diminishing the size of the others. It can expect to attract members without necessarily drawing them away from the others.

However, for currencies the situation is different. Owning any one currency carries a high opportunity cost of owning any other. I cannot use the same money to buy an investment in bitcoins and in silver coins or Canadian dollars. If I want more of one, I necessarily must have less of another. If any one currency is acknowledged to be the winner over the rest, then there is no additional benefit for anyone to own other currencies.

While it is possible for two social networks to coexist, the world is not big enough for two currencies. Any initial disparity between two currencies, no matter how small, positively reinforces itself, and there is no reason to expect this effect to end until one currency is driven out of existence. As the price of currency A begins to rise relative to currency B, holders of currency B begin to see that their investment is looking less and less reasonable. As more people flee currency B, its decline accelerates until it has effectively ceased to be a currency.

This conclusion does not appear to be borne out by our everyday experience of different national currencies within each nation-state. This is explained by the fact that these states typically have legislation such as legal tender laws and capital controls that artificially reduces the usefulness of other currencies within their respective borders. There is no jurisdiction in which Bitcoin is legally privileged, so there is no group of people required to treat it differently than any other. Thus, there is no reason to expect Bitcoin ever to be in a stable equilibrium with national currencies, the way that they are in equilibrium with one another.

From these considerations, it follows that Bitcoin’s future is an all-or-nothing proposition. If Bitcoin is good enough to compete with other currencies despite their legal privileges, then it will overtake them. If not, then it is a bubble and eventually no one will want it but a few true believers.

It might be argued that Bitcoin could retain its uses on illegal markets, but there is no reason for a drug dealer to accept bitcoins as payment if there is no one who wants to use it as a store of value or as an investment. He must either want to keep it himself or have someone he can sell it to in order for him to use it. Thus, if Bitcoin fails as an investment, it fails as a payment system, even for purposes to which it is especially adapted.

The Meaning of Bitcoin’s Upward Trend

All things being equal, a larger network is better than a smaller one. This puts Bitcoin at a disadvantage with respect to national currencies. One would therefore expect Bitcoin to decline relative to dollars or euros. The fact that this is not the case tells us that all things are not equal. It shows us that Bitcoin is still good enough compared to the national currencies. It can grow anyway despite their advantages over it. The network effect means that the bigger Bitcoin gets, the better its prospects. The fact that Bitcoin has grown in the immediate past is strong evidence that it will continue to grow in the immediate future.

chart-all-timeA possible objection is that Bitcoin’s demand is mostly investment demand rather than demand as a currency. Therefore, the objection goes, it is no longer the case that Bitcoin’s demand is self-promoting. However, a currency becomes more useful as a result of any kind of demand, not just demand as a currency. I would bet that most people who are invested in bitcoins today would be happy to get more by trading goods and services for them. They are also happy to serve as a facilitator for bitcoin trades via the dollar, which is effectively what happens when a merchant accepts bitcoins as payment and then immediately converts them to dollars. Thus, their investment demand enables more use of Bitcoin as a currency. By merely investing in Bitcoin, they enable more potential trades and make Bitcoin a better currency.

The interesting thing here is that we should expect the advantages of the national currencies over Bitcoin to decline as Bitcoin grows, and eventually to become disadvantages. Therefore, not only will Bitcoin’s expanding network further drive its growth, but the declining networks of its competitors will as well.

Based on this, my prediction for Bitcoin’s future growth is not just exponential growth, but faster than exponential growth. If it is successful I predict Bitcoin will take over the world faster than anybody expects, including myself. This prediction has been borne out in my own case: I am continually astonished by Bitcoin’s successes. Now one of my biggest fears in writing about Bitcoin is that my predictions will come true before I can publish them.

The End of the Trend

Predicting a change to Bitcoin’s growth trend requires thinking in terms of effects that are not relevant at present. This makes things difficult because it is hard to say what will become relevant first. It could be, for example, that Bitcoin’s growth will outpace its technology and the network will become congested enough that it hampers the adoption rate. If there was a concerted effort from governments around the world to destroy Bitcoin, this could greatly hamper Bitcoin’s growth as well—but at this point I doubt it could be stopped.

For now at least, Bitcoin’s present trend is self-reinforcing with no equilibrium in sight.

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  1. Crystallization implies a transition from liquid to solid, which is not appropriate for Bitcoin. An even better physical metaphor would be the more general concept of spontaneous symmetry breaking, which includes not just crystallization but all kinds of other processes without a transition from liquid to solid. However, unfortunately not enough people understand what that is to make it a good metaphor.