Intro
What is bitcoin? Even within the bitcoin community, there is great debate over what bitcoin actually is.
In this piece, I will present a short thought experiment, which I find helpful in thinking about the nature of this asset in steady-state equilibrium. My hope is to convey a few ideas:
- Society does not store value in bitcoin. Society ascribes value to bitcoin.
- A rise in the purchasing power of bitcoin need not come at the expense of productive assets in the economy.
- In equilibrium, bitcoin performs identically to the fully diversified market portfolio.
Thought Experiment
Let’s consider a small island nation with a thriving self-sufficient economy. On this island, there are commercial enterprises, which produce many types of goods and services that are valued by the local population. Trade on the island is conducted via frictionless barter, where one type of good is exchanged directly for another, and all goods and services are denominated in a unit of account called a “basket,” which reflects a consistent amount of value in real terms.
The aggregate market value of every asset on the island is well-defined. Let’s call this market value M, defined in terms of “baskets.” Every individual on the island owns some percentage of M, adding up to 100%. Individuals can own specific assets or the fully diversified market portfolio, which reflects a fixed percentage of every asset on the island.
Now, let’s suppose a digital asset with a fixed supply is introduced, which is not perishable and will exist as long as there are people on the island. Every individual on the island receives a percentage of the supply proportional to their ownership of M, and they can freely trade the asset thereafter. Let’s call the aggregate purchasing power of this digital asset B, defined in terms of “baskets.”
In and of itself, this digital asset offers no utility. It cannot be eaten, consumed, or otherwise transformed into something useful, and it solves no problems the islanders are facing, as their trade is already frictionless. In short, introducing the digital asset to the island has no effect on overall wealth.
Observations
We can make a few starting observations:
- The aggregate purchasing power of the asset B cannot exceed the overall value of all assets on the island M.
- No islander is wealthier than they were before, since the digital asset is distributed proportionally to each islander’s ownership of M.
- Islanders ascribe purchasing power to the asset simply by deciding on the number of “baskets” they would trade for it if given the opportunity, and vice versa.
- Under homogenous expectations, all islanders ascribe the same purchasing power to the asset at all points in time.
- As a result of #3 and #4, B can change without a single trade taking place.
- The aggregate value of all other assets, M, is purely a function of their discounted future cash flows / utility and is independent of B.
These observations are important because they make clear what the digital asset is not. First and foremost, it is not by default a store of value. The islanders can ascribe purchasing power to the asset such that B = M without a single trade taking place or any reduction in the value of M. In other words, the islanders can ascribe purchasing power to the asset without storing any value in it.
The second implication is that the asset does not be used as a medium of exchange to possess purchasing power. Islanders could certainly use it as a medium of exchange if they wish to, but in a frictionless economy, this is unnecessary. The island can continue to function precisely as it did before, with islanders ascribing purchasing power without the asset being used to facilitate a single trade.
The third implication is that it is rational for the islanders to immediately ascribe the maximum amount of purchasing power to the asset (B = M). Doing so leaves no islander worse off and is the only natural non-zero Schelling point, crowding out all future non-productive assets. Consequently, islanders know for certain that if another asset is introduced that offers no utility, zero purchasing power will be ascribed.
The fourth implication is that the digital asset will perform identically to the fully diversified market portfolio. If the aggregate market value of assets on the island compounds, so will the purchasing power of the digital asset B. Conversely, if the aggregate market value falls, so will the purchasing power of the asset.
So what?
This thought experiment highlights one specific way that bitcoin is an improvement over gold - it compounds alongside the market. Gold never has, and never will, perform identically to the fully diversified market portfolio, because ascribing more purchasing power to gold simply increases its supply.
Second, a rise in bitcoin’s purchasing power does not require an equivalent amount of assets being sold to purchase bitcoin. Commentators often use language that suggests that bitcoin is a zero-sum game, that assets must be sold for the purchasing power of bitcoin to rise. While it is true that bitcoin has the potential to crowd out other non-productive assets, buying or selling bitcoin does not affect bitcoin’s purchasing power directly. In a world where expectations are non-homogenous, trading is the market’s way of disseminating information about how much purchasing power should be ascribed.
Third, in a non-frictionless world in steady-state, bitcoin is perhaps the simplest way for an investor to access the fully diversified portfolio. The idea that investors could fully diversify by purchasing a single asset is a fascinating one, and I think it deserves greater attention.
Finally, this thought experiment suggests that bitcoin’s purchasing power will naturally converge to global real wealth. This conclusion does not require any assumptions about the monetary system the world uses to conduct global trade, nor does it require any assumptions about the dollar and whether or not it will inflate away. Bitcoin is a positive-sum game, and we can choose to ascribe greater purchasing power to it without taking away anyone’s real wealth.
Thought experiments like this one can be helpful, even if the assumptions are unrealistic, because they provide a way of thinking through complex ideas. There are few ideas as complex as Bitcoin, and understanding what it is and where it’s heading is an important task, which can at times be quite arduous. Simplified thought experiments are one way to make that task a little bit easier.