Now that Bitcoin has reached another all time high, the Bitcoin debates are starting anew. Is Bitcoin a speculative asset bubble, as argued by its detractors, or private money that will replace state fiat currencies, as Bitcoin Bro’s would have you believe? None of the above, I would say. Instead, Bitcoin is nothing but a game of musical chairs, where fortunes can be made and lost in an instant. I believe that Bitcoin’s true value to investors can be found in the game itself. The game score, namely the Bitcoin price, is a pure, unadulterated measure of global risk appetites.
First, let’s talk about asset values and asset bubbles. There are four drivers of asset values:
- Fundamentals. In the case of financial assets, fundamentals represent some expected stream of cashflows. Future cashflows have value because such cashflows can pay for future consumption. It is this ultimate use, or utility, that endows financial assets with value. This also applies to non-financial assets, such as commodities, that do not generate cashflows but have some actual use. For example, oil has value because it can be used to produce gasoline that powers cars. In terms of asset prices, fundamentals provide a value anchor. Having a value anchor means that asset prices cannot be indefinitely divorced from fundamentals (e.g., an IPO must produce a profit at some point to justify sky-high valuations).
- Risk. This is a measure of the variability and uncertainty of future expectations. The riskier an asset is, the wider the range of possible future outcomes, including outcomes that could not have been anticipated.
- Risk-free interest rates. These are the nominal returns associated with risk-free assets such as fiat currency or government bonds denominated in domestic currency. I should stress that I am talking about nominal returns here. In real terms, after adjusting for inflation, there are no risk-free assets. However, for the purpose of asset valuation, that’s a non-issue because we use nominal risk-free interest rates to benchmark nominal expected returns on risky assets. Basically, asset valuation involves this kind of apples-to-apples comparison.
- Risk tolerance. The final and most important driver of asset values is risk tolerance. Risk tolerance determines the required risk premium for a given amount of risk. If the expected return of a risky asset is higher than the risk-free rate plus the premium, the investor would be a buyer. If the expected return is lower, the investor would be a seller. Risk tolerance is unique to each investor and to each dollar at risk. Risk tolerance and, by extension, the required risk premium is determined by the size of the bet relative to the wealth of the investor (the bigger the bet, the lower the risk tolerance and the higher the risk premium).
The most important thing to understand about asset values is that the first three factors are objective, meaning that they can be assessed independently of the investor, but the fourth factor is not. To know what an asset is worth, you need to ask worth to whom. This means that there is no such thing as fundamental asset value that markets are supposed to discover. Instead, value is subjective (beauty is in the eye of the beholder so to speak). Setting the objective factors aside, the market price of a risky asset is simply a measure of the risk tolerance (or risk appetite, if you will) of the respective investors. As the risk tolerance changes with changing income expectations and/or rising and falling investment at risk, the market price changes as well. In other words, market prices are not subject to bubbles but to the ebbs and flows of investor risk appetites.
Now, enter Bitcoin. The genius of Bitcoin is that it has no fundamental value because it has no actual use (I am yet to see compelling use case for Bitcoin). This is actually a good thing. Without a value anchor, it’s value can be anything, a million but also zero. If someone were to actually develop a compelling Bitcoin application that would be a disaster for Bitcoin Bro’s because Bitcoin’s value would all of sudden be anchored to the utility of that application.
That does not mean Bitcoin is a bubble. As I explained above, there is no such thing as market bubbles because there is no such thing as fundamental value. The value of Bitcoin is no different than the value of the Mona Lisa or a rare wine bottle that will never be opened. Beauty is in the eye of the beholder. The more beholders there are and the fewer chairs, the higher the price.
In terms of risk, it is the riskiest asset of them all precisely because it does not have a value anchor. Bitcoin is a risk heaven. Practically overnight, you can strike it reach or you can lose your shirt. Should you play this game of musical chairs? Absolutely, if you have high tolerance for risk, meaning you are playing with dollars you can afford to lose. But don’t forget. A successful Bitcoin strategy is about two things: proper timing of the entry and exit and the size of the bet.
What about the argument that Bitcoin is hard money, which was the original impetus behind its creation? Could Bitcoin supplant the reserve currencies of today such as the US dollar or the Euro?
First, what is a reserve currency? It is the safest of safe currencies that people flock to during panics and times of crisis. There are two key properties that endow an asset with the capacity to act as a reserve:
- The underlying asset is risk-free both in nominal and real terms.
- The underlying asset either has objective value or if the asset has subjective value, its value is negatively correlated to investor risk appetites.
Just to expand a bit on the second bullet, objective value means that money must be worth the same to all participants in the market place, and its value must be unaffected by the risk tolerance of the people who use it or hold it. This is a very difficult, if not impossible, standard to meet. Just to illustrate, $1 is worth a lot more to a person who just lost their job compared to a person making $1 million a year.
Under a more practical standard, the value of money may be subjective but it must be negatively correlated to investor risk appetites. This is what a safe heaven means. When risk tolerance is low and risky asset prices are falling, the value of the reserve either stays the same or rises. On the flipside, when risk tolerance is high and risky asset prices are rising, the value of the reserve either stays the same or falls.
To illustrate these properties, let’s consider gold and the US dollar. Under the gold standard, holding gold was risk-free in nominal terms — a pound of gold was always and still is a pound of gold. However, the purchasing power of gold did fluctuate quite a bit in the short-term, which is evidence that its value was subjective. The reason gold acted as monetary reserve, despite having subjective value, is because its value was negatively correlated to the business cycle. In other words, gold acted as a safe heaven. During recessions, its value would rise as more people wanted to hold gold. During expansions, its value would fall as people would flock back to risky assets. This resulted in successive periods of inflation and deflation, which ensured that gold’s value and purchasing power were stable in the long-term. Long-term price stability under the gold standard did come at a hefty price though, namely pronounced business cycles and high cyclical unemployment.
Fiat currencies that act as reserves, such as the US dollar, require two ingredients: debt and an independent central bank dedicated to price stability. Every single dollar in existence today was created in one of two ways: a private agent borrowed from a commercial bank or the Fed purchased obligations of the US federal government or extended credit to banks. The notion that fiat money has no backing or intrinsic value could not be further from the truth. Fiat money is backed by 1) the obligation of private borrowers to redeem their debts and 2) the obligation of private citizens to pay taxes. It sounds counterintuitive, but the bigger the mountain of private debt denominated in US dollars, the stronger the value of the dollar. Furthermore, there is a massive institutional infrastructure to ensure those debts and tax obligations are met (think the banking system, bank regulators, the courts, property rights, the IRS), which is yet another reason the status of king dollar as the global reserve of choice will remain unchallenged.
The second ingredient is the price stability mandate of an independent central bank. This mandate ensures that fiat money is risk-free in both nominal and real-terms. It is not a sure thing, hence not all fiat currencies are considered reserve currencies, but the potential is there. Furthermore, central banks have learned a lot over the last 40 years. Volcker used high interest rates to break the back of inflation. Bernanke used QE to prevent deflationary pressures in the aftermath of the Great Financial Crisis, preventing a repeat of the Great Depression in the process.
Undoubtedly, the value of the US dollar is subjective — investors will always value it more in times of crisis (i.e., the demand for dollars rises). However, by increasing the supply of dollars during crises, the Fed can ensure that its value stays the same. This gets us a step closer to the money ideal, a fiat currency with objective value. There is a huge pay-off if we can reach this ideal. It will result in macro stability and the elimination of cyclical unemployment. Obviously, we are not there yet, but the path forward does not involve cryptography but better institutional design and better fiscal and monetary tools.
To see why Bitcoin can never become hard money and will not supplant the US dollar, look no further than its key feature: Bitcoin is a risk heaven. Bitcoin is positively correlated to risky assets, meaning that its price rises and falls with the ebbs and flows of risk appetites. This is the exact opposite of how monetary reserves are supposed to behave. The chart below illustrates perfectly. The big drops and peaks in Bitcoin’s price coincide or precede big drops or peaks in the S&P 500.
Bitcoin’s price is entirely a reflection of the risk appetites of the Bitcoin community. More importantly, as the community expands, Bitcoin will become a reflection of global risk appetites in general. While Bitcoin is neither hard money nor an inflation hedge, having a real-time, or maybe even a leading, gauge of investor appetites is immensely valuable. We’ve never had such gauge before since no asset class has been entirely lacking of fundamentals, at least not one that I can think of.
