Sunday, December 1, 2013

Understanding bitcoin price behavior with the Quantity theory of money.

Several arguments against the success of Bitcoin are doing the round:
  1. Bitcoin is a bubble, the present $1000+ price level bears no relation to the small bitcoin economy.
  2. People are hoarding bitcoin and not using it. How can that possibly be a successful currency?
  3. Bitcoin has a deflation problem. The general price level has to keep falling to accommodate the growing bitcoin economy, because of the fixed supply of bitcoin.

These arguments are false, and below I will show why. I will do this in terms that many students of economics are familiar with; the Quantity theory of money:
· V = P · Q

or the Money supply times the Velocity of money equals the Price level times the Quantity of goods. This relationship holds by definition.

People could argue that when the money supply M is fixed and the economy Q grows, the price level P must drop to accommodate it, which would mean deflation.
But then you are falsely assuming V, the velocity of money, to be constant.
What happens when people expect a drop in price level P? They will postpone spending. You know your bitcoin will be worth more tomorrow, so there is a free profit to be had. This drop in spending now would mean there is less bitcoin chasing after goods today. People are hoarding bitcoin. Price levels in bitcoin will adjust, going down now. Saying that the price level in bitcoin goes down, is the same as saying the value of a bitcoin goes up.
This hoarding will continue until the price level expectation does not provide a free lunch anymore. In a bitcoin economy with its fixed money supply, it isn't the price level adjusting to the growing economy. Instead it is the amount of bitcoin used in spending, or the Velocity of money.

So we can expect bitcoin to be hoarded at first. The bitcoin value should be expected to climb rapidly and then stabilize. 

So what the Quantity theory of money shows us is;
  1. The price of a bitcoin wil move now, up to a level fitting the size of the expected future bitcoin economy. Assuming bitcoin adoption, the $1000+ price is no bubble. The total value of bitcoin of about $15 billion is still very low compared to any reasonably sized economy. (
  2. Bitcoin hoarding is normal. The velocity of bitcoin will speed up over time. Bitcoin hoarding is a logical consequence of the expected growth in the bitcoin economy, in combination with the limited supply of bitcoin.
  3. There will be no constant deflation with bitcoin. The value of a bitcoin will jump to a level that fits the future bitcoin economy size and then stabilize. It is the number of bitcoin used in spending that will adjust to the growing bitcoin economy over time, not the price level.


  1. If you believe the value of a bitcoin will rise to a level that fits the future bitcoin economy, what is your prediction for the size of the future bitcoin economy?

    1. It could be anywhere between hobby size and world size, valuing bitcoin somewhere between a dime and $100.000. Bitcoin adoption is the only relevant variable in this game, and that is looking very good.

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  2. The only way it will be adopted is if it is stabilized and the only way it will be stabilized is if it adopted...

    Am I making too many assumptions? What business would trade in a currency which could drop 10-15% in an hour?

    1. Sure, although first you don't have to hold on to bitcoins very long and second the derivatives being developed will allow you to lock in any price you see.

      There is plenty uncertainty about what size the bitcoin economy can reach, which translates into price volatility. The demand for transaction balances will grow and serve as a bottom in the market, but that is well behind speculation at the moment.

  3. "There is plenty uncertainty about what size the bitcoin economy can reach..."
    First, I abhor the Federal Reserve and the concept of "fractional reserve banking" is, IMHO, nothing more than legalized THEFT. I hope this qualifies my position as better than a "troll".
    Next, I have no appreciation for explanations that do not include ALL possibilities, or at least more that "up, up, up". What if the bitcoin economy (participants) goes down?

    Is bitcoin better than gold or any other precious metal coin, excluding portability?

    Why do "tulips" keep coming to mind when I look at the extreme price increase in the bitcoin?

    1. It's not a stretch to to have a bitcoin derivatives market based on gold or any other asset class.

  4. In the presentation that I watched about the bitcoin, the speaker said that theft of the bitcoin would leave the robber with a "Mona Lisa", or impossible to use. How is that possible and how was it stolen in the first place if it is "electronic money"?? ....which, of course leads to the question of "hacking" those servers that are "eight times more powerful" than whatever number of computers they were comparing?....which leads to the question of privacy. If "stolen" bitcoins are worthless to the robber, how is it known that the bitcoin is no longer in the possession of the rightful owner?.....and who else has access to that information?
    In a widespread power outage, how do you make a transaction?

    Currency Collapse:
    As history proves that all fiat currencies eventually fail, why is this fiat currency different?.....It would seem logical that the very reason for the invention of the bitcoin is to defeat its competition (ex. U.S. "air" dollars). What medium will be used for "non-electronic" trade, keeping in mind the large number of just Americans that have absolutely no internet experience? ....What kind of currency will Equatorial Africa be using?

    1. This is a very good question however the answer could play itself out any number of ways.

      One potential scenario is cold bitcoins (bitcoins not connected to the internet).

      By the way one equatorial African country is already using bitcoin so this sort of demonstrates a widely held misbelief:

      Other possibilities could be an embedded coin that displays the amount of units available to spend which you can top up.

      There are so many possibilities to consider if you have even the smallest imagination.

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