In my previous article I discussed why bitcoin may not be as unique as first suspected. This perceived distinctness may have been one of the causes of the current explosion of cryptocurrency prices (as a side note, I believe Ultracrepidarianism could also have played a significant role in fuelling the hype – read my article about it for more information https://cbeconomics.com/2017/12/21/ultracrepidarianism/). While bitcoin itself may not be a unique asset, that does not mean that the behaviour of the market over the last year is not unprecedented. To explore this idea further, I will devoting some time to developing and considering a simple economic theoretical model, or at least discussing what the key features would be. This article is the first step towards that and will consider bitcoin from the viewpoint of traditional economic theory.
First things first, to consider the ‘agents’ and ‘firms’ that are in play. Three key entities spring to mind immediately: miners, traders and exchanges. To draw a parallel with traditional economic thinking these could be thought of as the origins of supply, demand and regulation respectively. I will examine them in separate articles in order to stop articles becoming too long.
Miners expend time and money ‘producing’ bitcoins. I use the term producing lightly as they do not add any value to the bitcoin, and given the nature of mining it makes more sense to think of it as a non-monetary wage. It is evident that the ability of an individual or firm to mine bitcoin varies greatly across the globe. Places where electricity is cheap, such as Venezuela or China, are exporting bitcoin on a huge scale and as such they show significantly low local price in comparison to countries where electricity is more expensive, i.e. India. This suggests that energy is a crucial input in the mining of bitcoins. Already there have been rumours of government regulating the use of electricity to mine bitcoins in China, where many firms have large warehouses of computers working 24/7 to mine bitcoins, – inflating the country’s (already large) carbon footprint.
Another feature of bitcoins which miners have to consider is the fixed supply. As more bitcoins enter circulation it becomes harder to mine and takes more energy and time for a smaller reward. Every 210,000 blocks mined the reward that miners get is halved. Estimates from 2017 put this interval at every 4 years although I would speculate it is much less than that now given the extraordinary price growth throughout 2017 and the subsequent ‘gold rush’. Just like the historical namesake, firms and individuals are relocating (their capital) and throwing their lot in the bitcoin ring to invest in mining.
This will slow down and then decrease as it becomes harder to mine and the reward for doing so decreases. Firms and individuals will begin to stop mining as the supply approaches the limit and many have speculated this could result in the limit never being reached. Alternatively, if the bitcoin market is indeed a bubble, there will come a point when it bursts and demand crashes. If this happens it is likely that supply will follow, leaving a far smaller number of miners. In this way, the market is identical to a normal asset.
On a side note…
If there is indeed a bubble, I personally will find it very interesting and it could potentially be critical to the future of economics. I say this because the core feature of the bitcoin industry is it’s decentralisation and lack of regulation. In the aftermath of a crash it is usually the regulatory authority’s job to attempt to return to stability, often with mixed results. A crash of the bitcoin industry would offer a ‘natural experiment’, and give the opportunity to see how a decentralised market reacts to a crash when there are no safety nets or regulators. Then again, it is entirely plausible and some would say likely that any crash will actually be caused by an attempt to regulate the industry. Even in the last few days, with South Korea announcing plans to ban cryptocurrencies and China shutting down mining operations, the market has been incredibly volatile and in descent. If this is any indicator of the future, all it would take is announcement of regulation from a heavily involved country like the UK, US or India and the markets would inevitably descend into chaos.
Thanks for reading and stay up to date at cbeconomics.com and on twitter @cbeconomic. In the next few instalments of the Cryptonomics series I will continue my investigation of a theoretical model for the bitcoin industry, moving on to analysis of traders (a group dominated by young males) and exchanges (the de-facto ‘regulators’ who shouldn’t have the influence they do). Please like, share and comment and let me know if there are more aspects of the cryptocurrency phenomenon or any other interesting topics you would like me to discuss!