Recently, Paul Krugman has been writing a series of blog posts about the Bitcoin cryptocurrency. I'm still on the fence about Bitcoin and friends, despite my recent dabbling in their technical aspects, but I'm honestly surprised to see someone ordinarily so smart be so far off the mark. So, let's start:
Krugman comments that "... it remains completely unclear why BitCoin should be a stable store of value" while leaving open the question of whether Bitcoin may (emphasis added) be a useful medium of exchange. But he then notes that "[he hasn't] been able to get [his] correspondents to recognize that these are different questions."
The answer, of course, is because they aren't different questions. The intrinsic value of Bitcoin is entirely derived from its utility as a medium of exchange.
Let's do a little thought experiment and assume that Bitcoin replaces Visa. According to Nerdwallet, US$3.273 trillion was processed by Visa in 2010. Processing a transaction in bitcoin (or cash) requires a certain amount of extant cash to float: In the case of Bitcoin, it takes about ten minutes before a transaction has been "confirmed" (by the process of mining). This step of confirmation is an important part of Bitcoin's security to prevent double-spending the same coin to multiple recipients.
(Update June 30, 2014 -- I typoed and used 3.723 instead of 3.273 in the first version of this post. I've updated the numbers now. The prior version said that there must be $70.8m of bitcoin instead.)
That's important: For ten minutes, the Bitcoin involved in a transaction is effectively tied up. This provides a first basis for determining the value floor of Bitcoin: $3.273 trillion per year, but you have to have enough value of coins in the network to support the ten minutes of float during transaction confirmation. Ten minutes of $3.273T/year is $62.2 million. There will be at most 21 million Bitcoins in existence.
Therefore, if Bitcoin replaces Visa, a Bitcoin would need to be worth at least $2.97 to support the transaction volume.
That's a little less than today's price of $700-odd USD. But that's not the only thing that keeps cash tied up. Consider a second example: An ATM card. These days, many ATMs charge a non-customer fee of a couple of bucks for withdrawing cash. If your own bank doesn't reimburse for these charges, when you want cash to buy a $5 grande-fraapy-latte-with-fluffy-sprinkles, do you pull $10 out of the ATM to do so? Of course not: You'd be losing 30% of your money in transaction fees. By withdrawing $100, you can amortize those transaction fees to a more-manageable 3%.
Using excess "cash" to amortize transaction fees increases the value of a currency.
In our ATM example, this was cash sitting in someone's wallet (which was not being actively exchanged). In the case of Bitcoin, it might be keeping $100 worth of bitcoin in your wallet to amortize the bank fees you pay to convert cash to BTC. Or it might be the reserve of BTC that a company like Coinbase keeps on hand in order to satisfy its customers purchases.
Summing up all of these factors isn't easy, but it provides a basis for estimating, if you really wanted to, a value floor for Bitcoin were it to become an important mechanism of exchange. Krugman has his doubts there, and I do too, but if it happens, Bitcoin will have some intrinsic value arising purely from having a high transaction volume.
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