Economic misunderstanding of crypto world: is cash savings? Does scarcity create value?

There are some important economic mistakes in the cryptocurrency story - how should we view themBitcoinAnd other blockchain assets.

Original title: economic misunderstanding of the crypto world

Written by Noah Smith

Compiling: block Unicorn

Cash is not savings, and scarcity itself will not create value.

Bitcoin and other cryptocurrency investments are still actively promoted around the world. During my recent trip to Tokyo, I saw a huge bitcoin sign on the luminous billboard, and books on NFT were piled on the tables in the bookstore. When I walked through downtown San Francisco, the face of Sam bankman fried (SBF), founder of FTX, appeared in front of me and told me: "the future of investment is cryptocurrency. Do you want to join?"

Most ordinary users who buy cryptocurrency may not conduct in-depth and careful analysis of its basic value, whether as a currency or as a technology. On the contrary, they may buy bitcoin in 2013 because someone at work now drives a Lamborghini, or their cousin has made huge profits by buying NFT. However, the stories related to bitcoin and Web3 may indeed have some importance here. When ordinary people ask themselves, "wait, why should I buy this thing again?" Even if the story itself can not persuade them to buy, there will be a story to tell them why this is a good investment.

So I think it is helpful to look at some economic stories circulating in the crypto world from a practical perspective. These stories are difficult to determine precisely because encryption is a decentralized enterprise, and no authority tells you how to view bitcoin or the metauniverse. Therefore, describing a story circulating in the market as a typical character always puts people in danger of being a scarecrow. Nevertheless, I think there are some important economic mistakes in the stories about cryptocurrencies that I have seen people tell on Twitter and elsewhere - these mistakes have an important impact on how we should view the value of bitcoin and other blockchain assets.

Myth 1: cash is a long-term savings

Supporters of bitcoin generally believe that bitcoin is a substitute for legal tender such as the US dollar. They give many reasons why fiat money always fails, and many people like to declare the death of the dollar (so far, it is too early). This forms the core of an investment paper - if the world is going to shift from paying in bitcoin to paying in bitcoin, then if this shift occurs, people who hoard a large amount of bitcoin in the early days will eventually become very rich.

I think this investment view is obviously wrong. Bitcoin will never really become a currency. David andolfatto has a very good explanation for this. (Disclosure: for other reasons, I do hold some bitcoin.) but there is also a moral aspect to the reason why bitcoin replaces legal currency. The refutation at this level is more subtle. Regardless of whether bitcoin has really replaced the US dollar, its supporters often think that it should replace the US dollar, because the US dollar will cause inflation.

Block Unicorn notes: David andolfatto is a dean of the Department of economics at the Herbert School of business in Miami, and previously worked in the central bank.

"Inflation" only means that the value of the US dollar is measured by such practical and useful commodities as bread, gasoline, and medical insurance. As time goes by, the value of the US dollar will decline. The Fed's target is an inflation rate of 2%, which is usually kept fairly close (though not now). That's why one dollar is not as valuable as it used to be - the value of one dollar in 1913 was about equivalent to $30 in 2022.

For many bitcoin users, this represents an injustice. Why can irresponsible, unelected bureaucrats devalue your hard-earned cash in Washington, D.C? To these people, bitcoin seems to represent personal autonomy, because the Federal Reserve cannot decide how much your money is worth. Bitcoin will appreciate rather than depreciate over time. This idea seems to attach importance to personal thrift and integrity, because it promises that people who work hard and save money will be able to maintain the fruits of their labor.

But this idea is based on a fundamental misunderstanding: that cash should increase in value over time. In fact, cash has never been a form of long-term savings.

Imagine a world in which cash will increase in value over time - just because you put some money under the mattress, you can bear more and more social production each year. In fact, it's a good deal - it's really great. It sounds like a good deal, doesn't it?. In this deflationary world, your wealth is gained without effort - society keeps transferring more and more of your labor achievements to you, but you do nothing.

If the money has a positive actual return over time, this return does not represent a reward for the hard work done; It represents a free thing, a charity. In economic terms, this is called rent.

If bitcoin really becomes a land currency, and its value rises year after year, this rising value will represent the transfer of real resources to those who sit on cash but do nothing. Where do these real resources come from? They must come from productive workers and companies. Therefore, bitcoin investors imagine a world in which productive workers and companies are subsidizing the lifestyles of cash hoarders.

This sounds unfair, and it is economically inefficient. Economists have repeatedly debated whether the optimal inflation rate is 0 or a decimal, but you will find that few people think that the optimal inflation rate is negative.

So, over time, cash should not make you richer. What should it be? The answer is simple: productive assets. When you invest your savings in a company, you are (at least in theory) helping the company to do something productive. By allocating your capital to productive projects, you are not a useless profit eater, you are a capitalist - you are taking risks and getting rewards from taking risks.

This is the source of one of the most basic principles of Financial Economics: risk return balance. In a well functioning financial market, the return is the compensation for the risk.

This is why deflation has no real meaning. A good short-term value storage (i.e., low volatility) will not be a good long-term value storage - that is, it will not get high returns. Good currencies are currencies with predictable value in the short term, so they will not get good returns in the long term. (this is why bitcoin, at least in its current form, will not be used as a currency.)

In other words, cash should not be your main savings tool. Your main savings vehicle should be long-term productive assets, such as stocks, bonds and real estate. You should only hold enough cash to make monthly purchases, plus a small amount of emergency fund. Your cash is your working capital (this view is too forward-looking and does not conform to everyone's values, not recommended).

Now, there is a big problem with this idea. For several reasons, it is not easy for the poor to hold productive assets. First, they can not afford to buy some productive assets, such as houses. Second, they lack information, and it is difficult for them to enter the financial market where they can buy stocks and other commodities. Third, the wealth of the poor is so small that maintaining a small emergency fund will account for the majority of their total savings. As a result, the poor are forced to hold their savings in cash.

This is a big problem, but the solution is not to turn our society into a deflationary currency, so that over time, cash can get a positive real return. Of course, doing so will allow the poor to get a small return from the small amount of cash they hold. But under this system, most of the returns will go to those who can hold large amounts of cash – in other words, to the rich. The return of a few dollars to the poor is not worth giving the rich a large amount of windfall. On the contrary, if you want to give the poor money to compensate for the fact that they can't buy stocks, give them cash benefits. Or use social wealth funds to buy shares for them. Bitcoin is not a solution to poverty.

Misunderstanding 2: scarcity creates value

Much of the cryptocurrency world is based on the idea that the way to make something valuable is to make it scarce. This is one of the basic theories of bitcoin. Since the total number of bitcoins will eventually be limited by the algorithm, the value of bitcoin will rise with time. This is also the basic concept behind NFT. If you take a boring ape JPEG image that is easy to copy and tell the world that only one person really owns this JPEG image, people will think that only you have paid for it because it is scarce.

Finally, this is also one of the most basic business models that people try to turn metaverse into. Many people seem to have the idea that the next iteration of the Internet will involve exclusive access to the digital environment (for example, you can't come to my house without my permission), just like land in the digital field. Real estate accounts for a large part of wealth in the physical world, so why not in the digital world?

Unfortunately, so far, this idea has not worked well:

This may just be too early, and eventually the digital world will be a very big problem. But in fact, we have a profound reason to doubt whether this idea will be realized: scarcity itself cannot create value.

Some careless high school economics teachers may tell you that scarcity can create value to refute the old practical value theory. But in fact, what creates demand is the combination of practicality and scarcity - on the margin, it is the relationship between the scarcity of a thing and its practicality.

"Value is determined by supply and demand." this is just a rhetorical device. Simply restricting the supply of something does not naturally make it valuable, because demand may be zero. This is why although some children's paintings have become famous and expensive NFT, it is extremely unlikely that your own children's paintings will get any positive price in the market.

However, even if there is a large amount of demand, artificially restricting supply may not increase prices much at all. The reason is that the effect of supply change depends on the elasticity of demand (speculation). Let's draw a picture.

In this case, demand is completely elastic -- people know what they will pay for something, and they won't pay any more. In this case, even if what you are selling is really valuable - maybe a lot of value! Limiting supply will not raise prices, and limiting supply (and no one will buy it) will not raise prices at all. On the contrary, you just sell less and earn less.

Now, this is a fairly simple model, and there is no real pricing power in the economy. I just use it to illustrate a problem. More realistically, if the company has market power, will it have the ability to choose how much to sell and how much to charge?

In such a world, companies can (and do) artificially make their products scarce to raise prices. But this is a bad result. It is a kind of market failure, because it causes the economy to produce too few things. This is the reason why economists do not like monopoly.

Now apply this principle to the metauniverse. The magic of the Internet is that it provides space for everyone - the cost of creating more "space" in the digital environment is very low, so people are not limited to what they can build as in the real world. Artificially limiting the number of times people visit the digital environment, resulting in the price being higher than the marginal cost.

This is either economically stupid or economically inefficient. In the case of fierce competition on the Internet - anyone can enter and create digital land at almost zero cost - then artificially making their digital land scarce will only lead everyone to leave, just like the metaverse product in the above tweet. If you have a monopoly on certain digital fields - for example, if you have a large existing social network, Everyone is using it - you can make money by restricting access and raising prices. But this means that you are making the economy inefficient. By charging for something, it should be free or almost free according to its basic cost structure.

Now, there are some exceptions to this general rule - people value things because they decide to take them as status symbols in a zero sum status competition. We call these Veblen products, and they do exist (real Rolex watches are a good example). If you can turn your NFT or metaverse content into something that people decide to spend in order to prove how rich they are, I think it will be more helpful to you.

In general, however, scarcity does not create value. Limit your own products until they are as rare as diamonds, and will not make them as valuable as diamonds. In fact, it usually only makes you lose money.

Cryptographers will consider many economic issues, which is good. However, they often think about this issue in a loose and impressionistic way, or think wishfully according to their own moral standards, or they just misunderstand how the basic economic principles work. Many times, they think they can force these misunderstandings into reality by shouting at others again and again. Guys, it's not like this.