'All that glitters isn't gold' - exploring Intrinsic Value
Updated: Mar 19, 2020
The foundations of the banking system shift
Whether we see it or not, there are some powerful changes taking place in the
financial world around us. The very fabric holding the global banking industry is
starting to strain as the foundations it is built upon begin to shift.
The underlying debate is whether the internet is about to do to the banking industry the
very same thing it did to the postal service. Destroy it? In my view, not quite. But force it through unimaginable change? Absolutely.
The threat comes in the form of crypto-currency, hailed as a banking system in and of itself.
No more need for bank branches, international payments performed in minutes and all backed by military grade cryptographic security.
As you would expect this has caused endless division, with traditionalists and innovators
pitted against each other on opposing sides of an increasingly heated debate. One argument that I am seeing again and again in the media is that crypto-currencies have no intrinsic value.
It’s an interesting idea, but when I consider it fully I have to ask myself, what does that really
mean? What is “value” and how can it be intrinsic rather than extrinsic?
What is value?
Looking back through history really helps when thinking about value. In the pre-monetary world of barter, value was exchanged, for example a dozen eggs for a
hair-cut. Each party brings value to the agreement and the value is exchanged
This is great and works perfectly if you can find someone who needs what you offer and offers what you need but not so well if you cant. What happens when what you offer is of more or less value than the person that you wish to trade with and the higher value offer is not easily divisible? It would be difficult to purchase eggs with a diamond.
Money was the solution to this problem, which became known as the “coincidence of
wants”. No longer did you have to find someone who had what you wanted and wanted
what you had, you could simply use money as a medium of exchange which stored value
for use with someone else or at a later date.
The concept of money facilitated trade, allowing value to be carried through time and
geographies by effectively providing a tally on who had done what. A lot of money meant
you had worked hard and created a lot of value whilst a lack of money meant the opposite.
Precious metals have historically been the commodity of choice for money and this is for
one very good reason. Scarcity.
Monetary metals as a store value
By not being readily available, you could be sure that whoever was holding the money has either provided value to someone else, or travelled across the world and mined the stuff themselves. Either way, it is a proof of work system and people could happily go about their daily commerce using money to store the value they had generated.
Imagine using something abundant as a form of money, say rocks. You would not know whether the holder had either worked hard for someone else or just gone to the end of the garden to collect them. I certainly wouldn’t give you my dozen eggs for something you could have collected yourself nearby.
Whilst rare metals have typically performed this function, there are many other commodities that have been used in the same way and what they all have in common is scarcity. In prisons cigarettes are used as a means of currency, this is due to their relative scarcity and a level of utility if you are a smoker. Collectors of football cards will understand how value amasses to those player cards that you just never seem to come by. It is the same concept in play – scarcity creates value.
Scarcity however, does not always equal value.
Scarcity equals value only in an environment where there is demand for that commodity. Now this is where it gets interesting, because the demand will only exist for one of two reasons, either it can be used and thus holds value through utility (think salt), or it stores value in and of itself.
Utility is straight forward. We need what we need. We need food, shelter, clothing and so on, all of which could effectively be used as money based on their use cases. Scarcity, however, generates value through network effects. We acknowledge that something is scarce and valuable because we know others acknowledge the same.
Imagine the first person to find gold. Whilst it no doubt had a shiny and appealing appearance, they would have had no idea that it would become one of the most valuable things on the planet. Value takes time to develop and only does so thanks to a network of users who all mutually recognise that something has value and can therefore be used as a store of value.
It is scarcity that permits something to be used to store value but it is the network effect that truly makes it happen. The same logic applies today to social networks, the value comes from the size of the network and the resultant connections that can be made. Facebooks value would decline to zero if you were only user left on the network.
So, is crypto-currency valuable?
I earlier raised the question of what is value and how can it be either extrinsic, intrinsic or even both. Does a crypto-currency have intrinsic value?
Value itself is borne through utility. By servicing my needs I recognise that someone adds value to my life. Be it the hair-cut and my need to appear groomed or the dozen eggs and my need for food. Once value is borne it gets stored in the system of money, to be traded at a later date.
Crypto-currency doesn’t on the surface appear to be something that creates value, rather as a subsequent store of value, very similar to the way we have historically used gold & silver, with universal agreement that these metals are of value. So extrinsically, the value of crypto-currency can be derived from the network effects of its users.
But is it well enough recognised to be used as a store of value?
That is a subjective question and whilst 282,000 transactions (todays number) suggest a significant network of users, whether the network will grow enough to one day truly challenge the banks remains to be seen. To give some context, Visa alone claims to perform 150 million transactions per day.
Now looking at the Intrinsic value of crypto-currency we need to ask the question, is it scarce? Using bitcoin as a proxy for crypto-currencies (although they all differ in their total supply) we know that built into the protocol is a maximum supply of 21 million coins, making it a finite supply.
Based on those supply rules, can that be deemed scarce? That really depends on the extrinsic network effects. If the world shifts to crypto-currency, the banks are ousted and five billion people are using those coins, then yes they will be incredibly scarce. If the network of users however shrinks, those coins will be in less demand and be less scarce.
As with any store-of-value, it can be reduced to zero if the users don’t use it. Same for gold, same for Facebook.
Hard to imagine a world where gold holds no value. Yet we are just humans and we collectively give gold its value. If the world falls out of love with it, then no physical law states that it cannot be replaced by another unknown element on the periodic table.
Sure this is an outlier event and unlikely to ever happen, but appreciating the possibility allows us to understand the laws that hold together our monetary system.
Intrinsic Value = Scarcity + Network
For a crypto-currency to have intrinsic value it must not only have scarcity as a feature but must be backed by a network of users to give it value. Something may be scarce but if no-one wants it then it doesn’t hold any value. Similarly, something can be too scarce. If we all want to use it as money but there isn’t any available then alternatives will emerge and be used instead.
Thus, scarcity is relative. There must be a balance between the availability and scarcity of something relative to the demand from the network of users. Gold & Silver clearly had the perfect balance for this and no doubt there is a complex formula that could be used to analyse this. Well outside of my capabilities I must add!
The statement that crypto-currency has no intrinsic value does seems a little presumptuous.
It’s limited supply certainly gives it the ability to develop Intrinsic value over time but this eventuality and its magnitude is entirely contingent on its growth as a monetary network.
People must first chose to use it and in the right circumstances it could evolve into the leading form of money. If however the balance between, scarcity, availability and price is not in balance with the economic laws surrounding money, then it could end up in the history books.
As for the financial commentators who are today saying it has no intrinsic value, I see them as the same types of people who looked over the shoulders of those who first unearthed gold, declaring it was just a grain of muddy metal and worth nothing.
At the end of the day, who knows. We can’t predict the future but I know we are in for an interesting ride when it comes to crypto-currency. I for one will continue to watch this space.