Eli Dourado

Tyler vs. Tyler on cryptocurrency network externalities

Tyler Cowen thinks Bitcoin is going to “plummet in price.” While I agree with my colleagues Jerry Brito and Andrea Castillo that the price is not really what’s interesting about Bitcoin, it is always worth grappling with Tyler’s arguments.

Tyler first argues that entry into the cryptocurrency market is limited primarily by the cost of marketing the new currency. Tyler notes that these marketing costs are isomorphic to the network externalities enjoyed by incumbent cryptocurrencies. “Alternatively you can think of that sum as representing the natural monopoly reserve currency advantage of Bitcoin.” OK, I prefer the latter terms, so let’s push marketing to one side.

From there, Tyler is able to derive the following theorem: “the value of WitCoin should, in equilibrium, be equal to the marketing costs of its potential competitors.” To put this in simpler terms, Bitcoin’s network externalities should drive the value of Bitcoin. Tyler says in theory you could argue that Bitcoin’s price reflects these fundamentals, but he doesn’t buy it. Therefore, Bitcoin is due for a crash.

I agree with Tyler’s theorem, or at least my simpler paraphrase. Nevertheless, I am not so convinced by Tyler’s conclusion. As a wise man once said (in an addendum to the same post), “expected price changes usually get compressed into the present and [] an overall expected rate of return equality must hold.” So the network externalities that matter in determining Bitcoin’s equilibrium price are mostly expected future ones, not present ones. Is it so unreasonable to expect that future Bitcoin network externalities would equal $20 billion or more?

Well, that depends on whether network externalities in currencies in general tend to be strong or weak. To answer that question we might turn to an expert such as Tyler Cowen, who in 2011 argued (1, 2) that currency network externalities are so strong that Bitcoin couldn’t possibly succeed. Now Tyler is arguing that currency network externalities are so weak that Bitcoin can’t possibly succeed. Who are we to believe?

I think a reasonable view is that in general, currency network effects are quite strong, but they can be overcome through technical superiority and perhaps an assist from the War on Drugs (although note that the latter is mostly a one-shot deal; additional cryptocurrencies without a pre-existing network won’t really benefit to the extent that Bitcoin de facto legalizes drugs). There’s probably a market for 2 or 3 major cryptocurrencies competing on different points on the technical possibilities frontier. Note also that Bitcoin is not a static project; technical improvements discovered in experimental currencies can be added to Bitcoin.

However strong you think network externalities are for currencies, they are higher for cryptocurrencies, because optimal currency area considerations are moot: no one is using them as media of account. Several of us repeatedly belabor the point that Bitcoin is really more of a payment system like Visa than a currency like the dollar. I take the fact that there are only three major credit card companies in the world as a sign that cryptocurrency network externalities are likely to be high.

Tyler is certainly right about one thing: there is a lot of mood affiliation going around in Bitcoin discussions. While I am happy to plead guilty to a bit of it myself, I’m not convinced that the majority of it is on the Bitcoin-optimist side. I think the technical aspects of Bitcoin are more impressive than has yet been widely recognized by the pessimists, but alas that discussion will have to wait for another post.