What is bitcoin backed by?

Dispelling a pervasive fallacy

This is a classic critique, articulated most recently by one of my favorite contrarians, Michael Shellenberger.

There is a deep and subtle fallacy behind this question of backing that, once seen, opens the door to an understanding of bitcoin that will be forever closed to talking heads who do not spend the time to discover it. To see this fallacy, let’s first look at US dollars.

Yes, the US dollar is backed by the government, which declares by fiat that dollars can be used to settle debts and pay taxes. But this backing does not determine the VALUE of dollars. Instead, what determines the value of a dollar is whatever people will exchange for that dollar. What will I give up for a dollar? How many dollars will I take in exchange for spending an hour at work, or for this item that I crafted, or for these tech stocks I’m trying to liquidate. Of course there are myriad inputs to these decisions, and how much I value a dollar is different from another person. But at the end of the day, the value of the dollar is determined by what individuals will exchange for it.1

The value is not set by the government. The government does not declare by fiat that a dozen eggs are to be exchanged for two dollars, and a gallon of milk for one dollar (and when they try to do this with price controls, chaos ensues). Instead, people figure this out on the open market.

So, if the government does not determine the value of dollars, what does it do? It provides a REASON that people use dollars for exchange. Everyone needs dollars to pay their taxes, and the US banking system runs on dollars. If you store your wealth in gold, the bank will not store it for you and shave off pieces to pay your bills, and they will not accept it as a mortgage payment. You must instead liquidate that gold into dollars before they will let you use it, and they will do this because the government said it’s okay.

So the government does not determine what the value of a dollar is. If they could, they could solve rising gas prices by simply stating that a gallon of gas should be exchanged for two dollars. They could solve price inflation by simply declaring that the prices of all goods stay fixed. This doesn’t work, however, because people who produce goods do so for a profit, and if the government caps the price, then this limits profits, and producers stop producing. To keep the system going, the government would need to force producers to work for no profit, which is the thinking behind communism. Not pretty.

To reiterate - the government does not determine what the value of a dollar is, the government does not set prices. Instead, individuals (consumers and producers and everyone else) determine this on the open market. The government merely provides individuals a REASON to use dollars as a medium of exchange, by requiring the banking system and tax payments to run on dollars.

So what gives bitcoin value? What is it backed by? Well, as we’ve seen with dollars, the value is determined by what individuals will exchange for it. No one sets the price of bitcoin, its value is not “backed by anything,” it is determined on the open market.

A better question is - why do people find it valuable? We know they find dollars valuable because of the dollar’s properties - they can be used for banking and paying taxes (among other things). It turns out that bitcoin has certain properties that make it appealing to some people as a store of value. It is scarce, it is accessible to anyone with an internet connection, it can be transferred anywhere in the world at almost no charge and requiring no one’s permission, and it is incredibly durable and secure. As more and more people discover these properties, and how bitcoin is unique in these regards, more and more people elect to exchange ever more value for bitcoin.

Sure, many people buy bitcoin simply because they see the price going up and want to jump on board to get rich quick. But that doesn’t negate bitcoin’s properties just because some invest in ignorance. And yes, many things without can be the subjects of speculative crazes without any real value behind them, like tulips and other crypto tokens, but just because bitcoin’s price history can look like those things does not mean it is those things.

Many people point to other stores of value, such as gold or real estate, and declare that these things can be USED for something, whereas bitcoin cannot. But the above argument still holds - the value of a thing is not determined by what it can be used for. It is only determined by what people are willing to exchange for it. Truffles can be used to flavor food, but those who don’t like the taste are unwilling to give up anything for them. Water can be used to keep humans alive, but since it is ubiquitous, few people are willing to exchange much for it. The use of a thing in itself does not determine its value.

In fact, when storing value, it’s best if the storage medium does not have any other uses, because those uses can impact the price in unpredictable and sometimes catastrophic ways. Silver has more industrial applications than gold, which can cause to supply of silver to fluctuate wildly, thus disrupting the price. Bitcoin’s purely abstract nature, totally lacking any practical real world use is a mark in favor of it as a store of value.

Lastly, there is a real world example of a store of value that had no practical use - the rai stones on the island of Yap. These were large chunks of limestone that had to be transported from far away, and considerable difficulty. The islanders would declare transfer of ownership of the stones in much the same way that the Stanley Cup is transferred from team to team, though the stones would remain in one location. All that needed to be done was to declare to the village that the transfer was made. The stone itself was useless, in fact this was integral to the success of its function. And the Yapese were able to have a monetary economy with these otherwise worthless stones that weren’t backed by anything.

It’s funny that so many public intellectuals are drawn to describe bitcoin as worthless because it isn’t backed by anything. Now you know why they’re wrong.

1- This is called the subjective theory of value, attributed to Austrian economist Carl Menger.