On June 20, Nassim Nicholas Taleb, a highly successful former ‘quant’ trader and author on topics including the philosophy of probabilities & mathematics in finance; published a 5-page paper criticising the utility of bitcoin as a viable asset in future markets.
Taleb provides 3 primary commentaries through which he concludes that bitcoin’s timeline is essentially doomed, and that its price will eventually reflect this in the not-too-distant future.
You can view his paper here.
How is it that Nassim Taleb predicts the gradual descent of bitcoin into digital antiquity? Is it fair to expect that bitcoin will become nothing more than a smouldering ruin, a failed experiment imprisoned in a glass case somewhere in the great museum of cybernated time?
To answer this, I’ll begin with Taleb’s first criticism.
Taleb begins his paper with the claim that the real value of bitcoin is exactly 0, investors, to their demise, just don’t know it yet. He argues first that bitcoin offers its holders “no expectation of future earnings” which is a central principle of securities pricing literature.
“Earnings-free assets are problematic” he continues; because of the absence of any expected dividend, reverse dilutions or buybacks that would provide earnings for holders in the future, the value of bitcoin will become zero once miners are extinct. He states that if we can expect such an outcome at any point in the future, then the value of BTC is already at zero.
This strikes me as fair criticism. What sort of value can we expect to see bitcoin provide if all of the current incentives for earnings become nullified once the last coin is mined? Obviously, the decentralized ledger technology that underpins the bitcoin project is something of immense and revolutionary value, but what is to stop any other cryptocurrency with an established market of real-world exchange and far greater use-value, combined with known future earnings potential for holders, to outstrip and replace it in the coming years?
Ethereum: The Bitcoin Assassin?
Consider that Ethereum, in my own infantile understanding, is an asset with enormous real-world potential, as it provides a platform for DApps and other de-fi services as well as acting a smart-contract intermediary. It has an active use-function; namely replacing the wild array of antiquated “accounting” and banking services that cost us as passive users of the fiat system nearly $3 trillion every single year.
Ethereum currently accrues approximately 0.05% of all potentially capturable financial earnings available in the banking and accounting services of the fiat world. If we assume that it’s capable of capturing a mere 0.5% of total fiat earnings by providing smart contracts and its swathe of blockchain-related financial services, then its price would be roughly $40,000 per token. Furthermore, contrary to bitcoin, this would be done via a real-world application of its utility, not merely sitting there as a “store of value” and acting as a symbolic flagship for the cryptocurrency project as bitcoin allegedly does?
Not Quite Digital Gold?
Speaking of “digital gold”, if we continue down the ladder of Taleb’s criticism, he argues making the “bitcoin is digital gold” comparison as many have done, including myself, is a poor analogy that falls far short of truth:
“Gold and other precious metals are largely maintenance free do not degrade over a historical horizon, and do not require maintenance to refresh their physical properties over time.
Cryptocurrencies require a sustained amount of interest in them.”
Taleb stresses that gold and other rare-earth minerals are indeed dividend-free, much like bitcoin, but they are intrinsically different as they have held financial status for more than 6,000 years and that people who own gold & silver can safely expect to continue ownership these possessions for another thousand years (they do not degrade or mutate over time).
Here, Taleb is appealing to something called the Lindy effect; a theory which dictates that the future life-expectancy of non-perishable things is proportional to their current age. Put more simply; if something has been around for 100 years, there’s a pretty good chance it’ll be around for 100 more. The fact that our cultures have created a value for silver and gold as used in jewellery for thousands of years suggests that we will continue to do so for the foreseeable future.
Furthermore, unlike bitcoin, gold has ample industrial utility, with half of gold supplies going to jewellery, one tenth to to industry and a quarter being used as central bank reserves. It has a variety of robust and anti-fragile methods through which it acts as a store of value, maintaining this status despite being mostly untethered from modern currency in 1971. I must admit the case that Taleb presents here is interesting.
Next, Taleb drops the term “path dependence”, which roughly means that things that have survived in the past do so because of their resistance to change. If something is path dependent, it is quite literally dependent on a “set path” and thus lacks the ability to survive critical shocks and stressors to its underlying systems. From this, he argues that:
“We cannot expect a book entry on a ledger that requires active maintenance by interested and incentivized people to keep its physical presence, a condition for monetary value, for any such period of time — and of course we are not sure of interests, mindsets and preferences of future generations.”
As we can see gold is not path dependent. Almost everything in existence today is a replacement of an older, less useful, or less attractive thing. The fundamental truth of progress is that innovation destroys, and it renders old things useless. This is just the natural process of evolution, or: “that which selects”. Technologies tend to be replaced by other technologies relative to their past survival duration.
If you look far back enough into history, you’ll find that 99.9% of species that have ever existed have subsequently gone extinct due to improvement or extinction. Items like gold and silver, however, have proved resistant to extinction despite vast changes throughout history, as we literally could not find anything better than these minerals to achieve our intended functions as they’ve changed over time.
Taleb then provides the following principle:
“Cumulative ruin — If any non-dividend yielding asset has the tiniest probability of hitting an ‘absorbing barrier’, then its present value must be 0”
An absorbing barrier is a term from the social sciences that refers to a barrier that prevents the spread of innovations and cultural forms. Taleb more colloquially defines it as the following in his book Skin in the Game:
“An absorbing barrier is a point that you reach beyond which you can’t continue. You stop. So, for example, if you die, that’s an absorbing barrier. So, most people don’t realize, as Warren Buffett keeps saying, he says in order to make money, you must first survive. It’s not like an option. It’s a condition. So, once you hit that point, you are done. You are finished.
In terms of bitcoin, this absorbing barrier would be the point at which the last coin is mined. All incentives for earning have ceased and the asset (unless our businesses have mediated an exchange function for it in the future ((e.g. like buying a Tesla with it)) falls to zero. Whether or not bitcoin will hit this absorbing barrier is yet to be seen.
Now, I know many of the bitcoin purists are going to come rushing in screaming for their respective rooftops that: “bitcoin has survived crashes before!” then continuing to urge that “bitcoin will do it again”. Why exactly is that though? Claiming that things will happen again because they have in the past is a fatal epistemological error, and it’s the primary reason we continue to make mistakes. Just because things have occurred in the past absolutely does not mean that they will continue to do so in the future.
Things that continue to survive moving into the future only do so because of their real utility combined with their respective life span and past ability to prove resistant to shocks. Bitcoin is only 12 years old, and yes it has survived past crashes but only seems to have done so through speculation on its future utility, which as Taleb points out, may very well be zero. The case put forward by Taleb is undeniably thorough and it is valid cause for concern that should push die-hard bitcoiners to revise their long-term hypothesis.
However, I am still at odds with the hypothesis that bitcoin cannot act as a gold-like substitute, as it does offer unique advantages over physical gold. Whether these advantages will prove useful over time is yet to be seen.
Bitcoin: The Advantages Over Gold
- There’s no way to independently verify the entire supply of gold, whereas the entire supply of bitcoin is immediately verifiable through the set of blockchain ledgers that it’s built on. Any financial institution can run a quick check and find out what the total supply of bitcoin is in a matter of seconds. This can’t be done with gold, as we don’t know how much is left in the ground or where every existing piece is at all times.
- It’s also quite hard to verify if gold is real. China’s largest jewellery company called Kingold Jewellery used 83 tonnes of fake gold to fraudulently secure a US$3 Billion contract that eventually forced the company to de-list from the Nasdaq and was done so at a loss to the tune of billions of dollars for investors. Fake gold has also made its way into the federal vaults of the United States and investment firms like J P Morgan. Bitcoin solves this problem by being instantly verifiable and being impossible to forge due to the near-unbreakable cryptographic code that it’s built on.
- Physical gold is also very difficult to transport, store and divide. You have to dig it out of the ground, refine it, smith it into bullions and then transport it to insanely expensive underground vaults via trucks that use real gasoline and require huge security operations to keep all of it secure. Bitcoin is easily divisible, instantly transmissible and can be stored safely by individual investors and giant investment firms alike.
This argument is very short, but it’s where Taleb identifies that the fundamental flaw and contradiction at the base of most cryptocurrencies is that:
“The originators, miners and maintainers of the system currently make their money from the inflation of their currencies rather than just from the volume of underlying transaction in them.”
From Taleb’s point of view the total failure of bitcoin to become a recognised currency (so far) has been masked by the inflation in the value of bitcoin, which in turn has created enough profits for a large number of people to enter the discourse around bitcoin well ahead of any actual utility being provided.
To put Taleb’s concern even more simply; any increase in the price of bitcoin has nothing do with its utility and are only false inflations that provide enthusiasts with enough financial “proof” to make loud noises about its value.
Speed, Cost & No Fixed Prices
He then, validly, takes aim at the current (high) costs and sluggish speeds of bitcoin transactions. How can bitcoin expect to compete with Mastercard or VISA, through which the purchasing of any item is validated within a matter of milliseconds, when it would take around 10 minutes to do so in BTC. No one wants to stand awkwardly in a coffee shop for 10 extra minutes just because you’re a crypto-enthusiast. If bitcoin or any other cryptocurrency for that matter expects to be seen as a valid payment system, it needs to be both fast and secure.
Furthermore, bitcoin’s current energy usage stands at a staggering 700KWh per transaction. This renders bitcoin, in its current form, completely incapable of accommodating a large volume of transactions, which in my humble opinion is sort of an essential feature of any large or ambitious payment system.
Taleb finishes this section by stating that:
“To date, twelve years into its life, in spite of the fanfare, with the possible exception of the price tag of Salvadorian citizenship (3 bitcoins), there are currently no prices fixed in bitcoin”
Here we return an analysis of gold, but this time Taleb looks more to its use as a foundation for the creation of currency, specifically looking at fixation of prices and the potential for arbitrage of crypto against fiat currencies.
Taleb uses a contemporary example in the history of gold and silver to better explain why precious minerals cannot be seen as reliable “numeraires”, (a relatively standardised benchmark for commodity prices; to use Taleb’s terminology) or inflations hedges.
The example is as follows:
In the early 1970’s, the Hunt Brothers (oil billionaires at the time) began hoarding silver as a long-play middle finger to the U.S. which had banned citizens from directly owning gold. As they accelerated their holdings of silver in the late 70s it created a price squeeze in the silver market, leading to a speculative explosion in the price of silver. This in turn lead to an approximately 5-10 times increase in the price of precious metals more generally. When the bubble eventually popped metals fell in value by over 50% and then stayed at those new lows for more than 20 years. The same thing happened in the financial crisis of 2008. The price of gold and silver in the wake of the crash flew up over 100% and then fell again once an economic recovery was achieved.
Gold, silver, and other precious metals are often seen as a hedge against inflation, but they do not always rise in conjunction with fears of said inflation (just look at the price of gold right now). They tend to only act as stores of value around the times of immense crisis or during artificial market “squeezes”. This leads Taleb to conclude that potentially speculative assets like precious metals aren’t the most effective benchmark for a currency, and in fact, the most effective numeriare is whatever the bulk of salaries are paid in (fiat currencies).
All consumer level prices are made in direct relation to the income they receive, thus items can be deemed expensive or cheap relative to that income. Things like a Lamborghini are expensive because they represent a single item worth a 5 to 6 times the median salary in the United States, and something like a coffee can be considered cheap because they are less than 0.01% of a median salary.
It is here that Taleb attacks the:
“naïve libertarian illusion that a transaction between two consenting adults… can be isolated and discussed as such, pairwise”
No transaction in an open economy can be considered analytically pairwise; meaning that prices of goods and services fluctuate depending on the vehicle through which people pay for them because the value of these vehicles also fluctuate. For a currency to function its price must be relatively stable.
Thus, in order for people to be able to regularly buy goods with a value that is denominated in bitcoin, the must also have an income that is fixed in bitcoin. Now, for an employer to pay a salary in bitcoin that employer must be receiving revenue that is also fixed in bitcoin. Furthermore, in order to create and manufacture goods that are sold for resulting revenue in bitcoin they must have their overhead fixed in bitcoin. We can now see how the scalability issue death spirals.
For all of the above to occur there must be a parity between BTC and the USD with low enough volatility for variations to remain inconsequential to bitcoin users. Any discrepancies between the BTC and USD prices that a large enough for people to notice will lead to either direct or indirect arbitrage.
Arbitrage refers to the simultaneous buying and selling of assets in order to take advantage of differing prices for the same asset. When the conversion rate for fiat currency is favourable then customers will buy goods from bitcoiners and when they are unfavourable will buy elsewhere.
“[Currently] The only items that appear to be somewhat priced in bitcoin are other cryptocurrencies. Even then there are numerous discrepancies.”
The concept of arbitrage quickly shuts down the idea of operating a dual currency (bimetallism) model, as we’d expect to see if bitcoin were to emerge as a legitimate method of exchange. Recent globalization and the supremacy of forex / options trading just doesn’t seem to allow for two or more different / unique currencies to coexist in the same marketplace. One of them must win.
To conclude his argument about the validity of bitcoin as currency, Taleb notes that it is desirable to have a real currency without a government. However, this new currency needs to be more appealing as a store of value that tracks “a weighted basket goods and services with minimum error”.
When I began reading this paper, I was prepared to deconstruct it with a fine-toothed comb and show you all its many flaws. Both fortunately and unfortunately, I am left with mostly empty hands in terms of valid criticism. All of the issues that Taleb have pointed out are quite valid and are backed by strong evidence. Despite the paper only being 5 pages in length, it effectively deconstructed many of the things about bitcoin I saw as favourable or just took at face value.
I still strongly hold that cryptocurrency more broadly, will provide immense utility to the financial space, and only a lot of brand new, well-researched information will change that. Ethereum and many other function based tokens as far as I can tell are sone of the most revolutionary financial technologies even to have been invented, and I will continue to hold large amounts of crypto.
What concerns me the most strongly in all of this, isn’t Taleb’s thorough dissection of bitcoin… It is the response from his former colleague and esteemed economist Saifedean Ammous.
Instead of responding with rational counterarguments that seek to find flaws in Taleb’s position, Ammous offers a poignant two-word reply:
I can’t say that this fills me with confidence…
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