What gives Bitcoin (or any currency) its value? An 8-year old story from Xuqa

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Several economists such as Paul Krugman have noted that what gives a currency such as the US dollar its intrinsic value is the backing by a government. 

Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2%/year

I don’t think that’s accurate. Government doesn’t give a currency value. A government can tax all it wants, but if there is unlimited currency to go around, it will never be worth anything. A government can force everyone to use dollars, but if they are unlimited, why do you need to work to get them? What makes dollars valuable is not that you pay your taxes in them (as Krugman states), but that there is a very limited amount to go around. 

I was once running a social gaming site called Xuqa. We had a points system called Peanuts. Peanuts were free and abundant. They were used to play free games on the site such as Poker, Backgammon etc. You could get more just by logging in and clicking a button. We figured people wanted them to play games, and so we gave out almost unlimited quantities daily. 

As a business operation however, Xuqa was running out of money. Forced by commercial realities, I decided to make Peanuts scarce. We stopped giving them away for free. You could not longer get them just by logging into the site. The only way you could get them now was by pulling out your credit card and paying. 

And wow. I will never forget what happened. 

I expected people to care even less about Peanuts now that you were required to pay for them. They were so much harder to get now. 

But the opposite happened. As soon as they became scarce, they became valuable. Users started hoarding them. Saving them. They instantly exploded in value to several thousand times their earlier worth. Groups of people on the site started marauding and harassing each other for Peanuts (just like they do in the real world). There were fights. Some forum moderators started taking bribes in Peanuts for administrative favors, such as banning someone you didn’t like. 

The craziest thing was that girls started reaching out to our engineers on their Xuqa profiles offering them sexual favors for Peanuts. “500 Peanuts for a cute pic”, or “10,000 Peanuts for a webcam nude show”, or “100k Peanuts for a real date”. 

Most people however were just earning Peanuts the regular way – spending hours grinding away at games (the same way most people grind away at jobs). I felt like I was the Central Bank, the Federal Reserve. I could create more Peanuts just by adding a few zeroes in the database. I could make everyone instantly richer or poorer. 

So I experimented. In order to boost daily site usage, we gave away some free peanuts to users. I thought this would make everyone happier – now they didn’t have to work as hard to get them. But it didn’t. The price of everything just went up: administrative perks, top 10 status lists, sexual favors, bribes etc. 

The opposite was also true. When we increased our sinks from the system (% fees in games), people initially complained. But then the price of everything just decreased in proportion to the amount of Peanuts we removed, and a new equilibrium was reached.  

It was this experience with Xuqa and Peanuts that taught me how central banks operate at a basic level. And it this same experience that tells me that Bitcoin derives a lot more of its value by being scarcer, and increasing in supply far slower, than things like the US dollar. 

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6 thoughts on “What gives Bitcoin (or any currency) its value? An 8-year old story from Xuqa

  1. Interesting post!

    Scarcity is exactly what drives value of anything. The principle of demand and supply is also based on the rule of scarcity. The limited supply of Bitcoin (21 million only) is the main reason it’s value will increase over time but considering how easy it is to create alternate digital currencies with increasing supply, I have lost faith in Bitcoin.

    • It’s easy to create an alt-currency, but it’s hard to get the network effect. In fact, alt-currencies already have a dividing effect on people. Because alt-currencies compete for value with Bitcoin, “Bitcoin only” people have an incentive to resist alt-coins. “Bitcoin and Litecoin only” people have an incentive to resist everything else.

      When virtually everyone has Bitcoins, there will be a strong built-in resistance to alt-currencies, simply because it drains value via inflation. They’ll be called scam coins (they already are), and as several fail, new ones will find it more difficult to gain a foothold.

  2. Paul Krugman clearly doesn’t understand Bitcoin .. remember in 1989 he clearly didn’t understand that the internet that was about to change the World when he said

    “by 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the Fax Machines ”

    I have created a nifty little animated gif that shows Paul Krugman trying to send some bitcoins over the internet ! !

    you can see it here

    http://bitcoinartist.files.wordpress.com/2014/01/krugman-fax-ani-bang.gif
    .
    .

  3. Pingback: What gives Bitcoin (or any currency) its value? An 8-year-old true story of currency experimentation from Xuqa | NewsBitcoin.com

  4. Krugman gave two reasons for valuing the US dollar in your quote. You say you think he’s wrong because you disagree with his first reason, but then your explanation perfectly supports his second reason.

    The difference between bitcoin, on the one hand, and US dollars and your Peanuts on the other hand, is that bitcoin’s supply is not limited in relation to its demand. Rather it is strictly limited in total supply, period. Dollars and Peanuts, on the other hand, are limited in supply in relationship to demand. Limiting the supply helps give value, but limiting the supply with respect to demand lends stability to the value.

  5. Pingback: What Gives Bitcoin (or Any Currency) Its Value? An 8-Year-Old Story From Xuqa - AlleyWatch

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