A Paradox of Value: Water, Diamonds, Cryptocurrencies
Given that water is essential for life while diamonds are not, why do diamonds command a higher price than water?
This is a question that has plagued economists and thinkers alike for centuries, with its earliest mention by Plato (Euthydemus 304B):
For only what is rare is valuable; and “water,” which… is the “best of all things,” is also the cheapest.
Plato conjectures that water is cheap because it is not rare. Perhaps a fair point in 384 BC, but not today.
It naturally leads to the argument that “diamonds are expensive because they are rare”. But are they really?
Diamonds were discovered 4th century BC (~same time as Plato, coincidentally) in India, deposited along river banks. It wasn’t until the discovery of diamonds in South Africa in the 1870s, that diamonds came into prominence. Cecil Rhodes, a British imperialist, came across Vooruitzicht, the farm of brothers Diederik & Johannes De Beer where diamonds were found. The British government forced the sale of the farm, and after Rhodes secured investment from the Rothschild Family (namely Nathan), De Beers commercial mining company was set up.
The allure of monopoly came knocking when Rhodes realized that by consolidating all the diamond mines, thereby controlling supply, he could inflate & maintain prices — which he did when De Meers Consolidated Mines (now De Beers group) was established in 1888. His successor Ernest Oppenheimer perfected the scheme, remarking “common sense tells us that the only way to increase the value of diamonds is to make them scarce, that is, to reduce production”. No matter how many diamonds it mined, De Beers sold only that quantity of diamonds which would yield a monopoly price. When demand would fall, they would simply restrict supply of diamonds in the market — reduce sales in order to maintain monopoly price. When a competitor attempted to circumvent the cartel, De Beers would flood the market with similar diamonds from their stockpiles. Through this scheme, the cartel effectively controlled up to 90% of the world’s diamond trade through the 20th century.
Basically, ‘scarcity of diamonds’ is pretty much a De Beers marketing scam.
Furthermore, synthetic diamonds can be created and De Beers is selling them too at this point. Diamonds are also found in space (asteroids abundant with diamonds have been found & with advancements in space-exploration in mind, this is not just a fairy tale).
The illusion of scarcity has marshaled diamonds to their price & prestige today. Water on the other side, really is scarce: only 0.014% of all water on Earth is both fresh and accessible, with an increasing population of consumers.
Nonetheless, it remains that diamonds are expensive, and water is cheap. Why?
The Marginal Theory of Value has been touted to solve this paradox. Essentially, the argument goes: Water has greater total utility, diamonds have greater marginal utility.
Water is more valuable than diamonds if one had to choose between water or diamonds, as a class of goods. Diamonds are more valuable than water on the margin.
Marginalists argue for the marginal usefulness of any given commodity over the total usefulness of that commodity. The Austrian School of Economics concurs with this argument, under their subjective, ordinal utility function: value is not determined by individuals choosing between entire abstract classes of goods (all the water in the world vs all the diamonds in the world) — rather an individual is faced with the choice between definite quantities of goods. And then, value is assigned by the individual based on which good of a specified (or marginal) quantity will satisfy the individuals most desired end.
This solution is intuitive for the individual (as are most Austrian formulations) yet it is incomplete due to the conjecture that water is plentiful and diamonds rare. The premise is that water is sufficiently abundant such that the loss or gain of a gallon would lose or gain only minor utility, whereas diamonds are in much more restricted supply, so the loss or gain is greater.
The Marginal Utility theory also inevitably crashes into diminishing marginal utility.
The Law of Diminishing Marginal Utility: the first unit of consumption of a good or service yields more utility than the second and subsequent units, with a continuing reduction for greater amounts. MU1>MU2>MU3……>MUn
Eugen von Böhm-Bawerk, one of the most important Austrian economists, illustrated this with his example of a farmer having five sacks of grain:
- With the first sack of grain, he will make bread to survive.
- With the second, he will make more bread, in order to be strong enough to work again.
- With the 3rd bag, he will feed his chickens.
- The next bag, he uses to make whisky.
- The last one, he feeds to parrots.
If one of those bags is stolen, he will not reduce each of those activities by one-fifth; he will simply stop feeding the parrots. The first unit of consumption is most important, with diminishing marginal utility.
Eugen’s Austrian colleague, Carl Menger, the founder of Austrian School economics formalized this notion:
“ If the product exists in abundance, it will be used in less-important ways. As the product becomes more scarce, however, the less-important uses are abandoned, and greater utility will be derived from the new least-important use.”
The first few uses of water are vital but it suffers diminishing utility (we end up watering grass & for toiletries). The Marginalists argue that diamonds don’t suffer from this diminishing of utility to the extent that water does. The 5th diamonds utility is equally valuable to the 1st diamonds utility.
Perhaps the most famous formulation and solution of this paradox came from the father of modern economics, who sought a middle path appeasing Marginalists & Austrians.
Adam Smith presented the paradox of value in his magnum opus, The Wealth of Nations (Book I: 4.13)
Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.
Smith here begins to explore the duality of value. He proposes that value can have two possible meanings:
- the utility of commodity: value in use
- the purchasing power of commodity: value in exchange
Commodities with greatest value in use, infrequently have value in exchange.
Commodities with the greatest value in exchange infrequently have value in use.
This entails Smith’s solution to the diamond-water paradox: water has the greatest utility to man (we can’t survive without it) but we rarely exchange it for another commodity. A diamond, while it has little utility (aesthetic, industrial knives), can easily be exchanged for an extensive amount of commodities.
…so how do cryptocurrencies fit into all this?
Enter, Bitcoin. In the wake of the 2008 Financial Crisis, governments across the world adopted quantitative easing: Central Banks increased money supply (printed more money) to inject liquidity into markets (bought financial assets, bonds). This considerably increased inflation of these currencies, decreasing their purchasing power, as the $USD fell against gold, petroleum.
It also increased wealth inequality, as it was primarily the wealthy that owned these financial assets. The government bailout printed money (increased monetary base in fancy economic jargon) to buy these same assets.
Making the rich richer by increasing the value of their investments & making the poor poorer by increasing inflation/reducing purchasing power of the common currency. It was evident that the centralization of banking had led to such a bailout, not just in the United States but all over the world.
Satoshi Nakamoto cited this headline with the first Bitcoin transaction. The hash of the first transaction contained “ The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.
Satoshi presented Bitcoin, a purely peer-to-peer version of electronic cash to allow online payments to be sent directly from one party to another without going through a financial institution. The Bitcoin Protocol solved the Byzantines General Problem and Double-Spend problem minimizing the trust needed for parties to conduct transactions, thereby not needing a centralized intermediary. In doing so, Satoshi created a decentralized, deflationary currency for the Internet.
Bitcoin’s uses:
1. Secure Financial Sovereignty (using a currency free of centralized manipulation, as opposed to $|FED / €|ECB )
2. Transact with Others (trust-minimized P2P payments)
3. Build Runway (holding wealth in BTC, a deflationary currency)
4. Full-node; validating transactions/mining blocks (becoming a Miner in the Bitcoin network)
5. Exchange BTC for goods & services.
For what Bitcoin was designed for, the first unit of consumption yields more utility than the second and subsequent units.
Further, as bitcoins become more scarce, people will consume BTC for its most essential use-values, and not for less-important ways like Carl Menger proposed.
Less-important ways here are something like
- using drinking water for toiletries, watering grass
- In the sack of grains example, using your last bags to make whiskey/feed parrots.
- using Bitcoin to buy into speculative coin offerings
As water and Bitcoin become more scarce, which they are, people will abandon these less-important use cases and go to their most important use case. The scarcity of water is increasingly a problem and as for Bitcoin, 17 out of 21 million BTC have been mined.
In the early days of Bitcoin, people were more focused on how it was being used for dark web transactions & criminal activity — most notably in connection with WikiLeaks & SilkRoad.
Meanwhile, a teenage computer scientist in Canada saw the value in the underlying protocol of Bitcoin — the consensus protocol provided stable foundations upon which a plethora of decentralized applications (dApps) could be built. Vitalik Buterin dropped out of the University of Waterloo & wrote the white paper for Ethereum.
The goal of Ethereum is to build a much more robust scripting language and build applications on top of blockchains.
Ever since then, Bitcoin maximalists & Ethereum maximalists have locked horns over which project is more important, and which currency (BTC/ETH) is more valuable. But I argue that this comparison is unreasonable, by using the paradox of value & it’s solutions as support.
Bitcoin has the greater value in use, and Ethereum has a greater value in exchange.
Bitcoin’s central utility (use value) is
a. Securing financial sovereignty in a deflationary currency residing in a consistent, immutable ledger
b. P2P transactions that are censorship-resistant, trust-minimized, with border-less operation & accessibility.
This is of paramount importance for a sovereign individual.
But in mainstream society, these are Libertarian views. They argue that it is what you can do with this — build decentralized applications for society that is more important. Some would argue that one is the launchpad for the other.
Ethereum’s central utility (use value) is
a. gas in smart contract transactions.
However, its exchange-value is considerably higher, as one can interact with a multitude of decentralized applications (dApps) built on Ethereum. You can use the same currency (ETH) to conduct transactions on all the apps built on Ethereum.
The criticism of Bitcoin then goes: there aren’t any apps, and no apps = no adoption. The criticism is essentially “there isn’t any exchange value”.
The metaphor extends to water & diamonds. Water, has great use value, but you can’t exchange it for many things. Diamonds does not have such use value, but you can exchange it for many things.
The metaphor extends to the United States Dollar & Federal Reserve.
$USD doesn’t have value in use (it’s just a piece of paper) but a great quantity of goods and services can be exchanged for it. But like Ethereum derives its stable foundations from Bitcoin, the $USD derived its stable foundations from gold stock. Even after the Bretton Woods System came to an end, the Federal Reserve holds significant gold stock in its balance sheet.
The point being, adoption for Bitcoin won’t be when you can buy a cup of coffee with your BTC (use in exchange). To adopt Bitcoin is to simply utilize its value in use.
All of these commodities have net use-value over exchange-value. To increase Bitcoin’s exchange value in an attempt to increase adoption, such as the Lightning Network, is neither interesting (bi-directional payment channels are nothing new) or particularly desirable towards the goal of adoption. Exchanging your bitcoin for most commodities, such as pizza or coffee, is to criminally undervalue it.
TL:DR
In order to maximize utility, one must utilize commodities with high use-value (water, Bitcoin) by using it & not exchanging it!
For commodities with high exchange-value, utilize it by exchanging it for other commodities.
And only then can they be valued correctly, without paradoxical implications.
Commodities cannot be judged on a criteria they weren’t designed for…
