Bitcoin from First Principles (Part I)

You are looking (want) to invest in a crypto currency so you’d like to know whether it has a chance of making it big or whether it is mostly likely to tank, right? You and everyone else, my friend. “If only I had a crystal ball…” I often wonder. Well, I don’t have one. And I don’t have one to give to you. But I do have something better, a tool for your brain. I present to you…

It’s a mental model. It’s a tool. Think of it like hunting with a bow and arrow instead of hunting with your bare hands. Think of it like adding an outboard motor to your canoe. While everyone else is paddling, you get to take advantage of modern technology. But using it isn’t easy… you’ve got to invest in understanding how to use it. Otherwise you just have a canoe with lacerations from an outboard motor, if you follow the analogy.

Let’s take an example.

Space Travel

Everyone said space travel was so 1960. People had kinda given up hope. The cost of space travel was just the same as it was back in the day. And the US had resorted to paying Russia to send things to the Space Station on its behalf. Why? It was just too expensive to send things to space.

Which was weird because the cost of nearly everything else complicated has gone down precipitously since 1960. Just consider the cost of computers! You have a computer in your pocket that is more powerful than most people could even dream of in 1960. To put it another way, if Rockets had reduced in cost as much as computers over the last 50+ years, we could be using rockets instead of airplanes for travel (obviously there are reasons why it hasn’t).

This irked someone named Elon Musk. How could the US not have a single commissioned, space-worthy vessel? People kept saying “Space travel is just expensive and that’s the way it is always going to be.” He thought about buying an Intercontinental Ballistic Missile. Eventually he used First Principles thinking to consider the real causes of high cost. Was fuel the main expense? It takes a LOT of fuel to get to outer space. But it turns out fuel only makes up 1% of the launch of a space craft. Was it raw materials that drove up the cost? It takes a lot of specialized materials to make something that can fly extremely fast through extreme cold AND heat. But raw materials only cost 2% of the total cost.

So what the hell cost so much?

The answer: Overhead and Profit. When he dug into the cost of the rest of the rocket and it turns out that because most contracts for building rockets and launching them use “cost plus” accounting (the contractor is paid for the materials and labor plus a percentage on top of that as profit, which actually incentivizes contractors to increase costs). From First Principles, there was no reason why rockets should cost so much. In fact, according to the ultimate laws of the universe (physics, not the laws of the US), sending rockets to space could go way down in price, approaching the cost of the fuel required for a mission. With the reassurance that physics was on his side, SpaceX was born.

Cryptocurrency

Let’s apply First Principles to cryptocurrency or bitcoin specifically. My family always asks, but what can I use it for? And they have a point, even if most crypto enthusiasts say “anything that you can do with normal money.”

There are usually 7 dimensions that a currency has to check off to be useful in the modern world: Durability, Portability, Divisibility, Uniformity, Limited Supply, Acceptability and Intrinsic Value.

And then we will take a few sample “currencies.” Dollars (of course), Gold (yes), Cigarettes (because believe it or not people commonly start using Cigarettes or Ramen noodles as currency in concentration camps and prisons), Cows (yes, cows were and are used a currency. When I lived in Kenya the bride price is negotiated in cows. Nearly all Kenyans still pay a bride price to the woman’s family. The details are complicated and I thought it was very strange and patriarchal when I first arrived but after 5 years it seemed quite amazing!

Let’s compare

• Durability: Cows aren’t unlike gold, you need to feed and water your cows otherwise they die. Gold has been chosen over the years, in part, because it doesn’t rust like iron does. Cigarettes last for quite some time, but not as long as gold. Dollar bills can decay, sure, but electronic dollars in a computer last as long as the internet/computers will. The caveat is that dollars experience inflation and every year the dollar is about 1% less valuable than it was the year before. But the risk of dollars is that the market collapses all at once typically once every 50–100 years (which means we are overdue for a crash of the dollar. Bitcoin is not inflationary, but a deflationary currency and it will last as long as the internet and computers do. So in some ways it is less durable than gold. A solar flare that knocks out all electricity to the earth could knock out bitcoin. Something for you conspiracy theorists to consider. But if a solar flare was so massive to knock out the internet, that would be the least of our worries.
• Portability: Though I have seen a cow being transported on a motorcycle, it is certainly easier to carry a wad of $100 bills, which are even more portable in their digital version. Gold is pretty easy to carry around, though fiat currency originally evolved because people found it too difficult to carry around chunks of gold. Cigarettes are pretty easy to carry around, as long as the transactions are smallish in value (and if you are in a prison, it’s not like you are going to buy a house). And bitcoin obviously can be carried around anywhere as long as you have the address and private key. You can even just write the private key down on a napkin.

Creating a Cash Cow in Kenya is about starting a microfinance institution there.

• Divisibility: “You’d like to buy a chair? that will be 1.5 cow’s legs,” is something you don’t hear every day. Cows aren’t very divisible as you might guess. In Kenya, the bride-price is always in whole cows — 11 cows or 12 cows and never 11.5 cows. Cigarettes are divisible down to 1/15th of a pack (assuming a 15 cigarette pack. I don’t know; I don’t smoke.) But once you divide them, the durability of cigarettes starts to be affected. Dollars are divisible down to cents which is more than enough for day-to-day transactions, but sometimes for electricity prices, it might be 11.5 cents/kWh. Gold is divisible down to the atomic level which is sufficient. Bitcoin is infinitely divisible.
• Uniformity: Cows are of various values so would 11 strong cows equal 12 weak cows? Are those equivalent? Well, cigarettes of a given brand and type are virtually identical. Dollars are always the same. A bitcoin is nearly always the same. But because of the public ledger (bitcoin is NOT anonymous) a certain address can be blocked meaning that if you inherit a shady address or you do something causing your address to be blocked, you might not be able to spend your bitcoin at that address. Dollars on the other hand don’t have this traceability. A dollar might be used in a drug deal in the morning and used to buy bagels in the afternoon and the users might never know. There are cryptocurrencies that are truly uniform because they are anonymous including Dash, ZCash and Monero.
• Limited Supply: Bitcoin as we all know is limited to 21 million coins ever. It has a limited supply… There is the caveat that while Bitcoin (BTC) is limited to 21 million coins, it forked (what’s a fork?) into Bitcoin Cash (BCH) and Bitcoin Gold so now there are actually 63 million coins. Looking at other currencies, dollars don’t have limited supply because more are printed
• Acceptability: Generally bitcoin has low acceptability. Dollars are acceptable at banks in just about every country and sometimes countries have their currency pegged to dollars. Gold isn’t very acceptable anymore, though every town probably has someone who will exchange gold for dollars. (NPR Planet Money podcast episode on Libertarian Camp ran into some challenges with using gold for buying food there a few years ago, but now it’s all paid in Cryptocurrency).
• Intrinsic Value: Typically currencies, at least early on in their lives, have intrinsic value. For example, cows can be used as a currency but they can also be eaten or milked. Cigarettes can be traded, but also can be smoked. Gold can be used for fillings, jewelry and statues. Dollars used to have inherent value when we were on the gold standard and there was a dollar worth of gold for every paper dollar in circulation. Currently dollars can be used for taxes so at least you know you can pay your government debts with them (which is why I controversially say dollars are “ish” when it comes to intrinsic value). Cryptocurrencies do not have any intrinsic value as far as I can tell.

Bitcoin is certainly Divisible and Portable. In nearly all circumstances it is Uniform and Durable. Bitcoin (BTC) is in Limited Supply, though if there are too many hard forks, that could affect the supply and thus the price. But bitcoin is only occasionally Acceptable and certainly does not have Intrinsic Value.

So there you have it, Bitcoin approached from first principles. Now you have an outboard motor attached to your canoe. First Principles Thinking can’t predict bubbles, but at least you have a solid foundation for Value Investing in digital currencies.

How does that affect your interest in buying certain currencies?

There’s just one thing that bothers me about this… We haven’t figured out why Bitcoin isn’t really acceptable. Why is that? Does that bother you too? It’s like we dug down to find treasure, found the treasure chest, but didn’t pry it open. So coming up next we will use the Mental Model called 5 Whys to figure out why it isn’t Acceptable.

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