Bitcoin and the Diamond-Water Paradox

One of Bitcoin's greatest gifts to mankind, beyond its value as a novel financial instrument, is the conversations that is sparks on the topic of economics.

Economics is known as the "dismal science" for a reason that Thomas Carlyle almost succeeded in articulating when he coined the phrase in 1849. He rejected the reductionism of supply and demand that leads one to conclude that humans left to their own devices will, in general, work to their own ends, trade with one another, and increase the wealth of their community in favor of a moralistic (and pro-slavery) position on labor itself. There was something virtuous and dutiful about the work itself, an intrinsic value if you will.

The successful decoupling of the concepts of "intrinsic value" and "market value" has been made at numerous points in the past, but is somehow always crowded out by competing views in which "labor" appears as the specter of Carlyle. The most common misconception is that labor itself imparts value unto the goods and services it creates. If something is valuable, then somebody must have worked very hard to make it, so the reasoning goes.

“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back,” said John Maynard Keynes, poster child of the prevailing economic theories of modern times. Ironically enough, he plays the role today of the defunct economist that he criticizes, but with the added twist that many of his views as they are manifested are in fact misunderstandings or outright misrepresentations of his work. "In the long run, we're all dead," he quipped, unsuspecting that these words would be used to justify a world of monetary policies that should be adhered to, even if it is well-established that they will inevitably lead to punishing financial crises.

When Carlyle was closest to the mark, he stopped short of admitting that what makes economics a dismal science is that it isn't even a science at all. Economics is more like politics than physics, where your best bet is to build frameworks around ideologies to promote broader themes such as equality, freedom, prosperity, fairness, security, etc. depending on your moral philosophical standards, than to co-opt the authority of empiricism.

When introduced to Bitcoin for the first time, many people make the mistake of immediately reverting to the Labor Theory of Value in a desperate search for the source of its justification. Bitcoin is backed by processing power because people mine it using computers! Bitcoin's value is derived from the amount of energy that the network is using to keep it secure! Bitcoin has an intrinsic value of zero because it is created from thin air! All of these are half-baked echoes off the wall of defunct economists' bad ideas.

Followers of the Labor Theory of Value pondered a contradiction known as the Diamond-Water paradox. If a man can happen across a diamond by accident, acquiring it through no labor, what gives it more value than, say, something as easily discovered as a stream in the woods? Why does a diamond have more value than water?

The best economic framework for understanding how and why goods and services exchange hands in the market is the Subjective Theory of Value, a set of postulates generally attributed to Carl Menger that explains beautifully and precisely why the Diamond-Water paradox isn't problematic in the least. It also helps to shed some light on why many early Bitcoin proponents were students of Menger and his contemporaries in the Austrian School of Economics.

The elegance of the theory is that all value is subjective. No good or service has anything intrinsically valuable about it. Rather, all goods and services are only more or less valuable than others in an order of preference in the minds of economic players. Specifically, we can only know that a cheeseburger was worth more than $3 to you at noon yesterday, not that a cheeseburger is worth $3 in general. 

The shining insight to the theory is that all value is subjective because there is no ruler against which to compare items. What the monetarists search for in vain when they dig up the labor required to produce something is a version of this ruler, something constant and uniform against which we can measure all things.

By now, many readers will have their thoughts turn to money, and rightfully so, because the concept of money is the trick and the key to conceptualizing something as exotic and confounding as Bitcoin. Surely, if labor doesn't provide this ruler that we need, then money must. But therein lies the crux: the value of money is also subjective.

In the same way that your 1st apple is worth more to you than your 100th, your 1st dollar is worth more to you than your 100th. Indeed your first few dollars will be spent on needs such as food, clothing, and shelter, whereas your 1,000,000th dollar might be used to invest in your brother's restaurant. Not only that, but these internal preferences change on a constant basis. Don't believe it? Try to sell a second cheeseburger to a person who just filled up on their first for $3. Not only will you likely need to lower your price, in some cases you may even have to pay them to comply! (And it doesn't matter how heartily the chef flipped the burger). These observations are known collectively as Marginal Utility Theory. 

Misunderstanding Bitcoin today is likely a misapplication of the Diamond-Water Paradox, when in reality there is no paradox to begin with, no soul-searching necessary to find the hidden ruler of value. The Subjective Theory of Value comes as close to empirical evidence as you can in economics, by only claiming truths that are easily demonstrable, and not going further in its conclusions than is warranted. Yet armed with only the fundamental building blocks of preference in time by individual actors, once this distinction is clearly understood, many rich and complex conclusions can be drawn about the nature of value itself, and the prospects for Bitcoin going forward.