Bitcoin and the Quantity Theory of Money – Why Bitcoin is Undervalued

If you were awake in your college economics class you might recall Milton Friedman’s classic theory: The quantity theory of money. Essentially, Friedman argued that the general price level is directly proportional to the amount of money in circulation We can apply Friedmans logic to bitcoin and use it as a starting point for valuation. The root of understanding the quantity theory of money is the equation of exchange, MV=PQ.

Ok, what does the formula mean again? MV=PQ.

M= The stock of money. How much money is out there in circulation.

V= The velocity of money. How fast does money change hands?

P=The overall price level.

Q=The economy’s output.

Then we can say that PQ is nominal GDP or total expenditures. The price of every good and service produced within an economy in a year.

So, Friedman’s logic was this: The velocity of money was stable and Q moved minimally. The real output of an economy usually only increases or decreased a few percentage points a year.

So the formula now looks this: MV =PQ. Because V and Q are relatively constant, an increase in the money supply, by a central bank, will lead to a proportional increase in the price level. In the long run, increasing the money supply faster than the real growth of the economy will always lead to inflation. Real wealth cannot be created by the printing press.

How can we take Friedman’s ideas and apply it to the bitcoin ecosystem? First M is constant. No central bank, dictator, politician or bureaucrat can increase the supply of bitcoin. The current market cap of around 250 billion dollars proves the code is good and the underlying idea that counterfeiting bitcoin can’t be done. We will also assume, like Friedman, that the velocity of bitcoin is relatively constant. So the bitcoin ecosystem looks like this: MV= PQ. Now, M and V are held constant.

So now we need to define PQ in the bitcoin ecosystem. Q is the world utility that is created by using bitcoin. There are 2 identifiable groups of people who would derive utility out of using bitcoin: those who want to get off the grid and those who want to get on the grid. Internet gamblers, people trying to send money abroad from economically unfree societies and a multiple of other people who use it for illegal activities.

In addition, there are people that have no access to the world financial system. These are people from war-torn countries like Afghanistan, Syria or Iraq or people in countries where the monetary and financial authorities have let them down, like Zimbabwe or Venezuela. They will be allowed to get on the grid with use and access to bitcoin.

Q is the real-output transactions the entire world needs to get on and off the grid. With M and V constant, the market cap change of bitcoin is the directly proportional to change in the world’s use and need for this type of payment system.

The total, world-value of the utility of bitcoin, in fiat currency price (P), divided by the velocity determines the market cap of bitcoin. M= PQ/V. Friedman argued the general price level is directly proportional to the amount of money in circulation. Increasing the money supply pulled up prices. Applying it to bitcoin, we can say that changes to the Q of the world bitcoin ecosystem will have proportional changes in the market cap of bitcoin. The roles are reversed now. The Q is pulling up the M, instead of the M pulling up PQ!

Next, if we can put numbers on the Q and V we can have a starting point for bitcoin valuation. Simple napkin math says that it should be a lot higher than 250 billion dollars.