I have thought about a theory for some time now. I think it is quite relevant for BTC although at first I thought about it only in regard to Gold (If Gold would tend to be the sole money in a world which had a money market completely free of government intervention). It is a bit longer though:
I have to define following terms first:
Industrial value: This arises from industrial demand only hence consuming it.
Monetary value: This is demand for the purpose to be used as medium of exchange.
Investment value: I think it makes sense to differentiate investment demand from monetary demand for the further elaboration, since demanding something for the purpose of a medium of exchange and a store of value are not tantamount!
Overvaluation/Undervaluation: This is when market participants try to anticipate future price movements. If the price of commodity X is at 5$ now but is expected by someone to be at 7$ in the future, then there is an arbitrage that can be reaped if this expectation turns out to be right. Hence commodity X was undervalued now compared to the future. The other way around is overvaluation. What actually is done is trying to assess the fundamentals of supply and demand of commodity X.
For non-monetary goods this is comparably easy to do, since it is only about industrial value. The investment aspect of value that is attached to it due to speculation/investment in such a good is neutral in the long run. If I invest today and increase its demand now, I will reduce the demand by the same amount when I finally sell it to realize either my profit or loss.
For a monetary good like Gold this is tricky. You not only have to assess the fundamentals of supply and demand due to its industrial value, but also of its monetary value. Although it may seem to many as an investment demand if a central bank holds hundreds of tons of Gold admittedly not to be a medium of exchange in the foreseeable future, but for “traditional” reasons of insuring themselves against tail risks, like a disintegration of the current fiat money regime, then this is not neutral in the long run. The central bank implicitly assumes that in case the current money standard fails they will need their Gold as a medium of exchange. Hence the demand of Gold really is purely of a monetary nature, not an investment nature that is usually based on an increase/decrease in industrial value. To make matters even more complicated such a demand for insurance purposes against tail risks also comes from private market participants. Such a demand generally can cause investments by other people who don’t see Gold as an insurance but only bet on an increase/decrease in monetary demand on Gold (that is tantamount to increasing/decreasing fear of a failing fiat money regime).
As I already suggested, it was good maybe to use BTC for transactions but other things like Gold as a store of value. No why is this, and why (I guess at least) does it sound intuitively reasonable to most people. Now please consider my following argument is based on the condition of a complete free market in money. Neither governments nor any central banks are involved.
Think of a world in which only Gold is used as medium of exchange initially. Now like Clayton argued money is inherently eliminative to variation. If that was true no other medium of exchange could come up and gain monetary value and rival Gold as a medium of exchange in this environment. I will argue here that is only true to a certain extent and counter forces are working that act in form of opportunity costs which at a certain level are bigger than the benefit to use the standard money which is Gold in this case.
If only Gold is used as medium of exchange then of course this means that its monetary value is huge compared to its industrial value. One effect would be that, if there were no electronic payment systems and money substitutes, this would cause a big problem because it is hard to split Gold into such small units as to reflect the value of small transactions. And as we really see in history in fact it has, therefore also other metals were used who did have smaller value per ounce like Silver and Copper. Today of course I think this would not pose a problem anymore due to electronic payment and clearing systems banks could easily “divide” Gold as small as necessary.
While I guess so far everyone will agree I am arguing there is even one more reason that drives people to use other things as medium of exchange as well. It really is the spread between the monetary value over the industrial value coupled with added volatility due to investment value that acts as a counterforce the bigger the spread. The basic concept is that markets try to find things that are undervalued to buy while at the same time they try to find things that are overvalued to sell, making a profit and avoiding possible losses this way. Monetary value for my point of view is very prone to overvaluation since no commodity also not Gold does have a monopoly to act as a medium of exchange. Silver for example can do the job just as well.
And this is how I think it would work: This means you will not save in cash only, but only as far as your subjective cash preference (How much of a cash balance you actually think you need for daily spending and unforeseeable events) goes. The excess cash will be invested in something other. This of course can be stocks, a mutual fund, general commodities, bonds or whatever. All of them will act as a store of value for you. Yet most investments will not pose a problem for Gold as money, but some are not only a good investment idea as a store of value because they are undervalued but are also quite potent to act as medium of exchange. Especially at the beginning there is a huge incentive not to have too much in Gold, because it is at its peak value, it just cannot go any higher in its value, which means losses are practically guaranteed. The next best solution was to invest in Silver. There is not much downside risk since it is at its industrial value. Gold only can lose, Silver only can gain. Since Silver is very liquid it can even replace the cash balance function of Gold extremely well. So from the outset we already have a strong incentive that would tend to drive Gold’s value down and Silver’s value up.
Additionally with companies like GoldMoney you can not only invest in different precious metals but they also allow you to transfer any amount of any metal (even very small amounts for quite low fees!) to other customers at GoldMoney (They even offer a general payment system as well, I guess it is a bit like PayPal.). So if Gold was initially the sole medium of exchange and I have invested in Silver and a too small cash balance in Gold and I want to buy something from someone who also has an account at GoldMoney and would accept Silver it would be stupid to sell Silver to have the Gold to transfer it to the other guy. Gold would still be the unit of account for the reason of economic calculation. In terms of payment however I just would transfer the Silver directly using it as medium of exchange and therefore decreasing the demand for Gold as medium of exchange, saving the sell and buy spread of Silver, while at the same time increasing the demand for Silver as medium of exchange. This would cause a small shift of demand for a medium of exchange from Gold to Silver which in itself could drive other people to invest in Silver to gain from this increase in value, at the same time encouraging them to use Silver directly as medium of exchange, which again would decrease the demand for Gold as medium of exchange and so on…
This could go on until Silver was overvalued compared to Gold. I don’t know in how far other assets and commodities like oil and so on could play a role, but I really think this would basically be a thing of precious metals. And the point at which this process would ultimately be limited is of course their industrial values. So while an expected rise in value might trigger also a demand not only as store of value but also as a medium of exchange, also the reverse is true, which is an expected loss of value that could drive people away from it and therefore also reducing its demand as medium of exchange.
A change in value due to changes of industrial demand doesn’t seem to be itself quite volatile, the more important part is that the decrease and increase in the monetary value itself would always act as positive feedback (compounded by investment behavior) to strengthen the current trend upward and downward, which is simple “bubble” mentality. The fundamentals of the industrial value are quite stable since no matter what only Gold is Gold. If you want a Gold ring, there is no way around it. However the monetary value which is derived from it as medium of exchange can be performed by Silver just as well as already said above. I hope you see where I am getting with this example.
I maintain that Gold would not stay the only medium of exchange in my given example. Its extreme spread between monetary and industrial value would make it absolutely unattractive as store of value for excess cash and maybe even large parts of the cash balance. This then would trigger a need to transact directly in whatever store of value that was chosen, which could be successfully met by commodities like Silver. This would level this spread of industrial versus monetary value among at least some precious metals.
Every market has an ideal amount of competing firms, some have thousands, some hundreds and some very few like less than 5. I believe the market of money, that is eliminative to variation yet also is still prone to volatility due to the market process that always seeks under- and overvaluation from which monetary value is not exempted, might be like the civil aeroplane market with Boing and Airbus. There are a handful of choices but at least 2 quite big ones.
How does BTC come into play here? I think not at all. There is no starting/stopping point of industrial value. This spread is infinite. Therefore there is no genuine undervaluation possible. There only is overvaluation possible (Of course it would be possible for BTC to be technically oversold and overbought → market psychology). Think of the same world as described above with the exception that BTC is the sole thing used as money at the beginning. As described before people/markets will look for undervalued possibilities to invest their excess cash. This necessarily will also include precious metals and maybe other things that might be easily transferable to other people made possible by firms like GoldMoney. BTC in this scenario can only go down from there; it cannot reach a higher value as at the beginning of our thought experiment just as it (nearly) was with Gold. The same thing would happen as explained above, but while there is a logical stopping point at which Gold really cannot go lower in value, for BTC such a point just doesn’t exist. I am not saying BTC would be demonetized in one day. If there really is a full-fledged economy based solely on BTC at the beginning of our thought experiment, then it would be possible that BTC might be the main medium of exchange for years or even decades. My conclusion is that in a world free of government intervention in the money market BTC would tend to become worthless.
Now you are saying that that the transactions costs are lower than of Gold. Yes right, but so are the transaction costs of Gold compared to Silver. While this is true that would hardly stop the whole process as described above in neither case. They would merely have an effect on how fast it would play out. If you agree above that Gold was successfully rivaled by at least e.g. Silver, you also must consistently agree that BTC would be affected the same way, with the difference that it has no industrial value. Yes transaction costs play a role, but only in so far as they increase the opportunity costs to switch to a different medium of exchange, but do not prevent it entirely. Especially not if you are already invested in e.g. Silver or Gold anyway. Compared to possible gains in value transaction costs of precious metals really are negligible (Electronic payment systems, Money substitution and clearing systems would make this costs very low anyway).
My conclusion: In a money market free of government intervention due to the market process not one thing alone could be medium of exchange (although one of them could be the ultimate unit of account for the purpose of economic calculation). This also is the reason why a crypto currency like BTC could not survive in such an environment, because it needs a huge barrier of entry into the money market that only a government could supply.
Any thoughts on this?