A beauty contest for bitcoin, or What drives the prices of cryptocurrencies

If you studied economic theory or just interested in this question, you probably at least heard of John Maynard Keynes, one of the most influential economists in history, which marked the beginning of the economic period known as Keynesianism. In 1936 Keynes published a book called “General theory of employment, interest and money”. Yes, most likely, you do not choose this book for bedtime reading or holiday. “The General theory” can also be the last place where you will find information on bitcoin, given that it more than 80 years. In the end, Keynes helped to create a financial system which is going to replace bitcoin. So, it would seem that his work is outdated and no longer relevant. But Chapter 12 “General theory” can shed light on the understanding of the forces that affect the price of bitcoin.

Satoshi Nakamoto in one of his posts referred to a similar idea that could be a source of inspiration to create the first cryptocurrency.

In this article, we consider the so-called Keynesian beauty contest. This is a simple but profound idea that can help you make a better decision the next time you want to buy bitcoins (or for the first time to invest in the cryptocurrency).

Keynesian beauty contest

Imagine you are in a room with 99 other people who are vying for part of the cash prize. You are asked to choose a number from one to one hundred. Your chosen room will determine what percentage of the winnings you will get.

But there is a trick. The winning numbers are not random. This is the number that will choose the majority of other people. The closer your choice is to this number, the more money you get.

So, what will you choose? You can choose 77 because it is your lucky number. But maybe you think other people will choose a round number like 50.

Realizing that you have time to make a decision, you start discussing it with several other people in the room. Each has their own theory. Someone will say that I found the correct answer and can sell it to you. Others will point to the statistics and will examine the results of such competitions in the past. Some people will choose at random.

This hypothetical competition is the perfect metaphor for asset prices.

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Keynes compared stock prices to a beauty contest. He gave the example of a competition in which participants chose six winners out of 100 photos with faces. Those who chose the most popular, received the prize.

As noted by Keynes, few participants chose the face they found most attractive. Instead, they found out who most people consider to be the most attractive. Smart party will think about what you think the majority of people. The result will be a kind of collective logic that has little to do with persons and things connected with perception.

A beauty contest for cryptocurrency

Keynes was referring to the stock market, but the same idea applies to any investment, and in particular to bitcoin.

Prices are not always based on people’s opinions about what they see as the main value of bitcoin. They are based on what people think about other people’s opinion regarding bitcoin value. Many investors buy a certain game with the hope that its price will rise, and not because they understand its fundamental value.

For example, the price of bitcoin is \$10,000. Hypothetical investor Max believes that it will rise to \$100 000. Max conducted his research and thinks that other investors will continue to buy until the bitcoin reaches that price. So he buys bitcoin expecting a tenfold increase.

Is this good or bad decision?

If Max understands technology and shall base its decision on its potential value in the future, he makes the right decision. Max bases its investments on core values.

But if the only thing that Max knows about bitcoin, is the assertion that other people will continue to buy it until the price reaches \$100 000, it’s not such a wise decision. This type of thinking can lead investors to buy because they don’t want to miss the opportunity to earn. In the result later, we can see “the market for fugitives”.

From the position of the Keynesian beauty contest, just such an approach contributed to the growth rate of the main cryptocurrency in 2017. Since then prices seem to go at a more realistic level, and investors are studying the practical use of bitcoin and do not concentrate on what figures we can expect in the future.

According to the materials published in the blog of the cryptocurrency the company Luno on Medium. Company Luno takes no position on the price of bitcoin and believes that it is important to have a clear strategy for investment. The study of driving forces helps make the best decision possible.

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