Is All of Finance Just a Big Network Effect?

In college I was a registered Republican. After I graduated I registered as a Democrat. And a few years ago I registered as an Independent. I guess I just couldn’t ever figure out which tribe I belonged to – which network I wanted to associate with. The last 8 years have been interesting to me mainly because I feel like I’ve watched two competing network effects trying to convince one another that their network is better and the more they can demean, retain and recruit others the more powerful their network becomes.

Anyhow, I am really exhausted from all the politics of the last few years so I won’t torture you with more of it. But it all has me thinking about the power of network effects and how people can buy into things that are only loosely grounded in fact (or sometimes void of any fact) just because they want to believe in the network.

This economic idea of network effects is grounded largely in the work of Hal Varian, a Berkeley economist. I’ve always loved this 2004 article in the NYT in which he asked why Dollars have any value. His answer:

In the jargon of economists, the value of a dollar is a result of “network effects.” Just as a fax machine is valuable to you only if lots of other people you correspond with also have fax machines, a currency is valuable to you only if a lot of people you transact with are willing to accept it as payment.

This seems especially timely given low inflation (which is evidence of surging money demand), skyrocketing Bitcoin prices and surging stocks. After all, how could inflation defy all this stimulus? How could Bitcoin’s valuation defy its relatively low utility? Or how could stocks defy what seem to be perpetually high valuations?

In 2014 I said that Bitcoin was really interesting because it was largely grounded in a network effect. There aren’t men with guns backing it. Taxes don’t “drive” this money as MMT people might claim. Bitcoin works as money because people find it useful as money. Full stop. No matter how silly you might think the narratives around Bitcoin are, the simple fact of the matter is that Bitcoin has moneyness because people believe it has moneyness. And the more people adopt that view the stronger the network effect becomes and the more useful Bitcoin becomes.

It’s an interesting way to think of much of finance and economics. In economics we often work from the perspective that there is some sort of fundamental underpinning for why things have value. Stock values are supposedly discounted by their expected future cash flows. Dollars have value because the government says so. Bonds have value because the government is a “risk free” asset issuer. Gold has value because it’s a hedge against government and inflation. Markets are “efficient” and all that…

As is often the case, the truth is probably somewhere in the middle. There’s probably some truth to the idea that currencies have value because the taxman says so. There’s also truth to the idea that currency is valuable because the network effect makes it valuable. But the interesting aspect about the network effect is that it helps to explain why something that looks irrational to some people is actually rational to other people. And the fact that it appears rational to some people makes it rational in reality…until they stop believing it’s rational.