Published daily by the Lowy Institute

The Bitcoin bubble

Bitcoin's price remains aloft, like cartoon character Wile E. Coyote, suspended in mid-air after running off a cliff.

Photo: Marco Verch/Flickr
Photo: Marco Verch/Flickr
Published 4 Dec 2017 

With Bitcoin trading at more than US$10,000 and suggestions it is not just a technological breakthrough, but also an exemplar of how to get around the failings of the nation state, it's time to try to sort out the various claims. Is it the next Amazon or tomorrow's Ford Edsel – a dismal flop? Is this just another financial bubble? Or even worse, a Ponzi scheme to rip off a gullible public?

At the start in 2009, Bitcoin was seen as an alternative to national currencies, potentially providing the three functions of a conventional currency: a medium of exchange, a unit of account, and a store of value. If it performed these three functions better than existing currencies, it would benefit society and be a commercial success. Does it – or could it – do the currency job better?

An effective medium of exchange has three attributes: widespread acceptance, convenience, and credible stability of purchasing power value over time. But Bitcoin's acceptance hasn't gone beyond novelty value - its 10-minute processing time and limited processing capacity are unacceptably inconvenient, and its value fluctuates wildly.

To outcompete existing means of exchange, Bitcoin has to be better or cheaper. PayPal, for example, succeeded because it processes some transactions more cheaply and conveniently than conventional payments systems. But Bitcoin's computationally-heavy processing, involving the dead weight cost of processers (the 'miners') competing with each other for the right to process the transactions, is intrinsically far costlier than conventional payments systems. For the same reason, it can't compete with PayPal's advantage for small transactions.

Miners are currently receiving Bitcoin as payment for processing transactions. This is effectively giving them the seigniorage (the profit that accrues to the issuer of currency) from the Bitcoin issue, which will end after just under 21 million Bitcoins have been issued and production (‘mining’) of Bitcoin ceases. As mining returns fewer and fewer Bitcoins, owners of the expensive computational resources used in verifying transactions will become more reliant on charging user fees for this task, and the business case for Bitcoin as a medium of exchange will become increasingly tenuous. Its remaining transactional advantage of anonymity (attractive for drug dealers and terrorists) isn’t enough for a viable business.

Lack of stable purchasing power also makes Bitcoin a poor unit of account. Imagine using Bitcoin as the numeraire for a home loan contract, with your liability varying manyfold depending on the whims of the Bitcoin market. Similarly, for company accounts, a stable numeraire is essential.

What about as a store of value? Almost everyone who bought and held Bitcoin has done well. Doesn't that make it a good store of value, just as many unusual and idiosyncratic things (rare postage stamps, Rembrandt paintings) have turned out to be effective stores of value?

To be a good store of value, an asset should have an assured stable price over time, low safe-storage costs and a liquid market, so that the holder can sell the asset at any time at a predictable price. Bitcoin doesn't have these attributes.

But is it overly fussy to expect a store of value to have a stable price? What about gold, which many would argue has been a good store of value? Let's not pick a fight with the gold bugs. Instead, we should wish them good luck with their risk-laden gold holdings, and explain why Bitcoin is different. The gold price is anchored, within a wide band, by the usual rules of supply and demand. On the demand side, gold's specific attributes give it intrinsic real-world uses (jewellery, industrial uses): it is not just a token or a digital string. On the supply side, there is a well-established long-run cost of production, which influences the price. These fundamentals are often overridden by speculative demand. But the fundamentals provide a long-term anchor and assurance that the gold price will not go to zero.

Bitcoin, without gold's anchor, has nothing to stop it going to zero. The better analogy is with Silicon Valley start-ups. Their ability to attract investors rests on the stunning success of tech giants such as Amazon, Alphabet (Google), Uber and Facebook: if you can link the right idea with the right technology, fabulous success will be yours. But for every Facebook, there were many start-ups that spent the investors' funds in the 'cash-burn' phase and fizzled out, valueless.

If this is the right analogy, then Bitcoin is not a Ponzi scheme, even though it has the key Ponzi characteristic of relying on attracting a continuing stream of new investors. A Ponzi scheme also has an element of fraud, which is not necessarily the case with Bitcoin. It is more like a bubble. There is nothing novel or surprising in the unhappy sequence of a corporate bubble: the 18th century South Sea Company left its investors with nothing.

This analogy is missing just one element: Bitcoin's lack of a viable business model has not yet registered with its investors. The narrative has become an enduring fairytale.

Why has Bitcoin's price remained aloft, like cartoon character Wile E. Coyote, suspended in mid-air after running off a cliff? Most Silicon Valley start-ups are being constantly evaluated by sharp-pencil investors who want to be the first to get out when the business plan is revealed as unviable. These enterprises survive the 'cash-burn' period only if they can maintain a convincing narrative of future success.

Bitcoin has managed to maintain its narrative, perhaps because it has a different set of investors: gamblers, those relying on the 'greater fool' theory of investment, and true-believers rather than gimlet-eyed analysts. The anarchic starting point appeals to libertarians, with currency freed from the shackles of intrusive government. Scepticism is for bean counters and small minds. The anonymity of the founder (or founders) creates an aura of mystery: the more secrets there are, the easier it is to evade rationality. Linked to the undoubtedly revolutionary blockchain technology, investors are participants in an epic technological adventure. Open-source software and competing miners suggest that this is a community endeavour, open to all. The excitement generated is akin to the thrill of being at the head of the queue to buy the latest iPhone: investors are early adaptors of the latest technology, pioneers of the future. As if this isn't already enough, Bitcoin has celebrity endorsements.

It was unkind of JP Morgan's Jamie Dimon to say that any of his staff found trading Bitcoin should be sacked, implicitly on the grounds that they were demonstrably dim-witted. After all, wasn't Sir Isaac Newton one of those taken in by the South Sea bubble?

The digital age has produced many surprising successes, outside the constraints of conventional thinking. Wikipedia, Uber, and Amazon all provide something that is demonstrably better than the existing model. It is also true that governments make huge seigniorage profits out of their currency-issue monopoly and that opening up government monopolies to private competition has often been beneficial for society.

Thus it was not irrational, in principle, to attempt to establish a competitive payments platform (recall PayPal's success). But Bitcoin has used up most of its seigniorage potential in subsidising the expensive costs of its transaction processing model without being able to establish acceptability as a universal payments system. It can serve none of the three functions of a currency. The narrative loses its credibility as the 21 million issue-limit is approached.

Can the Bitcoin experiment be justified in terms of its exploration of blockchain technology, which is already proving to have profitable applications elsewhere? Perhaps Bitcoin investors get satisfaction from this aspect of their investment, in the same way that contributors to Wikipedia have the satisfaction of advancing the greater good. This is, however, a stretch. It is like justifying the moon landing expenditure by pointing to peripheral spin-offs, such as non-stick cookware. It's not as if the Bitcoin adventure will be a costless example of 'dust to dust': all those computers and all that electricity represent wasted real resources.

One offshoot takes the form of Initial Coin Offerings (ICOs). Start-up tech companies offer their investors some version of cyber-currency instead of a share script. The attraction of this example of crowdfunding is that it provides an opportunity to cut out the fat-cat financial intermediaries who get rich from conventional Initial Public Offerings. It also bypasses the heavy hand of government regulation. The problem, of course, is that these intermediaries and government intrusions are what give investors some protection against business-plan narratives that make no sense. To issue some form of pseudo-cybercurrency that has no use in transactions just confuses the issues. Perhaps this is the promoters' purpose, helping to evade rational scrutiny. But it is just such rational scrutiny that protects investors from fairy-tale stories of future profits.

Does any of this matter or require policy response? So far the authorities in most countries have seen Bitcoin and ICOs as too small to do any widespread harm. At more than US$10,000, Bitcoin is no longer so small: with 16.7 million Bitcoins already issued, the current value of the outstanding stock would be more than US$167 billion. While this is far from trivial, the losses when they come will be spread over the globe; many holders bought their Bitcoins at a much lower price, so should think 'easy come, easy go'; and others might have acquired their holdings via the various hacking scams that have occurred, so might have no real grounds for complaint.

For these investors, a digital printout of their holdings can decorate their wall, alongside their pre-1949 Chinese government bonds and Weimar Reichsbanknote marks, as a worthless memento of their selfless contribution to the advance of the valuable technology of the blockchain and a reminder of the 'madness of crowds'.

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