Bitcoin Buyers Beware – it just might be a bubble!

December 20, 2017

At the time of writing the Canadian dollar price of one Bitcoin is $22,204.96. On the same day last year, the Canadian Bitcoin Index reported an average Bitcoin price of only $1168.98.  How many of us are now thinking coulda, woulda, shoulda?!

The Bitcoin fascination has grabbed our collective attention. Media are routinely covering the meteoric rise in the price of this crypto-currency. With increasing frequency, entrepreneurs are buying computing power to create or “mine” this commodity-currency. Is Bitcoin money? Is it an asset? Whatever Bitcoin may be otherwise, it has every indication of being a bubble. And bubbles burst.

The Trouble with Bubbles
The defining characteristic of a bubble in financial markets is a large and usually fast price increase followed by a precipitous drop in the price. On the way up, speculators reap considerable gains, buying low and selling for much higher. On the way down though, those last into the market lose a considerable amount. No one, of course, would knowingly pay in excess of $22,000 for something that will be worth considerably less a short time later. And herein lies the trouble with bubbles. Bubbles – and more importantly, when they will burst – are only ever confidently identified in hindsight.

Often what attracts people, especially novices, to a fantastic speculative opportunity is counting how much they would have made if they had only bought the asset last week, last month, last year. But will this price increase continue? Is there anything other than speculative enthusiasm justifying the price increase?

Is Bitcoin a currency?
Bitcoin is touted as a currency. Indeed, some on-line retailers have started accepting Bitcoin in payment for goods and services. To be an effective means of payment, though, the money must be generally and widely accepted. To be generally accepted as a medium of exchange it must be recognizable and stable in value. Bitcoin is becoming increasingly recognizable, if still poorly understood. The spillover effect of the Bitcoin craze is an increasing awareness of Bitcoin and the idea of a crypto-currency. But crypto-currencies are very different from currency as we know it in Canada.

In Canada (as in many countries), our currency is issued and backed by a state-owned bank. The Bank of Canada, issues our bills and backs our Canadian dollar. Bitcoin was created instead in 2008 by an anonymous person (or group of people) under the pseudonym of Satoshi Nakamoto. Where it is the Bank of Canada which works hard to prevent counterfeiting of our currency, the novelty of Nakamoto’s design is in the way coding and processing prevents the counterfeiting and double spending of a string of zeroes and ones.

Is there anything real “backing” the Bitcoin? No, but then there is nothing of tangible value backing the loonie either. The loonie is only an otherwise fairly worthless piece of metal alloy (now brass plated steel) valuable to me as a medium of exchange simply – but importantly – because you think it is too.  We collectively think our currency is valuable in exchange because the government has legislated it as such.  The government under the Currency Act deems loonies and toonies issued by the Royal Canadian Mint and bank notes issued by the Bank of Canada as legal tender or money approved by the government for the payment of debts.

What if I want to deposit my Bitcoins into my chequing account? The Canadian banks and credit unions don’t accept Bitcoins. I must first sell my Bitcoin on the Bitcoin market, receive Canadian dollars in exchange and then “deposit” the Canadian dollars into my bank account. An act of “depositing” Canadian currency into my chequing account is, however, technically converting one form of money into another form of money at a conversion price of $1=$1. Indeed, the currency in circulation – all those loonies and toonies and bills in our wallets – is a very small (~5%) fraction of the total amount of Canadian money used for exchange purposes.

Is there anything backing the Canadian dollars in our chequing accounts? No, nothing tangible. Most of Canada’s money supply has long been nothing more than electronic entries in a private, for-profit company’s ledger. What does make the dollars in our chequing accounts safe and secure is that the Government of Canada through the Crown Corporation of the Canadian Deposit Insurance Corporation promises to reimburse us up to $100,000 per insured account, $1 for $1 (no discounting) if our bank goes bankrupt. For this reason (and others), chequing account balances are nominally stable in value. Of course, if food inflation takes off, my $1 will buy less, but that’s a story for another day.

So, is Bitcoin an effective currency? Not in Canada. Is it widely accepted otherwise? Not really. Is it stable in value? Clearly not.

Is Bitcoin an asset?
An asset is anything that generates a flow of income or services over an extended period. A house is an asset since it generates accommodation services over many years. Assets, be they real assets such as houses, or financial assets such as stocks and bonds, earn income (or save me rent if I live in my own house) and may appreciate. Anyone watching the Toronto housing market may be wondering what is driving the house price increase in this city. It may be that, beyond the real value of a “roof over our heads,” people are speculating in Toronto real estate in the same way they are speculating in Bitcoin - buying Toronto houses and Bitcoins solely for the capital gain they expect to receive when they sell the object at a price higher than what they paid for it. The one key difference is that houses will always offer accommodation services in addition to their speculative gain possibilities.

Bitcoin is not a productive asset like a house. It offers no real value. It is a thing. An intangible thing. An unreal thing. Like currency in some respects but not stable enough in value to act as currency and not widely accepted enough to work as a medium of exchange. It’s only purpose is as an object of pure speculative gain. It is, in this way, no different than any other pyramid scheme or a casino gamble.

Are there any side benefits to the Bitcoin craze?
Derek Thompson writing for The Atlantic a few days ago pointed readers to Daniel Gross’ book Pop! Gross argues that there are significant side benefits to bubbles; that bubbles “often fertilize the next generation’s breakthrough technologies.” As I argue in my own (definitely less entertaining) book, Financial Crises: socio-economic causes and institutional context, speculative enthusiasm can fuel and has fuelled all sorts of spillover investment effects that alter the underlying value of associated real assets. In the case of Bitcoin though, much of the investment is in the computers people are buying to mine their own Bitcoins. Investing solely to produce more of a speculative object has little hope of promoting research and development. And I find it hard to imagine how crypto-currencies can improve upon what we can already do with electronic funds transfers, at least in the foreseeable future. Finally, the amount of energy needed to “mine” Bitcoin is insane. As CBS reported recently, Bitcoin mining consumes more energy than 159 countries!

So, Bitcoin is not a currency. It is not a productive asset. On the contrary, it appears to be a most environmentally destructive object. The likelihood that it is past price performance exciting the current market activity suggests that Bitcoin is now nothing more than the object of a speculative frenzy – a frenzy that has every indication of being a bubble.

(Note: If you are new to the world of speculation and finance and would like to read a longer version that elaborates on the underlying concepts, see Bitcoin Buyers Beware 20Dec17)