The Bitcoin Bubble
… It might seem that Bitcoin is just like a fiat currency issued by governments. Writing in the Wall Street Journal, Jack Hough says precisely that it’s a purely online currency with no intrinsic value; its worth is based solely on the willingness of holders and merchants to accept it in trade. In that respect, it’s not so different from fiat currencies like the dollar or Euro, but whereas governments back such money, Bitcoins lack central control. But this is a misunderstanding of what money does and where it came from. The “fiat” (meaning “let there be”) in “fiat money” reflects the power of governments to command and tax. Because of their power to tax, governments can make money by fiat, simply by declaring their willingness to accept that money in repayment of tax debts.
Historically, money arose from, and in conjunction with, this power. (This point has been made repeatedly over the years, most recently in David Graeber’s controversial Debt: The First 5000 Years, a surprise publishing hit for an anthropologist. )
By contrast, Bitcoin looks more like the “just so” story, commonly told in economics textbooks, in which money arises to simplify what would otherwise be complex and cumbersome barter transactions.
That would be fine if Bitcoin were simply a unit of account, used to keep track of transactions. But all the interest in Bitcoin is in the idea that it is a store of value, one that may be expected to show steady appreciation rather than depreciation. So Bitcoin needs to be evaluated as a financial asset.
Viewed in this way, Bitcoin is perhaps the finest example of a pure bubble. It beats the classic historical example, produced during the 18th century South Sea Bubble of “a company for carrying out an undertaking of great advantage, but nobody to know what it is.” After all, the promoter of this enterprise might, in principle, have had a genuine secret plan. Bitcoin also outmatches Ponzi schemes, which rely on the claim that the issuer is undertaking some kind of financial arbitrage (the original Ponzi scheme was supposed to involve postal orders). The closest parallel is the fictitious dotcom company imagined in Garry Trudeau’s Doonesbury, whose only product was its own stock.
As with any kind of asset used as currency, from gold to tobacco to U.S. dollars, Bitcoin is valuable as long as people are willing to accept it. But in all of these examples, willingness to hold the asset depends on the fact that it has value independent of that willingness. Tobacco can be smoked or chewed, gold can be used to fill teeth or make jewellery, and U.S. dollars can be used to meet obligations to the U.S. government.
This independent value is not fixed and stable. If people give up smoking, or wearing gold jewellery, or if the United States experiences inflation, the external value of these currencies will decline.
But in the case of Bitcoin, there is no source of value whatsoever. The computing power used to mine the Bitcoin is gone once the run has finished and cannot be reused for a more productive purpose. If Bitcoins cease to be accepted in payment for goods and services, their value will be precisely zero.
According to the efficient-markets hypothesis (EMH), which still dominates the analysis of financial markets, this should be impossible. The EMH states that the market value of an asset is equal to the best available estimate of the value of the services or income flows it will generate. In the case of a company stock, this is the discounted value of future earnings. Since Bitcoins do not generate any actual earnings, they must appreciate in value to ensure that people are willing to hold them. But an endless appreciation, with no flow of earnings or liquidation value, is precisely the kind of bubble the EMH says can’t happen […]
Comment by mrajanov, on April 17, 2013 — 5:13am:
This thing called Bitcoins is a non-entity in most practical senses. It is poorly designed and, in any case, even if it were designed soundly it would face serious threats from systemic actors with whom it competes.
Having said that, there are a few inaccuracies and technical errors here—
But in the case of Bitcoin, there is no source of value whatsoever. The computing power used to mine the Bitcoin is gone once the run has finished and cannot be reused for a more productive purpose. If Bitcoins cease to be accepted in payment for goods and services, their value will be precisely zero.
It can be shown that these sentiments are incorrect in that they are expressed in absolute terms. The value of Bitcoins could be zero in the scenario above, but this is not necessarily so. This is because it is a matter of market and social practice rather than economic theory.
For example, even putting aside that gold can be used in fillings, computers, wedding rings… et cetera, it has a conceptually distinct value relating to the special status that the market and society have given it in acting as a store of value, an instument of psychological comfort if you will. There is an implicit guarantee (a poor, but effective, term in this instance) that gold can be sold to someone else at some price in recognition of the uncertanties of a complex economic world and the psychological comfort that is consequently sought. There is no explicit guarantee. Whatsoever. It is simply that society (the “market” in some sense) has given it this role, accepted it, to the point where it will endure for the foreseeable future. It is not efficient — but it is reality. The below sentiments are spot on in that sense (especially in relation to gold once the distractions of tooth fillings and such are removed)—
they represent the sharpest ever refutation of the efficient-markets hypothesis.
If society, the market, were to consider Bitcoins as a better tool for the role (say it’s more compact, transportable, exchangeable, reliable, secure, non-perishable.. whatever attributes may be considered relevant at that time), then it is possible that Bitcoins could take on the role that society has currently bestowed on gold.
Because of Bitcoins’s technical and structural defects this is not likely but it is conceptually possible and therefore the absolutist statements above are inaccurate.
There is no economic reality outside our own thoughts and behaviour. There is no economic system outside the one we create.
At this stage of our evolutionary process, anyway.
