Like a movie sequel bitcoin has blasted its way back into the news after being presumed finished after its dramatic crash last April. Like the Death Star it has returned in the exact same way as before and has re-ignited the debate over the value of an uncontrolled currency. As I write this bitcoin is hovering around the price of $450 and it will probably reach $500 soon enough. Its return has surprised commentators (such as myself) who had presumed the currency was done for. Unfortunately, like the Death Star, it has the exact same flaw that will undo it as before. Bitcoin is soaring high at the moment, but it is only a matter of time before it crashes.
Let’s take a quick moment to take stock of where we are. As the chart below shows, bitcoin has undergone an exponential rise in the space of a year. After rising rapidly last it collapsed and lost 80% of its value in the space of a day, dropping from $261 to $50.
That should have been the end of the story but bitcoin started rapidly rising again. The question is, why? The peculiar thing is that no one is quite sure. Nothing about bitcoin changed and there was little news or reason for people to change their expectations of its value. The biggest news was that Silk Road was closed down and it was found that bitcoins were being used to pay for crime. Demand from China has risen but by nowhere near enough to justify it. So it is clear that there is no fundamental reason for the rise in bitcoin, it is purely down to speculation.
Let me explain how this works. Let’s say a few people in China want to buy bitcoins. As there’s so few bitcoins, this small increase in demand leads to a large rise in the price. People notice that the price has risen and decide not to spend their bitcoins but rather to save them. This reduction in supply pushes the price up. Even more people decide to hoard bitcoins and new people decide to buy into a rising market. News spreads about the rise and articles are written about bitcoins which gets more people interested, which raises the price, leads to more hoarding, more articles etc. Thus we have the virtuous circle of a bubble which feeds on itself rather than any intrinsic or real reason for growth.
There are many bitcoin owners who are delighted by the recent rise. It is common to hear stories of people buying for $50 and have now got ten times their money. That’s all well and good, but it means that bitcoin is no longer a currency, it is a speculative asset. People are viewing it as a stock, something to be bought cheap and sold high. A currency is meant to be traded in exchange for goods and services, not hoarded like buried treasure. If the price is constantly increasing only a fool would spend bitcoins now. Why buy something when you can get it half price next month? Ironically enough, the price rise has not showed the strength of bitcoin but rather its weakness. A currency that is never used is like car without any wheels.
Some see bitcoin as a long term investment. They buy now and intend to sell in a few years time. This is understandable but bitcoin is not a money making machine. If I buy at $50 and sell at $200, there has not been an extra $150 created. Rather the wealth has transferred from the new guy to me. My gain equals his loss. So the idea of buying now and waiting until the price is say $1000, is based on the belief that someone will want to pay that much, that they will be willing to lose in order for your to gain. So the net benefit from bitcoin is zero, it merely shifts money from one person’s pocket to another. Just like property development, the people who get in first make a lot of money, but the last person left with the house finds no one to sell to and is left holding the bag (unless of course the first people are foolish enough to buy it back).
All bubbles thrive so long as no one tries to cash out. During the boom, we were all delighted at how much the value of our houses had risen. However, like bitcoin, this was all paper money and could disappear as fast as it arrived. What people didn’t realise was that the price was high because people weren’t selling; because the longer they waited the richer they thought they were getting. So long as no one leaves the party keeps going.
However, at some point people try to cash out and turn the rise in asset value into actual money. What they soon find is that very few people want to buy at the peak. So the price drops and people start to worry that maybe they’ve partied enough and should leave before they lose their fortune. This drives the price down even more and soon everyone is running for the door. Everyone is desperate to sell to and save their money which means that no one does. People realise that their paper fortunes were an illusion that only existed as long as they didn’t try to touch them. Asset bubbles only maintain their high price as long as only a small number of people sell and realise this price. If large groups try to, the price collapses.
Bitcoin defenders will leap to its defence and argue that bitcoin is fundamentally different to other assets as it will revolutionalise society as much as the internet did. They claim that transferring currency easily without the need for transaction charges means that this time is different. All bubbles claim that they are based on some change in fundamentals or change in technology. The internet has greatly changed society but that doesn’t mean that it wasn’t a bubble in the 90s or that pets.com was worth the money. We may use electronic currency in the future but that does not mean it will be bitcoin.
Plus is it really that revolutionary? How dire is the need to transfer money abroad? It is ironic that bitcoin has been so popular with Americans, people who are renown for not travelling abroad. Most ordinary people don’t need to and while bank charges are a pain, that doesn’t mean a new currency is the answer. Banks are really the only people who would find an advantage from it and they are the people who are least likely to get involved in bitcoin. Plus banks pay far too little tax and get away with far too much as it is without bitcoin make it even easier to hide their actions. If you don’t see the harm in banks being from to act without constraint then you really need to look at the world around you.
When you buy a bitcoin you are essentially replacing your trust in the government with trust in the bitcoin exchange. Unlike governments, exchanges are not accountable and not as well protected against thieves. Many bitcoiners have a libertarian ideology and view the government as untrustworthy thieves and seem unaware that it is just as easy to be robbed of your bitcoins as it is of your money. A bitcoin exchange with 1,000 customers and $4.1 million worth of bitcoins has simply vanished. It has been found that of the 40 bitcoin exchanges set up in the last three years, 18 of them have now closed. 13 of the closed didn’t even give any notice of closing and only 6 refunded their customers. Money is based on trust and bitcoin is no safer than the Titanic is unsinkable. Bitcoin merely transfers who you trust from professionals to unknown people on the internet. How safe does that sound to you?
Bitcoin is not a complete waste of time and in fact I see it as a useful experiment to test theories on it. For example it deals a blow to the Efficient Market Hypothesis by following a trend that cannot be called random. Its extreme volatility should dispel any illusion that investors have rational expectations and believe the long term price of bitcoin is $261 one day, $50 the next, $150 the next and $100 the day after that. Instead people seem to be following adaptive expectations and basing their opinion of the future price on the current price. So people (like myself) thought the decline would continue just as currently people thought the rise would continue (in between people thought the price would stay in between). There is also a curious lack of arbitrage in the market. At the moment the price of bitcoin is $463 on MtGox, $437 on BitStamp and $422 on btce. Between American exchanges alone, the price varies from $390 to $503. This is to say nothing of the differences between bitcoins traded in different currencies. Why are these markets not clearing? Why does no on not buy at the cheap exchange and sell at the expensive one?
The more things change the more they stay the same. A lot has happened since last April, but the flaws of bitcoin are still the same. The price of it is too volatile for it to be used as a currency. Numerous times it has lost a quarter of its value in a single day and gained as much just as casually. How can people possibly make decisions on how to spend it if they don’t know what its value will be? The problem of hyper-deflation is as bad as ever, with it making far more sense to hoard rather than spend. A currency that is not spent is not a proper currency but just as gambling scheme. We’ve been here before; now all we have to do is wait for history to repeat itself. Bitcoin will fall and it will fall hard.