The Return Of Bitcoin

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.

The change in price of bitcoin in a year
The change in price of bitcoin in a year

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 different American exchanges have widely different prices
The different American exchanges have widely different prices

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.

24 thoughts on “The Return Of Bitcoin”

      1. PLEASE do some research. You are making a fool of yourself.

        https://blockchain.info/charts/n-transactions-excluding-popular

        Bitcoin ‘crashed’ in April because there a limited amount of points of failure (ie. Mt Gox, the exchange with 80% of bitcoin trading/transactions at the time) was DDOSed which lead to a panic sell (most likely by, you guessed it, SPECULATORS!). The data is there and it IS being used for transactions so please do yourself a favor and DO SOME RESEARCH.

        1. Bitcoin ‘crashed’ in April because there were a limited amount of points of failure ie. Mt Gox, the exchange with 80% of bitcoin trading/transactions at the time, was DDOSed which lead to a panic sell (most likely by, you guessed it, SPECULATORS!).

          edited for poor grammar oooof

        2. If the only reason bitcoin crashed was because one exchange was hacked, why did the price not instantly recover as soon as the exchange was repaired? Why did other exchanges also have a price drop? What about the numerous other drops of 25% that bitcoin has undergone since then?

          Also if you want people to listen to you, I wouldn’t recommend typing in all caps.

  1. With all due respect, but if you were wrong about this subject before, why would it inherently interest me to read what you have to say about it now?

    I also seem to remember you not being too keen on predictive models. Aren’t you doing the same in this blog entry of what you accuse others of doing in this respect? Namely conjecturing on the basis of unknown unknowns and ill quantifiable unknowns?

    Sure it’s going to crash, friend a foo are in agreement on that. But what is the point of this speculation if not the speculation itself?

    1. Well I thought it would crash so I wasn’t entirely wrong. Nor do I have any idea why you would be inherently interested in what I have to say unless you like my writing.

      Notice how I have built a model or used mathematical equations whatsoever. Nor do I make an exact prediction (which is the supposed main advantage of models). I have said the price will fall by a lot but I am well aware that how much it will fall cannot possibly accurately predicted. So rather than falling into the trap I’ve criticised, I’ve explicitly avoided it. This is at heart an opinion piece.

  2. Bitcoin still has a serious liquidity problem. Just try selling any significant amount of it for dollars. Who knows where the price will stabilize when it’s possible to settle millions of USD with it, and not lose all your bank accounts in the process. If banks and governments ever allow that to happen.

    Here’s Forbes discussing that problem:
    http://www.forbes.com/sites/kashmirhill/2013/11/15/bitcoin-companies-and-entrepreneurs-cant-get-bank-accounts/

  3. 1. You are badly misinformed regarding bitcoins.
    2. Just because you haven’t followed the developments or bothered to research why the price has risen so dramatically, does NOT mean that there was “no reason” for the price increase.

    With respect to 1:

    “Bitcoin merely transfers who you trust from professionals to unknown people on the internet. How safe does that sound to you?”

    A major advantage of bitcoin is that you can be your own bank. You are a total fool if you leave your money on an exchange. The whole point is that YOU generate your own private wallets and only YOU have access to signing the transactions. The counterparty risk is 0. Unlike bank deposits, which do have counterparty risk.

    It is not a traditional currency. It is more similar to medium of exchanges such as gold, other precious metals, cowry shells, and rai stones. These items have no “intrinsic value” but are / were nevertheless widely used by societies as a medium of exchange since they are 1. Rare, 2. Difficult to counterfeit, and 3. Easily transferrable.

    Bitcoin is not attempting to be a currency for a major economic zone. It is a medium of exchange that is very advantageous for certain situations, and cannot be manipulated like fiat currencies.

    Yes, right now there is extreme volatility. Bitcoin is only 4 years old. It will not just instantly be stable. As time progresses and the “market cap” / monetary base grows, the volatility will decrease. It will likely grow to a much greater order of magnitude or it will go to 0. If you are a merchant, you can use several services such as bitpay for a fee of 1% to have 0 currency risk and be paid in your local currency.

    “The biggest news was that Silk Road was closed down and it was found that bitcoins were being used to pay for crime.”

    Wow… Yea no one realized it was being used for criminal activity before the shutdown…

    With respect to 2:

    Do just a bit of research and you can easily find out why the price has skyrocketed. See appearances on major CCTV programs, incredible success of Secondmarket’s BIT, launch of new exchanges, etc. Just because you are lazy and don’t care to research your topics, does not mean there is “no explanation.”

    I respect your viewpoints and reasoning, but you are just badly misinformed and haven’t thought enough regarding this topic. Bitcoin does have many weaknesses, but you have not highlighted them in this piece.

    1. Ah I love to wake and start each day with a fresh pot of insult and internet rage. Let’s begin.

      “A major advantage of bitcoin is that you can be your own bank.”

      Yes and banks get robbed. It is an illusion that bitcoins are safe and protected as even last week there was a spectacular robbery of over a million dollars worth of bitcoins.
      http://mashable.com/2013/11/08/bitcoin-theft-tradefortress/

      There have also been many other thefts and robberies

      https://bitcointalk.org/index.php?topic=83794.0

      “The counterparty risk is 0.”

      There is no such thing as zero risk.

      “It is more similar to medium of exchanges ”

      The problem is that very few people are using it in exchange, rather it is being held as a speculative asset.

      “As time progresses and the “market cap” / monetary base grows, the volatility will decrease.”

      The problem is that it seems to be getting more volatile not less. The more people join it the faster the price shoots up, only for it to come crashing down again.

      “Just because you are lazy”

      Its funny that I am apparently too lazy to research and you are too lazy to explain. I’ll just have to take your word for it that I am wrong and leave it at that.

      “I respect your viewpoints and reasoning, but you are just badly misinformed and haven’t thought enough regarding this topic.”

      Well I’m glad that after calling me a lazy idiot who doesn’t know what he is talking about, you end the comment on a respectful note. Don’t you hate debates that are just people insulting each other and saying how stupid they are without explaining anything? Good thing yours wasn’t one of them.

      1. I would kindly suggest to RN: spend more time reading and less time writing, at least for a couple of years. Think about the ratio of the words you have read to the words you have written on each subject. Is it satisfactory? If you knew that someone whose work you were analysing had that same ratio, would you consider it worth reading?

        1. That’s uncalled for. I’ve written a grand total of two posts this month, I didn’t think that would come across as excessive. I always put a lot of work into my posts and research it as much as possible. I don’t see any problem with my ratio of read to written and I usually begin a post with links to a host of opposite thinkers.

        2. Indeed, this comment by GM is uncalled for and counterproductive to productive discussion of any topic. Robert has thought about this matter carefully. His posts are long for a blog, but, infrequent. Their infrequency and content is strong evidence that he uses this process: 1) encounter discussion about a topic on the web or in other news media; 2) read more about the topic; 3) think about what he’s learned; 4) write a draft or outline of his thoughts; 4a) convert his outline into a draft; 4b) revise this draft; 5) goto 4b (a “do-loop”) until satisfied with the form and content of the draft; 6) check spelling, usage and grammar until satisfied (never perfect but so what?); 7) publish.

          If his commentators used this process, the discussion would have much better content. Robert’s blog is not for flame throwers or readers who just want to express their opinions rather than to engage in reasonable discussion about them or about Robert’s opinions. In the blogosphere, quantity appears to be more valuable than quantity; this valuation basisis unfortunate. This blog is about quality, which is why I read it.

          Reading is not a prologue or prerequisite for writing. We reify our ideas by expressing them in language (spoken, written, graphic, animated). We engage in our reading by writing about it. Without engagement in both, the quality of each suffers. The ratio of words read to words written is a ridiculous measure of thoughtfulness. Is a data table or chart one word or one thousand words (the “value” of a picture?)? Imagine holding Cervantes, Montaigne, Hugo, Dickens or any number of thinkers to this standard.

          1. CB blames the commentators instead of asking why RN’s blog doesn’t attract more high-quality comments.

            TT wrote us a comment of reasonable quality which gave the impression of someone who has first-hand and perhaps in-depth experience of bitcoin. RN’s rebuttal of TT’s points was shallow and throwaway, as was typical of how he dealt with my explanations of Austrian economics. Never mind that I have probably spent in excess of one thousand hours reading primary material on that subject, certainly far in excess of RN, nothing I said made any impact on his absolute mental clarity on the topic. Equally, nothing that the most advanced bitcoin expert could say would make any impact whatsoever on RN’s absolute mental clarity.

            TT said:

            “A major advantage of bitcoin is that you can be your own bank. You are a total fool if you leave your money on an exchange. The whole point is that YOU generate your own private wallets and only YOU have access to signing the transactions. The counterparty risk is 0. Unlike bank deposits, which do have counterparty risk.”

            RN’s rebuttal? “Yes and banks get robbed…”, with links to a story about a theft from a online bitcoin storage company and various other thefts from exchanges and bitcoin storage companies. In other words, thefts from people who weren’t, at the time they were robbed, “being their own bank”. So RN completely missed the point made by TT and acted like he was getting everything right, as usual. Why would TT bother replying to this?

            I understand that it’s a useful mental exercise for RN to write blogposts about these topics. The problem is that it’s not a useful mental exercise for people with expertise to read them or to write comments on them. If RN’s goal is to be able to come up with a bunch of plausible opinions, he is succeeding. If his goal is to be able to discuss difficult topics at an advanced level, his blog output suggests that it’s a fail.

            1. “TT wrote us a comment of reasonable quality which gave the impression of someone who has first-hand and perhaps in-depth experience of bitcoin.”

              It was also full of the condescension of a fanatic who believes that everyone who disagrees is too lazy or ignorant to understand.

              “Never mind that I have probably spent in excess of one thousand hours reading primary material on that subject, certainly far in excess of RN,”

              Wow, you really let your sense of superiority out here.

              “Equally, nothing that the most advanced bitcoin expert could say would make any impact whatsoever on RN’s absolute mental clarity.”

              Well that’s quite a statement. Its a shame that you think I’m so close-minded, especially when I acknowledged in my post that I has previously been wrong about bitcoin. Oh by the way, have you changed your view of bitcoin or do you have “absolute mental clarity”? That’s the thing about not having your own blog, its like being a hurler on the ditch. You can say why everyone else is wrong, without them being able to pick through your views.

              “acted like he was getting everything right, as usual.”

              Doesn’t everyone act as though they are right? I mean I’m hardly going to go around acting as though I’m wrong.

              “If his goal is to be able to discuss difficult topics at an advanced level, his blog output suggests that it’s a fail.”

              And here I was thinking we were becoming friends.

  4. Who mints the bitcoin? or who manufactures this metal fabrication? how is the number of bitcoins circulated? and known as a limited number? and what safeguards as being authentic? do you go to the police if you think the coin is a forgery?

  5. The value of bitcoins is primarily due to the fact that libertarians have faith in it, they would accept it even if a bitcoin would be close to zero. This faith is anything but rational, instead it’s purely ideological. And given that some subset of the population will believe in it anyway, other people will try to take advantage of it.

    Personally I would say let bitcoins be bitcoins. The bubble will colapse under its own weight.

    1. There is certainly a very strong libertarian element to bitcoin. It is common to hear people talk about being free from government control or the evils of central bank inflation. However, its hard to tell how large a share of the bitcoin population they are. A large section is just speculators, people who have bought bitcoin because they think the price will go up. Then there is a third group who are curious about this novel experiment.

  6. One aspect of Bitcoin currency that should be included in this discussion is its use as a currency for criminal activity. The FBI (in the US) arrested a man who ran the web site, Silk Road, a transaction exchange for stolen or counterfeit goods and drugs. In two and half years, he facilitated transactions estimated to total $2.5 Billion (US), for which he earned about $80 million (US) in fees. Relative to the markets for drugs, stolen and counterfeit goods, these amounts are tiny. Imagine that Bitcoins could be exchanged for national currencies easily or, worse, were accepted as a medium of exchange widely. The effect on such markets, the currency markets, the cross-border mobility of capital and the ability of governments to tax their citizens would be disastrous. Suppose, in the U. S., that the wealthiest 5% of income earners converted their currency into bitcoins. The tax base would shrink by 30% (at least, I haven’t done the maths). Every aspect of government activity would shrink to levels consistent with such activities in the fourth quarter of the 19th century. Central banks would become ineffective, perhaps pointless. This list could continue for quite a few pages. Of course, the libertarians and anarchists love it.

    I hope Bitcoin is simply a “pump-and-dump” scheme and will disappear when the sharks have finished their meal of minnows.

    1. Good point. The main advantage of bitcoin is that its anonymous, but that also means that it can be easily used for crime. Dollars can also be stolen, but they can also be traced and there is a chance they will be recovered. With bitcoins there is no such chance.

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