Bursting Bitcoin's bubble

I first heard about Bitcoin almost three years ago. I was chatting with an impressively drunk Russian who told me about the virtues of a wonderful new digital currency. I thought he was having a lend of me; trying to wind up the economist for his own amusement. It sounded like something out of World of Warcraft rather than a legitimate financial instrument. 

Although he seemed paranoid at the time – government spies, the Illuminati and tinfoil hats – that vodka-loving Russian is possibly a millionaire now. Yet despite the investment performance of Bitcoin I remain highly sceptical about its future and doubt that it will become a valid currency.

A recent academic paper confirms that view, suggesting that Bitcoins exhibit all the characteristics associated with a speculative investment rather than a legitimate currency.

For a currency to be successful, it must work as both a medium of exchange and a stable store of value. Australian dollars are successful because we can go into any store in the country and use them to purchase goods or services. We also know that the Reserve Bank of Australia has a mandate to do whatever it takes to ensure that the value of the Australian currency changes incredibly slowly from year to year.

The same can be said for most currencies around the world – the US dollar, the pound, the Euro and the Yen are all very similar to the Australian dollar with respect to characteristics and value.

From time-to-time, a currency will fail as either a medium of exchange or as a stable store of value or often as both. The best known recent example was in Zimbabwe where inflation ballooned to 11.2 million per cent in June 2008 prompting the abandonment of the currency. Businesses would no longer accept the Zimbabwe dollar and nobody knew what it was worth so it stopped being a legitimate currency.

The rise of Bitcoin comes as a response to the fear – an irrational fear in my opinion – of inflation, combined with a fear that government-backed currencies are doomed to be debased by opportunistic governments and their reliance on debt.

But even if those concerns are legitimate – and that is a big if – Bitcoin remains less reliable than any widely traded currency.

Bitcoin has a limited use as a medium of exchange. It is occasionally used by online stores but it remains incredibly rare. As for real world usage, well that remains mostly unheard of.

Though there are a few exceptions a person can rarely go to a coffee shop and order using Bitcoins, nor buy their groceries. As a medium of exchange Bitcoins are about as useful as trying to buy goods in Australia using walnuts.

As for a store of value? Since their creation, Bitcoins have proved to be highly volatile and far more volatile than the most heavily traded currencies or even gold. People complain about annual inflation of 2½ per cent but what about inflation or deflation of 10 to 20 per cent in a single day?

Some firms let customers pay with Bitcoins but their goods are not expressed in terms of Bitcoins. Firms have made the decision to acknowledge the existence of Bitcoins while showing unwillingness to expose themselves to the vulgarities of its volatility.

In addition, Bitcoins are essentially conjured out of thin air, although there is a ridiculous and unnecessarily resource-intensive obstacle course than supercomputers must jump through to create one. At present its value is derived because investors believe it has value as opposed to the fact that it has a defined purpose or use.

Any event which compromises that belief – such as the view that there is a Bitcoin bubble, regulation of the market or attempts to realise capital gains – may result is a massive or complete loss of value. That’s not ideal for a currency.

Even if Bitcoins work perfectly – and exactly as the designers envisioned – there will still be issues. The currency will be capped at 21 million units. It is therefore designed to be a deflationary currency.

While deflation does not render a currency useless as a medium of exchange – the Yen still works – why would anyone spend Bitcoins if they are deflationary? If given the choice consumers and businesses would naturally prefer to spend money that is losing value rather than a deflationary currency. By being both a niche currency and deflationary, the circulation of Bitcoins is certain to drop to a level that will ensure it eventually fails.

For many, Bitcoin is either a welcome return to the gold standard or an unwelcome return to the Dutch tulip-mania. Realistically it will never become big enough to be as destructive as the gold standard or indeed as destructive as the tulip craze of the 17^th century.

Right now Bitcoins are more a distraction than a revolutionary force in global finance. Evidence suggests that it displays no correlation with existing currencies or gold and cannot be used to hedge against global financial risks. 

They have limited practical use and currently exist almost purely as a speculative investment. To some extent the Bitcoin bubble reminds me of the dot-com boom when investors became enamoured with products they didn't understand only to learn a quick and harsh lesson later.

With no official legitimacy or backing I anticipate the Bitcoin bubble will burst as soon as international governments try to regulate the market or when investors look to cash out on their substantial holdings. China and India have already taken a firm stance against the currency and others may follow.

Luckily for the financial system the market is still relatively small at around $11 billion so at least this is a bubble that when burst will not cause widespread financial turmoil.