The Bitcoin bubble

No one is quite sure what the Bitcoin phenomenon will come to, but the unit's recent rise from $20 to $147 suggests that in a world of increasing distrust in fiat currencies it's not going away.

Bitcoins are either a revolutionary new currency that will eventually replace national fiat currencies, as well as gold, or a crazy speculative mania, or both. Or neither.

But they’re definitely something, that’s for sure. During the past few weeks the price of a Bitcoin has blossomed from less than $20 to $147 last Wednesday and then back to $130 on Thursday. Some guy in Texas has just bought a 2007 Porsche Cayman with 300 Bitcoins.

I used “blossomed” because the closest parallel seems to be the tulip mania of 1636-7. Tulips and Bitcoins don’t produce any income and there’s no way of knowing what their value might be. But while the tulip price bubble crashed spectacularly in February 1637, tulips are still around.

But Bitcoins might also be the soundest money ever created – the first that is impossible for politicians to debase, so they can surreptitiously tax their citizens through inflation.

Most people, if they’ve heard of Bitcoins, dismiss them as a crazy geek thing that has turned into a speculative bubble that will soon crash, so we can go back to forgetting about them again. But actually they are very interesting.

The price could still do anything – it could go to thousands of dollars like the price of a tulip in 1637 – because the amount that can be created, unlike either normal money or gold, is strictly limited to 21 million. At the moment there are about 11 million in circulation, with 25 new ones created every 10 minutes.

As the Federal Reserve and the Bank of Japan roll up their sleeves and get stuck into the Great Reflation, printing billions of dollars and yen every month, the limited supply of Bitcoins is proving very attractive to people who are losing faith in government managed money.

Bitcoins were created in 2009 by someone named Satoshi Nakamoto, which may have been a pseudonym, possibly for a group of people. Since 2012, he, she or them, has/have dropped out of sight.

It’s a form of virtual cash that exists only online. There is no central bank or issuing authority – it’s all done automatically, although there is such a thing a “Bitcoin community” that can make changes if necessary, which they have done.

The genius of the system involves solving the problem of “double spending”, which is the usual failure of digital cash, where money tokens can be duplicated and spent twice.

The essence of Bitcoins is that transactions are timestamped and a chain of records is retained that can’t be changed. Each owner transfers the coin to the next signing a hash of the previous transaction and the public address of the next owner. All transactions are open and public.

It’s difficult to get one’s head around, but it seems to work a bit like gold: it’s not impossible to produce more of it, but it’s very difficult. Bitcoins operate on a massive peer-to-peer computer network of more than 20,000 nodes using a system of rewards for computing mathematical problems. There’s a good description in Wikipedia and a clear rundown of how the reward system works in Quora.

Satoshi Nakamoto was motivated by the 2008 financial crisis to create the system as an alternative to fiat money. In 2012, before disappearing from the web, Nakamoto published a nine-page paper on Bitcoins that concludes:

“We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity.”

Is it the future of money? Well it seems to work, and it’s no more ephemeral than credit default swaps.

The Bitcoin price actually took off the day after the Cyprus government announced that it was going to impose a levy on all Cypriot bank accounts, including the smallest ones. It seems Spanish bank depositors were especially active buyers of Bitcoins that week, as they tried to find a safe place for their money.

So Bitcoins are both an ingenious and possibly acceptable solution to digital money, as well as being a speculative mania, just as tulips were a beautiful flower as well as being a mania for a short time.

Henry Blodget, the internet stock analyst from the 1990s who founded the US online publication Business Insider, wrote a nice column last week jokingly raising his price target for Bitcoins to $400, as he famously did with Amazon 15 years ago.

The parallel he drew was a telling one: “The odds Bitcoin speculators are looking at are similar to the odds early internet speculators were looking at: The most you can lose is 100 per cent of your bet. The most you can make, meanwhile, is theoretically unlimited. And in some circles, assuming only a limited amount of capital is wagered, those odds are what might be described as a 'good bet'.

"So let the speculation continue!"


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