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Bitcoin - Currency, Asset or Mirage
The chart below (right) highlights the dramatic rise in the price of bitcoins since its introduction as a digital currency in 2010. But, an understanding of what constitutes 'Sound Money' is more important here than any understanding of technology in trying to determine whether bitcoins are a currency, an asset or a mirage.
As far back as 330 BC, Aristotle, the great Greek philosopher, defined the five characteristics of good money as durable, divisible, convenient, consistent, and has use value in and of itself. And not much has changed in the intervening 2,000 plus years. Bitcoin and other cryptocurrencies are probably durable. They are certainly divisible, consistent, and they are convenient so long as you have Internet access and that others are also willing to transact in bitcoins with you. The key question is: have bitcoins any use value in and of themselves?
People have traded with each other in goods and services since time began. Paper money and credit facilitates trade, and, to be accepted as payment, each must be trusted and have intrinsic value use (use value in and of itself). We receive payment for our goods and/or services and we lodge our payment into the banking system. We trust the banks to safeguard our money.
This trust was broken in 2008 and led to bank runs all over the developed world, as depositors feared for the safety of their monies. But central banks stand behind domestic banks. And in 2008, central banks stood behind domestic banks in the US, UK, and in the Eurozone to safeguard depositors' monies. The system was tested to the core, but it did survive, at a price, and with old lessons having to be relearned. But what backs the central banks? Governments, of course! A sound banking system and a country's currency is underpinned by the government's ability to raise revenue through taxes, not just today, but into the indefinite future. One might argue that paper money has no use in and of itself. And in a narrow sense that is correct. But it misses the wider point - that if your government is backing the country's currency then that's a pretty good substitute for 'having value in and of itself'.
In the vast majority of times, your bank deposits represent 'Sound Money'. And banks can use client deposits to lend out as credit, thus expanding the supply of money as trade expands while at the same time earning a return for both the bank and the depositors. Money in a trusted banking system is both a medium of exchange and a store of value.
However, as paper money can be created at will, not all paper currencies have acted as a store of value - think of the German Reichsmark after WW1 and, more recently, the Argentinian peso and the Zimbabwean dollar - all worthless as a store of value due to the fact that their governments spent recklessly and printed money in huge quantities to try and pay for that spending.
Under Aristotle's rules, gold ticks all five boxes; it is durable, divisible, convenient, consistent and has use value in and of itself. Gold is a medium of exchange that operates outside the banking system. When you lodge your savings with a bank you get an I.O.U. in return. You are dependent on the bank making good on that I.O.U. Not so with gold! When you accept gold in settlement of a trade you have an asset whose value is not dependent on a third party.
Also, there is a base demand for gold for jewellery and industrial uses (i.e. it has use value in and of itself). It currently costs circa $820-850 on average to get an ounce of gold out of the ground and when you add on the miners margin it is easy enough to argue that a base price for the ancient metal of kings is probably in the order of $1,100 an ounce, so that gold has intrinsic value. If you come back in twenty years, there'll be a price for your gold, and over the millennia, due principally to the fact that new gold supplies are limited, the gold price has matched inflation. Gold has been a better store of value than most paper currencies throughout history. Yet, as the supply of gold cannot be increased at the same pace that trade expands, there has never been enough of it around to facilitate the settlement of faster expanding trade. Gold is an excellent store of value, but it has never been an ideal medium of exchange.
Bitcoin is a digitally created currency and is in limited supply. And under Aristotle's rules, bitcoin ticks four of the five boxes; it is durable, divisible, convenient and consistent. But it does not tick the most important box - it has only a very limited use value in and of itself. Bitcoins are earned by those who verify transactions using blockchain technology over the Internet, so that one could suggest that a base intrinsic value for a bitcoin is the value of the programmer's time and the cost of the required computing power..
Unless the blockchain technology is going to lead to some revenue flow for owners of bitcoin currency, bitcoins appear to have limited intrinsic value. They simply represent a new medium of exchange for settling trade in goods and services. But they would not appear to be a store of value. Supporters argue that bitcoin transactions settle outside the bank system, like gold. Our observation on that comment is - so what?
If bitcoin and blockchain technology speed up and/or lower the cost of settling trades, then they represent a positive development. And the technology looks robust with the banks themselves already starting to adopt the new distributive technology.
The Internet itself was a revolutionary development, yet, in itself, it makes no money. Rather, it has changed our lives, lowered costs in many areas, increased choice and spawned new innovations. If bitcoin is going to revolutionise trade settlement then its supply should not be restricted, but should be expanded at the same rate as trade. Fans of bitcoins seem to be placing all their faith in the strictly limited supply. But a limited supply means nothing if there is no 'value in and of itself'. In our view, buyers of bitcoins are confusing its potential usefulness as a medium of exchange with a store of value.
A colleague of mine pointed out an alternative argument that supporters of bitcoins promote. Bitcoins offer anonymity. Given the abundance of illegal trade and the increasing volumes of it over the Internet there is a natural demand for transacting in a currency that has no trail. Gold offers similar benefits, but gold is too heavy and too valuable to transport quickly and safely for the settlement of illegal trades. And this is not just the domain of large rogues and criminals; think trademen working for cash, small-scale drug trafficking which is growing exponentially on the dark web. You just need to look at the scale of illegal online movie and music downloading to see the propensity for using the web illegally. For crimes more readily targetted by law enforcement such as drug sales, the dark web and bitcoin provide an irresistable combination.
If this is the attraction of bitcoins, then surely authorities will move to clamp down on such trade if or when the problem becomes big enough. Even if authorities are behind the curve, anonymity does not explain why the supply of bitcoins has to be limited. Indeed, in our view, this is the achilles heel of arguments put forward by supporters of bitcoin. They simply cannot explain why the supply of bitcoins has to be limited. Indeed, one might argue that it is this short-term limit in supply that is leading to the rise in price. If, for whatever reason, demand for bitcoins is outstripping supply then it is self-evident that the price will rise. But, that does not mean there is any value in a bitcoin. Just because there is a mass of people buying bitcoin and cryptocurrencies does not mean they have any value. More likely, they are mixing up a new, and perfectly legitimate, medium of exchange with a store of value.
If bitcoins are a novel way to settle trades outside the banking system, then why limit the supply? Sound money must expand to settle a greater volumn of trade. Indeed, that is money's primary purpose; to settle trades. If the supply of cryptocurrencies (not to mind bitcoin) is increased, as we think inevitable (already new digital currencies are cropping up by the week) then the prices will fall back to their intrinsic value, which in bitcoin's case is far below today's price, and most likley close to zero. We are probably witnessing a speculative development where the limited supply of bitcoins is leading to higher prices as the demand to own them multiplies, with these higher prices bringing in more speculators who drive the price still higher.
There is an old phrase in stock markets: beware the parabolic curve; that phenomenon where the price accelerates upward thus exhausting demand. The bitcoin price went parabolic in 2017 as demand totally outstripped supply, but when demand is satiated the price will revert to intrinsic value.
If we have misunderstood the bitcoin revolution we stand ready to change our view. As economist John Maynard Keynes once said "if the facts change, so do I - what do you do, sir?" Humility is an essential tool for survival in the investment game!
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21st August 2017