The Bitcoin Bubble

In the normal course, I do not do requests for this blog.

I have a job writing articles for a reputable publication. I write the articles that my editor assigns to me.  For the blog, I generally write about something that interests me. Usually, it is based on something that I have read or a conversation that I have had.

In the last few weeks, several people have asked me for my opinion regarding Bitcoins. The truth is I really do not have one. I think that they are a fad. They may be around for a while but ultimately I do not see that they will become a legitimate part of mainstream finance.

More and more people are investing in Bitcoins and more and more businesses are accepting them for payment. The recent run-up in their price has generated a lot of interest. Note that I said price, not value. Bitcoins have no inherent value.

A lot of people seem to confuse Bitcoins with blockchain. Blockchain or distributive ledger technology is just that ledgers; bookkeeping records of transactions that are created by parties to the transactions. Blockchain ledgers are public and every transaction is broadcast to everyone to reduce cheating.  Both FINRA and the US Federal Reserve have looked at blockchain and essentially yawned.

There is nothing inherently wrong with keeping various parts of transactional ledgers disbursed but I fail to see the benefit. The idea is to replace the institutional intermediaries like banks with digital ledgers where a lot of people enter their own transactions. This assumes that everybody in the system is honest.

Using blockchain, it is possible to effect transactions instantaneously everywhere in the world.  If I make an on-line purchase from a merchant they may not get my payment for a day or more.  The transaction is in fact, instantaneous, but the bank or banks in between slow it down so that they can have use of that money overnight.  With a large bank that can result in an enormous profit.

It would seem logical that a blockchain is only as secure as its weakest link and more susceptible to hacking and data breaches than any of the large banks or the US Federal Reserve.  And no matter where and how the ledgers are kept, every bank and public company that uses the blockchain system will still have to be audited once a year.

This brings us to Bitcoins which is essentially a string of computer code and which touts itself as a cryptocurrency. Bitcoins are not the only cryptocurrency. There appear to be more than 100 but Bitcoins seem to have the lion’s share of the market and are subject to the most hype.

I have some experience trading currencies in the foreign exchange market and teaching about them. When I was very much younger, I bought and sold currencies on the black market in Mexico and Italy.  So I think that I am qualified to peel back the curtain and take a reasonable look at Bitcoins and to size them up against other currencies.

When I did, what I found was essentially nothing.

Perhaps a unique aspect of Bitcoins is where they come from.  Bitcoins exist only on a distributed ledger and are the brainchild of an unknown computer programmer who first published the idea in 2008 and then the software to create the system in 2009.

The number of Bitcoins in the world increases every time someone, usually a cryptographer I suspect, solves a complicated mathematical puzzle. If you perform any task and receive a reward for doing it, I suspect that the IRS will consider that to be a taxable event.  I have yet to see IRS guidance on the subject, but I have no doubt that the IRS will catch up to this.

If you looked at this from the outside and said that a group of sophisticated cryptographers was going to create a code and that code would be accepted as money, you would be right to be skeptical.  Who, besides another cryptographer would want it?

Records of Bitcoin transactions are kept on blockchain ledgers and a lot of the trading is anonymous. A lot of people seem to think that most Bitcoin transactions are being made by criminals seeking anonymity. That may or may not be true, but the anonymity that comes with Bitcoin transactions would certainly attract a criminal element.

People who swear that Bitcoins will soon become the currency of choice usually make several arguments. When you examine them, it is obvious that none hold any water.

Bitcoin advocates argue that Bitcoins are no worse than any fiat currency. If the government can just keep printing money without anything behind it, why should not the marketplace be able to do the same?  As a member of the generation that first coined the phrase “question authority,” I think I am qualified to respond.

There was a lot of debate when President Richard Nixon took the US off of the gold standard in 1971.  Most of the people who favor Bitcoins today were not yet born and know nothing of the debate that took place then.  While it is true that the US no longer exchanges currency for gold at a fixed rate of $35 per ounce there is still a lot of gold stored at Fort Knox and elsewhere.  Most of it was purchased at $30 an ounce or less and at current prices would still back some portion of outstanding US currency.

Gold itself is a monetary fiction.  People have sought it and accepted it as an exchange for other items of value going back into antiquity. In reality, it is a rock. Once or twice every year someone walks along the bank of California’s Sacramento River and picks up a sizeable nugget. Any monetary system needs a hitching post and for centuries gold has been it.

Gold and all currencies are based on our willingness to accept them for things we consider to be valuable.  All currency is about perception.

In addition to gold, and perhaps more importantly, the largest asset held by the US government is land. Land has had value going back to feudal estates because they were places where you could grow crops and later build factories. Land adjacent to a river or shoreline has always had extra value.

The US government owns millions of acres of valuable land.  You might speculate about how much it would get if it sold the 98% of Alaska that it still owns but it is easier to add up the value of the someplace like Camp Pendleton, California with its miles of Pacific shoreline just waiting to be turned into high-rise condos, theme parks, and golf courses.

What is behind Bitcoins? Nothing. All fiat currencies are not created equal.

Currencies must be accepted in exchange for other goods and services. While more and more merchants are accepting Bitcoins, in most cases average wage earners in the US are required to pay their rent or mortgage in dollars and also their health and car insurance, groceries, cable, and phone bills.  There is not a lot left over for Bitcoin transactions.

I can get a meal from most street vendors in almost every country in the world with a US $20 bill.  In the aggregate street vendors sell a lot more meals every day than does McDonalds and McDonalds does not accept Bitcoins either.

Currencies function as a place to store value.  The recent run-up in the price of Bitcoins is an example of how poorly they perform that function.  There has been no countervailing deflation of the dollar to justify the increase in Bitcoin prices nor underlying economic events to explain it. The price of Bitcoins has run up based purely on speculation. The hype has created demand and the run-up has fed off of itself.

If the price of Bitcoins can increase that quickly, certainly the price can decrease that quickly. Would you want to contract to perform a service for one Bitcoin, perform that service today, send an invoice at the end of the month and be paid 30 days later?  The purchasing power of that one Bitcoin 30 or 60 days from today could be substantially less. Without stability Bitcoins are essentially useless as currency.

That is why many articles about Bitcoins refer to the tulip bubble in the 1600s. In both cases, prices were based upon what economists call the greater fool theory.  Everyone believed that the price would increase and bid the price up until there were no more buyers.  The bubble burst and the last fool got left holding the bag. I do not care if Bitcoins continue to go up until they reach $10,000 each or higher.  At the end of the day, someone will get left holding the bag.

A more recent twist on Bitcoins is their use in venture capital. Several companies have claimed to have raised millions of dollars by selling stock for Bitcoins or other cryptocurrencies.  They call them initial coin offerings (ICOs). Several companies profess that they have raised millions in a matter of hours. That may be because holders of Bitcoins cannot spend their coins in very many other places.

I could not locate a prospectus for one of these offerings. I do not believe that any were registered with the SEC. I would particularly like to see how the attorneys who wrote the disclosures handle the “risk factors” relating to the Bitcoins that the company received for its shares. Call it professional curiosity.

If I took anything away from my look at Bitcoins it is that there is a lot more hype than substance.  A lot of people seem to think that it is possible to create wealth by solving a mathematical puzzle. But Money for Nothing is a song by Dire Straits, not an economic reality.

 

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