June 12th, 2011:

I recently read former BACE speaker John Robb’s thoughts on the emerging bubble in Bitcoins. He wrote the following:

As a store of value or an asset it’s shady.  Here’s why:  since the supply of bitcoin is limited and knowledge/use of it is growing (potentially virally) it’s the perfect breeding ground for a speculative bubble.  In a world awash with scams and financial speculation (a defining characteristic of our time), it was only a matter of time before the pump and dump mobsters moved in.  Spamming message boards everywhere.  Generating buzz.  Taking speculative positions.  The rapid rise in bitcoin’s value relative to the dollar can be seen below (on thin trading) demonstrates that this is already going on:

…As far as I know this could become the first P2P bubble.

I want to share my own thoughts on why there are clear signs of a bubble forming in Bitcoins, and I think it goes far beyond the his view that “the supply of bitcoin is limited and knowledge/use of it is growing (potentially virally).”

The aspect of Bitcoins that is the most concerning to me regarding their tendency to be a vehicle for a bubble is that Bitcoins are backed by nothing; they have no value in themselves and do not represent a promise to deliver, do, or refrain from doing anything. Even gold, whose value many attribute to its relative scarcity and stable supply, has uses in chemical and electronic technology and a prominent place in the marriage traditions of India and in jewelry craft worldwide, all of which underpin its value and mitigate risk in dealing in it. And even national fiat currencies, while some criticize them because they are not redeemable for anything like the gold their predecessors were, have value that is in some sense intrinsic because they must be used to pay taxes and as legal tender they can be used to settle court-adjudicated debts. This is to say nothing of the petrodollar arrangement by which US dollars, commonly held to be a fiat currency, can be seen as being backed in a sense by an extremely important energy commodity.

In the analysis of stock prices and stock market bubbles there is an attempt to distinguish between the fundamental or intrinsic value of a company, which is due to its assets, profitability, and success and prospects in business, and its speculative value, which is due to market perceptions of what the market price of the company’s stock will be in the future. In the sense of this distinction, Bitcoins have only speculative value: the only tie they have to the broader economy is a price determined by their market’s perceptions of what that price will be in the future. They themselves are useful for nothing and are not directly redeemable for anything at all, useful or not.

In models of bubbles such as one in Didier Sornette‘s Why Stock Markets Crash, the intrinsic value of an asset is a baseline around which the speculative price deviates, and a kind of constraint on the speculative price’s deviations, in that some proportion of people in a market can be expected to make investment decisions based on estimates of intrinsic value, while others, with more appetite for risk or gamesmanship, will be willing to make speculative investment decisions, and their interplay determines the final price. My passing familiarity with such models, my familiarity with the history of cases where the tax collection systems, courts, and national reputations that stand behind national fiat currencies’ values have broken down, and my gut feeling on the matter all lead me to believe that an asset whose value is purely speculative, such as the Bitcoin, will have an especially brief and volatile existence before its value crashes. And already 30% to 50% swings in value in a single day have been seen for Bitcoins.

Another troublesome aspect of Bitcoins is that the number in circulation grows, by design, in such a way that the rate of growth slows to a negligible one over a period of two decades or so, with most of the growth occurring, or rather having occurred, in the first few years. (Bitcoins were devised in 2008.) Meanwhile, every other general measure of economic growth in the broader economy is conventionally considered to be exponential in the short term, and long-term data on economic growth of nearly everything resembles a power-law with log-periodic oscillations, and in either case the economy is shown to grow at a rate that either remains constant or increases in time. This assures a growing mismatch between the number of Bitcoins in existence and the general economic value that they would have to reliably measure as a stable currency, and one that will favor early participants in the market more and more in time until the eventual collapse, when those who fail to exit in time, often late entrants waiting for a significant return, are left having paid for a worthless asset (the same pattern of enrichment and impoverishment seen in a pyramid scheme).

This leads me to mention the third troublesome aspect of Bitcoins is that most of the coins created through ‘mining’ of them will be in the hands of early enthusiasts of the system. They thus constitute an insider group with a large incentive to hype the value of Bitcoins to the rest of the world and dump them on whichever greater fools they are able to find or create. We are now witnessing the first broad effort to hype the value of Bitcoins, with the predictable results. Sadly, the final stage of this trajectory is a dramatic collapse, and due to their lack of intrinsic value to stabilize them as an asset I expect the ride to be especially bumpy and brief in the case of Bitcoins.

According to various rubrics, such as Bernard Lietaer‘s here, four key roles that a currency might serve are measure of value, medium of exchange, store of value, and tool for speculative profit, where to be useful as a currency the first two are indispensable, and the last two undermine the second, and speculation undermines both of the first two. Let’s see how Bitcoins look in terms of this rubric:

• Measure of value: Bitcoin prices are set by a purely speculative market where variations in a single day are routinely a significant percentage of Bitcoin total value, making them very poor choices for measuring anything’s value: during the time between you ordering something online and the seller shipping it to you, the price in Bitcoins can easily change by half, to say nothing of doing something like making a contract for long-term business (say over a span of years) in Bitcoins. In keeping with the general behavior of bubbles, this volatility should worsen as time goes on and the bubble nears its collapse. Bitcoins fail as a measure of value.
• Medium of exchange: Bitcoins’ only connection to the rest of the economy is through an extremely volatile speculative market for them. They are not currently broadly accepted as payment despite a certain notorious example, the Silk Road (semi)-anonymous marketplace. They lack any kind of backing, credible or otherwise, in something of broadly accepted value, such as a commodity, by which currencies throughout history typically earn trust as a medium of exchange. Their strong deflationary tendencies will mean that people holding them will much prefer holding them to spending them. Bitcoins fail as a medium of exchange.
• Store of value: Bitcoin prices are extremely volatile and all signs point to their following a severe example of a bubble trajectory ending in a dramatic collapse, with no intrinsic value to put a floor under that collapse. Bitcoins fail as a store of value.
• Tool for speculative profit: I personally think that I could not have engineered a better tool for speculative profit had I been trying for the last ten years. No backing to slow the bubble dynamics down or hinder rapid growth of the system, the pretense of which is behind even the shadiest penny stock pump-and-dump or largest dubious IPO. Enough cryptographic and algorithmic sophistication to the system to give it geek chic and an appearance of integrity and far-sighted design, but not so much that strong anonymity, or anything dispensable to the purpose of running a speculative market, is a feature. A free-money feeling to the activity of mining that has created a group of early adopters who are now carrying everything to its conclusion by acting to get that free money in the form of actual money. And growth is rigged so that those closest to the system at the beginning get the richest. Bingo.

In brief, Bitcoins are a fascinating economic experiment whose conclusion I look forward to eagerly and with great interest. But as far as I can tell, Bitcoins seem much more like a refinement of some of the most systemically dangerous things in the economic system that led to the collapse and the still-dragging-on depression than something likely to challenge such things or provide a meaningful alternative to them.