Bitcoins and bubbles
The government can do it — why can’t we? The government turns worthless paper into valuable currency; it turns meaningless deposits in Federal Reserve banks into valuable purchasing power. In this electronic age any programmer can create notional electronic credits — shouldn’t they be valuable too? That’s Bitcoin. Its total issue is limited, in principle, and occasional additions to the issue are supposed to be based on solving a family of mathematical problems. It has no guaranteed backing, no guaranteed use, no guaranteed conversion value in dollars or euros. You can’t buy gasoline or food with Bitcoin, nor can you pay your taxes with it. How much is Bitcoin worth? Whatever the consensus of users expects its value to be tomorrow. That’s what a bubble is.
In 2002 notes and coins in a completely new intrinsically worthless (fiat) currency, the EURO, began to circulate. All goods in participating countries were soon priced in euros and euros were accepted as valuable throughout the Euro-zone. Worthless paper was transformed by command of the European Central Bank (ECB) into a valuable tradeable asset. Why can’t a clever programmer do that too? What has the ECB got that any electronic programmer hasn’t? The support of governments, each with police, judiciary, taxing authority, and jails. The governments agreed that euros were acceptable in payment of taxes. And not paying your taxes could get you into trouble. It’s the power to tax that sets government-authorized fiat currency apart from privately issued instruments. The US government jealously guards its currency monopoly: the Stamp Payments Act of 1862 outlaws notes that are “intended to circulate as money or to be received or used in lieu of lawful money of the United States.”
Any asset (including a notional currency) whose value is based only on the expectation of its future value is a ‘bubble.’ Like the tulip bulbs of the 17th century Netherlands, or Las Vegas apartments in 2006. That’s true even for gold, which trades at a price far beyond its dental or jewelry value simply because its holders expect it to be even more valuable in the future. Bubbles eventually burst. In 1975, private ownership of gold was legalized in the US, fully demonetizing gold. Since then the value in of gold in US dollars has varied from $200 per ounce (January 1975) down to $100 (mid 1976), up to $800 (1980) down to $400 (1981), up to $ 1900 (2011), to $1365 (mid 2013). It won’t go to zero only because gold makes nice looking wedding rings. Since the local peak in 1980, gold’s price hasn’t even kept up with inflation.
Bitcoin’s price has varied from a few dollars in January 2012, to a few hundred dollars in April 2013, to under $100 in July 2013. What will its price be in 2014? Whatever its owners and buyers expect the price to be the following day — that’s what a bubble is. When the bubble bursts, the natural stopping point for the price of an intrinsically worthless instrument is zero. Once it gets there, there’s nothing to lift it back up.