Photos provided by Carolyn Forsyth
The question is not if bitcoin is a bubble; it's a bubble. The issue is when it does pop (or explode) Where will your money be? This article gives you a background in the nature of bitcoin and some questions you can ask your second cousin when he claims he's retiring on his bitcoin fortune.
To bitcoin or not to bitcoin?
There is a tremendous amount of publicity around Bitcoin. There are those who encourage investment (The Winkelvoss Twins) and those who issue warnings (Jamie Dimon). It’s hard to think that you are being smart by not investing when someone points out that the price has gone from $1,000 to $19,000 in a little over 4 years. However, it’s also important to know that Bitcoin is not a currency nor is it an asset (in our current understanding of an asset).
Let’s try to get a handle on what it is. Currency or the “coin of the realm” is a medium of exchange. Currency has two basic benefits. One is that it allows you to purchase something from someone else and the value of the purchase is established. For instance, I want to purchase an acre of land from Farmer Bob down the road. I could ask him to accept 40 sheep for the land and he might agree. What is the value of the transaction? Sheep have a nebulous value until eaten or sheared for their wool. Are the sheep young or old? The same issue goes with the land. Is it mostly hilly and not suitable for farming or is it prime “bottom land?” Is it cleared of trees and ready for farming? For Farmer Bob and me the transaction worked just fine but for anyone else trying to understand what was really paid for the acre, it’s a nightmare.
Currency, as a medium of exchange, works quite well when both parties have faith in the value of the currency. Farmer Bob has some land he wants to sell and he wants $400.00 for it. I have 40 sheep that I sell to the butcher and he pays me $500.00. I can now go to Farmer Bob and pay him $400.00 for the land. Now all of the questions above still exist but a recognized value has been established. Anyone can walk by the land and decide if the purchase was a good deal or a bad deal.
Now the second aspect of currency comes into play. The tax collector is going to know that Farmer Bob has less land and I have more land. I also have less sheep. At some point both Farmer Bob and I have to pay taxes. It’s a whole lot easier for the tax collector if he can collect coins rather than acreage and crops or sheep and lamb chops. Moreover, there’s an established and recognized value to the transactions that makes tax collection more efficient.
Now let’s put Bitcoin into the mix. Same transaction but I want to pay in Bitcoin rather than dollars. Farmer Bob could say sure and I could transfer to him “the equivalent” of $400.00 in Bitcoin or he could require me to convert the Bitcoin to dollars (much like selling the sheep above) relieving him of the transfer risk in Bitcoin. In effect, I am using Bitcoin to hold my dollar assets rather than my checking or savings account.
The issue for Farmer Bob now becomes what do I do with the Bitcoin payment? If he’s already a registered Bitcoin owner he adds it to his account. If not, he has to establish an account and he’s got to monitor the Bitcoin price for any untoward changes in value that he wouldn’t like (if Bitcoin declines in value he has to worry about it or take an action). It’s a bit like going to Canada and having a bunch of Canadian currency in your pocket when you leave. Do you exchange it or do you keep it for your next trip? I’ve got a jar full of Canadian currency on my desk and every time I go to Vancouver, B.C. I try to remember to bring it with me. It’s only good in Canada so next time I hope I remember.
Bitcoin makes a huge deal out of the claim that only 21 million Bitcoins will ever exist (currently 16 million exist). This is what makes Bitcoin go up and down in relative value. If someone decides they want a Bitcoin they will have to purchase one and the transaction will be at the current price. But why the focus on 21 million Bitcoins? What would happen if you added 2 Bitcoins to the 21 million? Will all Bitcoins drop in value 0.0000001%? The Tulip Bulb Craze in the 17th Century probably ended when someone realized that everyone could actually grow more tulips and eventually everyone would have all the tulips (in every conceivable color) that they desired. Once that realization hit home, the price of tulips plummeted. For more information on this follow this link (Tulip Mania). Personally, I believe my argument is more realistic and a lot more likely.
One of the key arguments put forward is that Bitcoin is an “unregulated by governments” currency. This represents an opportunity for those who have illegal operations or are trying to move wealth from one jurisdiction to another presumably in violation of the local laws. Bitcoin uses a distributed network of computers to handle transactions and thus makes it extremely difficult to track individual transactions. However, major financial transactions aren’t currently done in Bitcoin (try to put a Bitcoin in escrow for a home purchase). This means that the “farmers” aren’t taking the risk of a Bitcoin meltdown. That might change in the future but listing your home for sale at 100 Bitcoins might get you on the evening news but it won’t necessarily make your home more saleable to buyers.
Bitcoin is out there and people are free to decide if they want to move their savings/investment dollars into Bitcoin. The run-up is amazing and it’s been called the biggest bubble ever (which isn’t saying a lot because the world economy has progressed dramatically since the 17th Century and even from the Dot.Com Bubble). There are pundits saying “I’m not in it and if I was in it, I would only put money that I was prepared to lose.” That’s not really a heady endorsement but people make their own decisions.
It all comes down to land and sheep. At some point you will want to buy something from Farmer Bob. Do you think he will take Bitcoins, Dollars or sheep? This is the key aspect of the Bitcoin value rise. There is nothing to prevent someone else from creating an alternative to Bitcoin and there is nothing to prevent a government or company from creating alternatives. If there is nothing preventing more Bitcoin-like alternatives it’s a lot like tulip bulbs. You might have the prettiest tulip but, eventually, it’s just a tulip.