Will the Bitcoin Bubble Be Validated?

January 4, 2018

“You made the case that current house price inflation is not yet a bubble. How about recent bitcoin inflation?”

Recent bitcoin inflation is at least 90% bubble. Most of the bitcoin purchases that have driven up the price have been speculative, based on the assumption that prices are bound to increase further. The question up for grabs is whether or not the bubble price will be validated by widespread future use of bitcoin as a transaction currency.

Bitcoin Defined

The bitcoin is a decentralized digital currency that allows payments to be made over the internet without an intermediary. A bitcoin is a computer file owned by someone, say A, who can discharge a debt to B through the transfer of the file to B, without any third party involvement. All transactions are recorded in a public file called a “block chain”, and every transaction is checked against that file to assure the integrity of the process.

 New bitcoin comes into existence through “miners” whose computers create it through a time-consuming energy-using process. At some point, however, the outstanding volume of bitcoins will hit a maximum that was built into the system, and mining will cease.

 Bitcoin will be used as a transaction currency to the extent that it comes to be viewed as superior to existing currencies in important applications.

 Bitcoin as Remedy for Currency Mismanagement

The major potential advantage of bitcoin over some existing currencies is its credibility. Bitcoin is transparent to everyone but controllable by no one. This gives it an enormous appeal in countries like Zimbabwe and Venezuela, where the local currencies have lost all credibility because of Government mismanagement. In Venezuela, bitcoin mining has been extensive because of the subsidized cost of the electricity used to power the computers used in mining.

Since currency mismanagement is common, bitcoin may have a future as a partial though perhaps a temporary fix wherever its credibility is needed.

 Bitcoin as a Dominant Currency

It is difficult to visualize bitcoin as the permanent or dominant currency anywhere because of the following shortcomings:  

  • Short-term Value Instability:  The price of bitcoin fluctuates markedly because of speculation. Since no one wants to be paid with assets that can decline sharply in value shortly after they have been received, value instability makes bitcoin a poor medium of exchange. But bitcoin value might become more stable over time.

  • Long-term Value Increase: When the number of bitcoin reaches its maximum, further growth in demand must increase the price of bitcoin, which means that the value of everything else denominated in bitcoin declines. The prevailing view of economists is that declining price levels depress economic growth, which could make policy-makers hostile to bitcoin.

  • Pricing Confusion:  When I checked the price of bitcoin on December 30, 2017, it was $17,367.  That means that the price of a $2 loaf of bread would be .0001104 bitcoin. Many consumers have great difficulty dealing with numbers less than 1, and the more zeroes there are to the right of the decimal, the greater their difficulty.  While this would be a potent barrier to bitcoin becoming the major currency, it would not prevent its use as a second currency, where prices of goods and services were denominated in the primary currency.

  • Difficulty in Accessing Bitcoin:  After all bitcoin mining ceases, the only way a country in need of a credible currency will be able to  obtain bitcoin is to buy it from existing holders. To do that, would-be purchasers must have assets acceptable to potential sellers, including US dollars. That may or may not be the case.

 Bitcoin as the Means of Payment in Specialized Block Chain Systems

The block chain technology developed with the bitcoin system is now being developed for application in a wide range of industries, such as banking, insurance, medical and real estate. The technology has the greatest potential when applied to processes with multiple participants, which includes real estate transactions. It is possible, perhaps even likely, that a means of payment will be integrated into some of these systems, in which case bitcoin would be a logical choice – though it will have competitors!

In sum, bitcoin could be vastly overpriced today, but it might also be vastly underpriced.

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