On November 28th, 2013, I wrote a blog post about the Bitcoin with some explanation what the money supply of the Bitcoins is and how the value may evolve. I said many things about the substance that I still believe to be true but I also included a prophesy – which was also included in the title – that the Bitcoin bubble would probably await some new peaks before it bursts.
With the hindsight, I tend to think that my prophesy was completely wrong. I am not a good prophet – because there are probably no good prophets allowed by the laws of physics. November 2013 when I wrote the blog post was actually the month when the price of the Bitcoin peaked. On November 17th, 2013, the price surpassed $1,200 at MtGox but it was before I wrote the blog post where I already talked about the "current price near $1,000", so you couldn't earn any more money by the extra investments.
Since that time, the bitcoin-to-dollar ratio dropped from those $1,000 or $1,200 to $307 today, by a factor more than three. It's easy to see that the drop of the Bitcoin surpassed the drop of the Russian rouble and the Ukrainian hryvnia (they're similar, after the recovery of the rouble yesterday).
Bitcoin was already voted the worst investment of 2014. So I hope that no TRF reader interpreted my 2013 blog post as invitation to make any substantial investments into the Bitcoin.
The 70% drop in a year is bound to undermine the confidence of many people that they may use the Bitcoin for savings and investments. It may easily happen in 2015 or the following years, too. The potential for a spectacular growth has shrunk and you just don't want an investment that is likely to drop by 70% in a year.
The Bitcoin fans don't seem to care about the value of one Bitcoin and its dynamics at all.
They seem to be focused on some technicalities of the payments – the anonymity and decentralization of the "log" that remembers all the transfers. You know, from a theoretical viewpoint, I think that the solution to the mathematical problem how to guarantee the "decentralized record" of the payments etc. is a cute piece of mathematics.
However, I don't think that this theoretical cuteness translates to any practical virtues. I don't really want a currency or a payment system to be completely decentralized, independent from a "state". If someone robs me in some way, I want to have a place to complain, to fix something that are obvious errors or frauds even though a human judge is needed to see it. I don't want the anonymity to be absolute because in serious enough circumstances, it's simply right to find out who made a certain transaction.
Equally importantly, as I have already suggested, the proponents ignore all the economic complaints. They say that the price of one Bitcoin – and the stability of the price of products if expressed in Bitcoins – is irrelevant. But that's just silly. If the Bitcoin or anything else were supposed to serve as a currency, as the name indicates, the prices of products bought for that currency should be stabilized or determined "from the first principles". They should not rely on the price in a conventional currency that is converted to the constantly changing price in the Bitcoins.
If the dollar price is still used to calculate the Bitcoin price, then the Bitcoin is just a payment system to pay dollar-denominated prices, and I think that an inconvenient one. You first need to convert your cash from the conventional currency to the Bitcoin to buy something – which is a lot of hassle – and then use the Bitcoin to pay. Or you accept Bitcoins and you must immediately convert them back to a conventional currency because you don't know what will happen with the value of those Bitcoins.
Some mechanisms of the price stability (or predictable inflation rate) in a given currency are absolutely necessary. Central banks target the inflation rate, either because of official or semiofficial rules or due to some tradition and expectations. The U.S. dollar is such an important reserve currency partly because the total amount of savings in the world that are stored in them is large. This "large mass" gives the dollar a "large inertia" which is a reason to expect that the average prices of "other things" won't change dramatically.
Like the gold fanatics, the Bitcoin enthusiasts like to talk about the solid, not evaporating nature of these alternative currencies and the gold or Bitcoin savings. You can't create these commodities or crypto-currencies out of thin air! You can't but it's irrelevant. It doesn't mean that the real value of your savings won't plummet. The real value of the gold savings dropped by 35% since the 2011 peak, and the real value of the Bitcoin savings dropped by 70% in a year. It's primarily the exchange rate that matters and you simply can't overlook the rate – and the things that drive it – because it's the key issue.
So of course that a fiat currency may be more reliable than these "unproducible" alternative currencies like gold or the Bitcoin and the year 2014 was another example of that.
But there's a related, equally important point. Even if the gold savings or the Bitcoin savings were guaranteed not to lose their value, it wouldn't be a virtue for their being a currency. The reason is that if something is guaranteed to gain value – because an increasing number of increasingly wealthy people in the world need to use the fixed amount of gold or the Bitcoins – they just won't get rid of these remarkable investment tools. Whoever has these hypothetical precious, guaranteed-to-grow commodities and numbers on the hard disk, will keep them "forever". It's better to keep them than to own houses, cars, and so on. The payments done in Bitcoins will be limited to the minimum for this reason and even the people who own the Bitcoins will try to find something else to use for the payments, something that is not this miraculous.
This problem may be described in a simpler way. The gold and Bitcoin fanatics seem to care about the savers – but they don't care about the borrowers. But in a healthy economy, savers are partly lenders and lenders and borrowers are equally important, two parts of an important transaction. So everything that is good for the savers would be bad for the borrowers. The optimum situation for the system is not the situation that maximizes the virtues for the savers, or one that maximizes the advantages for the borrowers. It is some balance between the two. And at least some aspects of the balance – the long-term real interest rates – are unavoidably dictated by the free markets, regardless of the currency system.
If I return to the paragraph before the previous one, one should realize that the very derivation what would happen if there were this "miraculous guaranteed to grow investment tool" has one extra implication: such an investment tool obviously cannot exist. If something is really guaranteed to grow forever (and, let's assume, at a higher rate than what you could get anywhere else as long as it is safe enough for you), you don't ever want to get rid of it. But if you know that it will never be used to bring you some great products, services, or luxury, then its actual price for you (and even your descendants – we assume that the investment will keep on being miraculous in the future) is zero.
So the whole calculation assuming that the value of the Bitcoin or the gold would safely grow has to be wrong or inconsistent. As I already said, it's of course wrong because it completely ignores the actual mechanisms that decide about the price of gold or the price of one Bitcoin: the supply and demand. In the hypothetical situation where the gold or the Bitcoin is so marvelous for the savers, the supply drops to zero (no one wants to lose his miraculous Bitcoins or gold) which actually means that the price of the gold or the Bitcoin is incalculable, like the 0/0 indeterminate form.
This intedeterminate form may be zero or one or 307 or infinity and they're very different results. But these big differences are irrelevant, too, because there are no exchanges occurring that would use this miraculously growing currency.
In the real world, no investment tool can ever achieve this "absolute" status. Everything has a finite price and the price is dictated by the supply and demand. The more lively the trading involving the object is, the more accurately its price may be expressed from the market transactions. Everything is equal.
From some purely material viewpoint, the intrinsic price of the gold, the Bitcoin, or the U.S. dollar banknotes is zero. In all cases. Unlike the Russian caviar, those things can't be eaten and they can't be directly used for almost any other practical things, either. Almost all of their high price in the real world is indirect. They have a big value because they're viewed as currencies, to one extent or another, and this adds some (huge) "premium" to their value.
In the case of the pictures of Benjamin Franklin, the "premium" is most spectacular, in absolute terms. The pictures would cost much less than $1 if there were not this whole culture saying that "you can get almost everything for these pictures". But because the whole world has been preprogrammed to assign some value to the banknotes, everyone takes this value for granted. The value has a huge inertia because the supply and demand can't "radically change". The Federal Reserve almost certainly won't be pouring quadrillion dollars from the helicopters without doing anything that actually compensates almost all of these maneuvers – it is extremely unlikely because it's also illegal – and the rest of the world believes that such a high value of their wealth and obligation is denominated in the U.S. dollars that this world can't really "conspire" to do something that would suddenly change the value of the dollar dramatically – or, equivalently, that would immediately change the value of everything expressed in the dollars.
Just exaggerate a little bit. Imagine that 99% of the people's wealth is in the U.S. dollars and there are N dollars in the world. In that case, one U.S. dollar can be pretty much defined as 1/N of the mankind's wealth. And the mankind's wealth is naturally an almost stable unit of wealth (even if the mankind gets richer or poorer, comparing yourself with "everyone else combined" is just a natural way to quantify how rich you are), and that's why the same thing holds for the U.S. dollar.
The dramatic change of "all prices in dollars" won't occur simply because these prices – and various promised salaries, pensions, obligations, debt etc. – have fixed numerical values written in the U.S. dollars and those things are the cause of the inertia and stability of the U.S. dollar. Price stickers in the supermarkets may be rewritten and countries with inflating currencies have to do it much more often. But even in the modern world, even this "trivial" operation is nontrivial and the existing stickers in the shops are actually a significant portion of the reason why the value of the conventional currencies is largely fixed.
However, contracts, treaties, commitments, and bonds play an even larger role for this inertia. People and companies realize (sometimes long-term) construction projects for a pre-agreed number of dollars (or another conventional currency), the governments promise to pay a certain amount of dollars (or other currencies) as pensions and other things, and all these (medium-term and long-term) treaties help to define the actual value of the currency for the following years. They more or less guarantee that the value of the U.S. dollar (relatively to some inclusive and objective enough basket of things you may buy) won't change by a factor of 3 in 3 years.
Many things may change but some people are still promised to be getting $1 million for something in 2017. While you may say that you don't know what one U.S. dollar will mean in 2017, you may know that $1 million is the same thing that a hockey player will be getting somewhere, and it's not bad. You also know that it's equal to N' times the average pension somewhere, or the debt that someone will have to repay to someone else, and so on. Those are the things that allow you to plan in the U.S. dollars – the U.S. dollars are a good unit of wealth even for the future planning. And that's essential.
Similar considerations must be applied to other currencies but also to gold and the Bitcoin. Their "direct" and "intrinsic" value is near zero, as I explained. But their actual value depends on the "currency premium" – how big a portion of the savings has been converted to this form. If someone could guarantee that all the people in the world will agree to convert all of their cash savings to gold and the world will use it, then indeed, it's clear that during the process, the price of the gold would have to increase by a factor of 100 or 1,000 and by the assumptions, gold would be able to back all of the global savings and the world economy again. The price would be $1 million per ounce, or something like that, and it would be very unpractical to use it.
But of course that in the real world, no one will convince the people to be getting this ever smaller amount of gold for their dollar savings. The people who already had gold before this operation would be in a huge advantage. They would be made 100 or 1,000 richer than those who bought the gold at the insanely elevated price. And everyone, at least everyone who was already buying at the insanely high price, will agree it's unfair. They just won't agree that they should switch to the "new currency". Why should they be doing it? It is clearly against their interests. It is a plot of the old owners of gold to get richer. It would make the new buyers of gold relatively poorer – by orders of magnitude – if they are compared with the chosen ones who had lots of this "new currency" before it became the new currency.
So this "switching to a new currency" accompanied by a drastic increase of the premium associated with a currency just won't happen in the real world, at least not in any short enough time scale. Everyone would know that someone (the early adopters) would benefit and others would lose. If you realistically want to switch to a new currency, it is actually absolutely critical that the number of the "new coins N" is variable and it is being adjusted so that the rate (analogous to a temperature or a chemical potential in thermodynamics) is kept more or less fixed during the switching process – the exact opposite of what the "currencies celebrated because they can't be produced out of thin air" promise. It is very important for a new currency that should replace the existing ones to be produced out of thin air so that the rate, and not the number of the "new coins", is fixed! The gold and Bitcoin fanatics are celebrating a lethal economic flaw of a would-be currency as a virtue.
The very same ideas apply to the Bitcoin or anything else. The number of the Bitcoins is guaranteed to be below 21 million – the maximum reached around the year 2140, by the Holy Scriptures of the Bitcoin. The deviation from this "ultimate upper bound" is decreasing exponentially with time so we're almost there, anyway – the number of the Bitcoins is about 13 million now and is growing rather slowly.
Because of this more or less fixed number of the Bitcoins, the price of one Bitcoin would have to grow by more than 4 orders of magnitude for the Bitcoin to match the part of the world economy denominated in the U.S. dollars. So if the whole world were supposed to switch from the U.S. dollars to the Bitcoins, it would mean that the people will be converting their savings etc. from the conventional currencies to the Bitcoins at an increasing price – because the "currency premium" of the Bitcoin would strengthen along with its currency status.
But it's very clear that you can't get too far. At some point, people who are still mostly in the conventional currencies (all of the people) start to ask whether they may survive or keep their wealth or anything if they convert everything (or too much) into the Bitcoin. The old dollars still work – to "ban them" immediately is impossible (at least without a huge crash) – so aren't they better than the new Bitcoins, the people would ask? Because by that moment, it's totally clear to everyone that almost all the Bitcoin price is the "currency premium", they will inevitably start to ask whether this "currency premium" is sustainable.
And it's only sustainable if the Bitcoin is actually able to work as a functional currency, similar to the U.S. dollar. The mythical "final state" world where the U.S. dollars are completely replaced by the Bitcoins is theoretically conceivable. The stability of the Bitcoins would be determined by the same "stickers" and "numbers written on bonds and pension laws and other treaties with compensations" as those I described in the case of the U.S. dollar. There is no difference.
But the problem is that we can't get to that point. To get to the middle of the road, the Bitcoin would have to become a "pretty good usable currency" in the middle of the process so that it can go further. But it won't become a pretty good currency because no significant loans and long-term commitments will be denominated in the Bitcoins. To borrow X Bitcoins for a year or two is a very risky thing because the price of one Bitcoin may grow 10 times and you will have to pay 900% interest rates. You may make a profit if the Bitcoin goes down, too. But it's the other way around for the lender. You may lose almost everything if the price of one Bitcoin goes down while you can make a big profit if the price goes up.
It's a big lottery for both sides of the Bitcoin loan. And it's a speculation which side is more likely to benefit etc. because you don't know for sure whether the Bitcoin has already peaked. But in the absence of any numerically fixed contracts, price stickers, and even in the absence of any other mechanism that would stabilize the price of the Bitcoin, the price will simply never be stabilized. So the Bitcoin can never really get a "really big currency premium" that would make the total value of all Bitcoins comparable to the value of the U.S. dollars (or at least Czech crowns) in circulation. It cannot simply because it is not really a currency.
And because we know it will never happen, it's a waste of time, and that's why we may conclude that the very high price of the otherwise worthless Bitcoin is just due to its "temporary mirage currency status" that can't last because the road towards the real currency status is mathematically impossible – and the Bitcoin is therefore a bubble that is guaranteed to burst or fade away. And I feel that the year 2014 is already making this "sketch of the future" rather obvious.
If you want to introduce a new currency that is supposed to become the new one in a whole nation or be comparable in influence to a national currency, you simply have to guarantee some mechanisms that stabilize the value of this new currency relatively to the old one(s) or relatively to something else. In the case of new national currencies – or newly reformed national currencies – the policymakers often choose to peg their currency to another one, or a basket of other currencies, sometimes strictly, sometimes within some bands, and so on. Obviously, their ability to control the number of new coins and banknotes in circulation is essential for their control over the exchange rate.
(I am writing these things about pegging as a guy who has "lived" through the process of making the Czechoslovak crown convertible after the Velvet Revolution. Big changes like that may potentially cause havoc and Czechoslovakia avoided it in the safest and most conservative way, and we didn't really allow any inflation of the type known in Poland or Hungary or elsewhere. Pegging to a basket of currency has been used for years.)
When you achieve this stabilization, at least approximately, it becomes irrelevant whether you own the old currency that the new one was pegged to, or the new one. People are not afraid to borrow in the new currency which is why contracts, treaties, and price stickers denominated in the new currencies start to spread, and those are the reasons why the value of the new currency may be stabilized. But with no inflation targeting or pegging of the new currency to anything stable, its price is guaranteed to oscillate unpredictably (perhaps by those 70% a year that we saw in the Bitcoin's story of 2014) which prevents the adoption of this currency by anyone who actually needs to quantitatively plan the future.