Bitcoin – is it worth anything?

Bitcoin
Bitcoin

If you had bought $400 worth of bitcoin in 2012, it would be worth over a million dollars today! Bollocks! All this time I’d dismissed it as a worthless fad. It may still be a fad but some have made a pretty penny. Recently I heard one economist say that the price was probably heading for a fall but it could still double before that happens. So should we buy bitcoin?

I’m not really concerned here with the technicalities but for those who don’t know, Bitcoin is a virtual cryptocurrency with an infrastructure distributed globally over numerous computers. The total quantity of bitcoin is capped, there is no central control and payments are anonymous.

Since the technology is well understood anybody can create a cryptocurrency and competing cryptocurrencies do exist. There are around 40 of the  but what I’m interested in is: are they worth anything?

Since the global financial crisis I have pondered the nature of money and wondered why a dollar or a pound has any value at all. In days gone by, a pound was worth a fixed amount of gold. The Bank of England promised to pay in gold for each pound note in circulation. The pound was a promissory note; an IOU. However, the Western world came off the gold standard in 1971 and, since then, most currencies float freely. They are, what are known as, “fiat money” without intrinsic value, established as money by government regulation.

So now, when we ask why the pound is worth anything, the answer is more tricky. One reason for sterling having value to me is that other people believe is has value. If the vast majority of British people accept sterling as payment for debt then having a few pounds in your pocket is useful irrespective of the rational. Broad acceptance endows a currency with value. In countries which have experienced hyper-inflation the currency loses credibility and is not accepted for transactions. People resort to other payment methods. The Zimbabwe currency became so worthless that the whole country switched to using the U.S. dollar.

The pound is broadly accepted and backed by the British government. Bitcoin is starting to gain acceptance but the lack of official endorsement deterred me.

Built to impress
Built to impress

But does the phrase “backed by the British government” have any meaning? I’d argue that it does. Whether we like it or not the British government can force acceptance by demanding that certain transactions are denominated in sterling. Tax for example. By demanding payment of tax in sterling the British government creates demand and therefore acceptance.

I heard one “expert” claimed that Bitcoin was not a currency but a commodity like gold. The analogy with gold is interesting. Like tin or copper, gold has intrinsic value in that it can be used to manufacturer electronics or jewelry. Bitcoin has no intrinsic value but, like gold, bitcoin have a defined quantity (at least on planet Earth) and that is a useful feature for a currency. What really makes gold similar to bitcoin is that gold has traditionally played a role as a store of value irrespective of its intrinsic value. Gold has a sort of de facto acceptance based on tradition.

The role of money is far more complex and subtle than is commonly understood. One economist said to me recently that money isn’t money if it does not move. By this he meant that if the government took 2 billion pounds in cash, buried it in a hole in the ground and forgot about it then, after an initial revaluation of remaining currency, it would cease to have any influence on economics. Having been taken out of circulation it would no longer serve the purpose of money.

An accountant friend once explained to me that the price of an asset is not dependent on the quantity of that asset but on the quantity in the market. For example, London house prices are usually over a million pounds but if all the houses in London suddenly came onto the market at the same time then the house prices would plummet. It is similar with money. Money must circulate. It must be in the market. That is its role which is why there is far less physical, and even electronic money, (M0) in circulation than the market value of all the assets. It’s a bit hard to get your head around. Perhaps money is no more than an economic lubricant?

Rai
Big Money

Traditional currencies shed light on the nature of money. Some form of money based on sea shells appears to have been found on almost every continent. The people of Micronesia used large 12ft stone donuts known as Rai. It did not matter that these stones could not physically circulate easily. Records were kept of who owned various fractions of the Rai, and most interestingly, when a Rai was being moved to a new location and was lost at sea the wise people of Micronesia realised that the physical presence of the object was irrelevant. The ownership of the various fractions of the object continued. In effect, their money was not the Rai itself, but the records of the ownership of the Rai. Their money was simply accounts of worthless assets – Sounds a bit like bitcoin. So in a very real sense money need have no intrinsic value at all. It merely requires common acceptance or demand.

One aspect that put me off bitcoin was that it was just a bunch of computers some of which were probably sitting in some geek’s bedroom. Surely that must make it worthless?

But let’s do a thought experiment: The computer gaming market was said to be worth more than $25 billion in 2014. Many games such as Warcraft place the player in a virtual world were it is possible to buy and sell items. In some of these games it is possible to cheat by paying real money to increase your points in the game or to add new features. What we have in effect is a virtual currency within the game. Now suppose that you earned a lot of this virtual currency and then the manufacturers discontinued Warcraft and brought out something else. They aught to allow you to transfer that money to the new game. Now suppose that the makers of games worldwide decided that supporting payment software was too expensive so they outsourced this to a software service supplier who supported various game makers. Many computer games would be able to use the same virtual currency.

The question is: Would the currency have value?

Well it would have value to game players as they could use it to purchase assets within the games; swords, castles and whatnot. Because of this demand it might also have value for people who did not play the game.

Take another leap of faith with me here and imagine that the currency could be withdrawn. A payment made to your bank account in your local currency. The exchange rate floating like any other currency.

Say I registered an account and did not play the game but a friend on the other side of the world owed me money. He could play the game and give me some virtual currency. He could pay dollars into the game in New York and I could withdraw sterling in London.

Now suppose that everyone in the world suddenly grew bored with computer games and stopped playing. What would be left would be a payment infrastructure. It would still be possible to buy and sell the virtual currency but answer me this? Is the currency worth anything?

It seems to me that this is pretty close to the situation we have with bitcoin? If the price of bitcoin were pegged to the dollar then it would be seen as a very clever, robust and anonymous payment system. The fact that it floats might, perhaps, make it a currency.

The drivers for bitcoin value are acceptability and demand. As with all currencies and assets, part of the demand is speculation. People think the price will rise, so they buy bitcoin and the demand forces the price up. The demand for bitcoin may have been accentuated by irrational speculation which has gone unchecked because of an inability to short sell. Short selling is controversial but is claimed to play an important role in capital markets for a variety of reasons, “including more efficient price discovery, mitigating price bubbles, increasing market liquidity, facilitating hedging and other risk management activities”. Well brokers are now starting to offer this facility so it’s possible that the bitcoin bubble may soon burst. Perhaps it’s time to sell?

On the other hand, there is another demand for bitcoin and that is for anonymous transactions. i.e crime. According to Forbes the cost of world wide cyber crime alone could reach $2 Trillion by 2019! That’s almost the total GDP of the United Kingdom. That a lot of demand! Perhaps it’s time to buy?

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