I do not
like calling anything a bubble if it's true value cannot really be ascertained.
But for lack of a better term most people refer to the price surge in the value
of bitcoin as a bubble.
While most economists and financial expert agree that bitcoin is a bubble, it will be quite ridiculous to assume that bitcoin should trade at zero since it has infact been used as a form of payment for transactions. The value of the cryptocurrency must then be measured against the relative cost of purchasing such a product or service in dollar terms or any other fiat currency. This concept of currency valuation is known as purchasing power parity.
While to most monetary economists, it is no news to hear that all fiat currency or paper money is a bubble (since the paper in itself is worth nothing), in truth all commodities, products and services are all either in a positive or negative bubble since their intrinsic value cannot be ascertained easily or universally accepted. The only reason why paper money is generally accepted is trust in the Central Bank that they will do everything possible to protect the value of the currency.
Still what is most baffling about this cryptomania is that each cryptocurrency is valued relative to the dollar and there is still no crypto to crypto exchange rate like is popularly done with paper currency (at least none that I know of). This must be because these currencies are not mostly used as a medium or exchange or as a store of value, rather it is used as form of investment or an escape from paper money and banking trail.
The danger of treating a cryptocurrency as a form of investment is that since investors are rational, they will only purchase an asset if they truly believe there is possibility of an upside in the price or value of such asset over time. Based on this belief, they act in a manner that in fact causes the asset price to increase regardless of whether the fundamental supports that increase or not.
Usually when fundamentals do not support the price increase like many including myself believe is the current case of bitcoin, the price reverses to a more rational level. Only time will tell if we are right but what is true is that after two bitcoin crashes in 2011 and 2013, the price did not drop to zero. In 2011, bitcoin price fell around 99% and in 2013, price fell about 78%. If that happens again in 2018, the economic consequence will be far greater than the total loss in market cap on bitcoin at the time because the millions of people who have poured their savings into the currency will suddenly become either bankrupt or broke thereby hurting aggregate demand.
I opine that like the dotcom bubble, the cryptobubble will explode but the price explosion will not weaken the case for a better working cryptocurrency financial system as it did not weaken the case for the internet in 2000. What will happen in fact is that government regulations will enter the crypto market and could effectively seize the technology all together as we begin to see institutions like the Federal Reserve Bank of America create things like cryptodollar which will be more welcomed by the economic and business community.
Part of the key challenges with the cryptomarket today is the wild price volatility which is almost unprecedented. To control the price of bitcoins, supply of bitcoin will have to rise proportionately to the increase in its demand. For bitcoin though, the single fact that it has a finite number of coins that can be mined meant that it was designed to be a bubble asset and it cannot be used as a global currency. The reason is that the world will continue to create value in excess of the current stock of money and if money fails to increase to account for the increase in output deflation occurs and its effect on supply can cripple an economy like Japan experienced in the 1990s. It is also for this reason that America went off the gold standard so that the Federal reserve can be allowed to print paper money in excess of the gold reserve to satisfy the ever-growing demand for dollar.
Excess printing of fiat currency though leads to inflation which is what the creators of bitcoin sought to solve by creating a digital gold which could not suffer inflation. However, what they have achieved with bitcoin as a currency is steep deflation as continuous increase in the value of the currency means people have to spend less (almost daily now with the daily price growth) to purchase the same amount of goods using bitcoin. Deflation is the opposite of inflation and even more scarier to economists than the latter.
In the end, the value of bitcoin will be determined by it's generally accepted purpose. The purpose I refer to is not what Satoshi Nakamoto (the founder of bitcoin) intended for bitcoin but rather how the world chooses to use his intelligent creation. If the world decides to treat bitcoin as a currency, then it will probably be worth 99% less than its value today for convenience as a medium of exchange. But if it is treated as an asset class, a store of value or for lack of a better word, a digital gold then it's current value may be justified, and it could be worth a lot more tomorrow or a little less, who knows?
My advice to intending bitcoin investors is to ask themselves if this digital currency should really be trading at more than 10 times the value of an ounce of gold because if it shouldn't be worth that much then you are investing in a bubble. And we all know how bubbles end, POP!
While most economists and financial expert agree that bitcoin is a bubble, it will be quite ridiculous to assume that bitcoin should trade at zero since it has infact been used as a form of payment for transactions. The value of the cryptocurrency must then be measured against the relative cost of purchasing such a product or service in dollar terms or any other fiat currency. This concept of currency valuation is known as purchasing power parity.
While to most monetary economists, it is no news to hear that all fiat currency or paper money is a bubble (since the paper in itself is worth nothing), in truth all commodities, products and services are all either in a positive or negative bubble since their intrinsic value cannot be ascertained easily or universally accepted. The only reason why paper money is generally accepted is trust in the Central Bank that they will do everything possible to protect the value of the currency.
Still what is most baffling about this cryptomania is that each cryptocurrency is valued relative to the dollar and there is still no crypto to crypto exchange rate like is popularly done with paper currency (at least none that I know of). This must be because these currencies are not mostly used as a medium or exchange or as a store of value, rather it is used as form of investment or an escape from paper money and banking trail.
The danger of treating a cryptocurrency as a form of investment is that since investors are rational, they will only purchase an asset if they truly believe there is possibility of an upside in the price or value of such asset over time. Based on this belief, they act in a manner that in fact causes the asset price to increase regardless of whether the fundamental supports that increase or not.
Usually when fundamentals do not support the price increase like many including myself believe is the current case of bitcoin, the price reverses to a more rational level. Only time will tell if we are right but what is true is that after two bitcoin crashes in 2011 and 2013, the price did not drop to zero. In 2011, bitcoin price fell around 99% and in 2013, price fell about 78%. If that happens again in 2018, the economic consequence will be far greater than the total loss in market cap on bitcoin at the time because the millions of people who have poured their savings into the currency will suddenly become either bankrupt or broke thereby hurting aggregate demand.
I opine that like the dotcom bubble, the cryptobubble will explode but the price explosion will not weaken the case for a better working cryptocurrency financial system as it did not weaken the case for the internet in 2000. What will happen in fact is that government regulations will enter the crypto market and could effectively seize the technology all together as we begin to see institutions like the Federal Reserve Bank of America create things like cryptodollar which will be more welcomed by the economic and business community.
Part of the key challenges with the cryptomarket today is the wild price volatility which is almost unprecedented. To control the price of bitcoins, supply of bitcoin will have to rise proportionately to the increase in its demand. For bitcoin though, the single fact that it has a finite number of coins that can be mined meant that it was designed to be a bubble asset and it cannot be used as a global currency. The reason is that the world will continue to create value in excess of the current stock of money and if money fails to increase to account for the increase in output deflation occurs and its effect on supply can cripple an economy like Japan experienced in the 1990s. It is also for this reason that America went off the gold standard so that the Federal reserve can be allowed to print paper money in excess of the gold reserve to satisfy the ever-growing demand for dollar.
Excess printing of fiat currency though leads to inflation which is what the creators of bitcoin sought to solve by creating a digital gold which could not suffer inflation. However, what they have achieved with bitcoin as a currency is steep deflation as continuous increase in the value of the currency means people have to spend less (almost daily now with the daily price growth) to purchase the same amount of goods using bitcoin. Deflation is the opposite of inflation and even more scarier to economists than the latter.
In the end, the value of bitcoin will be determined by it's generally accepted purpose. The purpose I refer to is not what Satoshi Nakamoto (the founder of bitcoin) intended for bitcoin but rather how the world chooses to use his intelligent creation. If the world decides to treat bitcoin as a currency, then it will probably be worth 99% less than its value today for convenience as a medium of exchange. But if it is treated as an asset class, a store of value or for lack of a better word, a digital gold then it's current value may be justified, and it could be worth a lot more tomorrow or a little less, who knows?
My advice to intending bitcoin investors is to ask themselves if this digital currency should really be trading at more than 10 times the value of an ounce of gold because if it shouldn't be worth that much then you are investing in a bubble. And we all know how bubbles end, POP!
Emeka Ucheaga
Managing Partner,
Emeka Ucheaga Advisory
Nice post EMEKA.
ReplyDeleteIs it impossible that the amount of bicoins that can be mined can become infinite, maybe by some new technology or so?