At a superficial glance, the rocketing value of Bitcoin may seem like an irresistible thrust in the daunting direction of the future. The cryptocurrency is currently trading above $7000 according to Reuters data, compared to $1000 ten months ago. One glaring question which is often overlooked is where exactly is this value derived? Paul Krugman followed this line of questioning back in 2013, and the majority of responses are based on Bitcoin as a means of exchange. Such answers, however, will do little to settle the prudent nerves of Krugman. Current price levels appear to be a speculative bubble, fit to burst all over the flocks of people who believe the currency to be a fail-safe investment.
For the sake of analysing the value of Bitcoin, many effective comparisons can be drawn with established currencies. For any established currency to maintain its value it requires a controlled supply being injected into the economy, traditionally backed by the gold standard but more recently determined by central bank credibility. Restricting the supply of the currency means that pre-existing balances hold their value, thus avoiding price inflation which in extreme cases renders currencies valueless. A classic example is of German hyperinflation in the 1920s, when a single U.S. dollar was worth over 4 trillion marks. For Bitcoin, the supply side cannot be centrally controlled as the currency is not produced by an organisation or institution. However, a complex system known as ‘mining’ enables the currency to continue entering the market at a controlled rate. This is when ‘miners’ solve coding equations to form ‘blockchains’ – a form of anonymous accounting that allows individuals to trade bitcoin from one ‘wallet’ to another. This process requires vast amounts of computing power and electricity, and therefore comes with a cost to potential ‘miners.’ In this way the supply side of Bitcoin is controlled, allowing the currency to store value; a necessity for conventional currencies.
A crash in Bitcoin’s value is therefore far more likely to arise from the demand side. As the currency is not based on any underlying assets, its value is entirely determined by what consumers perceive the value of Bitcoin to be. The use of Bitcoin as a medium of exchange is limited, as the currency is mired by a reputation of solely being used to buy drugs and arms. Bitcoin’s growth is therefore largely underpinned by speculative investment – investment from individuals and organisations who believe that the value of Bitcoin will continue to grow at a fast rate. As is so often the case in financial markets, the subsequent events are a self-fulfilling prophecy. It is believed that Bitcoin will become more valuable, so investment increases. This increase in demand pushes the price up; supposedly proving the investors right. However, since there is no intrinsic value to Bitcoin, this bubble is liable to burst under the slightest strain.
Tulip mania in Dutch markets in the 17th Century is a good example of such a bubble, although the best comparison to draw is with the dotcom bubble in the late 1990s. At the
NASDAQ’s fluctuations experienced during the dotcom bubble
Is Bitcoin about to face a similar fate?
I would therefore suggest that the bursting of the Bitcoin bubble is all but inevitable – it is merely a question of when and how. There are myriad factors that could kickstart the process; government intervention or regulation, sudden mass-selling from a holder of an extremely valuable ‘wallet’, or the emergence of a more secure alternative. The hysteria around cryptocurrencies ought to set alarm bells ringing – keeping an eye to history would serve investors well.