Bitcoin: cutting through the hype

Bitcoin has had a lot of publicity over the past year and has gone through several cycles of its value fluctuating wildly. This has given reason to some to discard it as something doomed to fail eventually and the people who have invested money in it to lose their all money. However, I believe that the current turbulence in the bitcoin world is more akin to the gold rush of the nineteenth century than to the tulip bubble in my home country in the seventeenth century. Ultimately tulips became worthless and gold has been a stable factor in the world’s economy ever since people learned how to melt it.

Tulips were rare flowers that only grew in particular regions (Turkey) and consequently, they were somewhat rare in seventeenth century Amsterdam where the stock market had just been invented. Fortunes were made and lost by people trading bits of paper and they were essentially gambling on the success or failure of trade missions to the far east, the prices of common goods, and indeed tulips. Basically the value of tulips continued to increase until finally somebody figured out how to grow them in large quantities near Amsterdam and they ceased to be a rare good. At that point the price collapsed and the first stock crisis happened.

Very interesting, but Bitcoin is fundamentally very different from tulips. By design it is more similar to gold and consequently what we are currently seeing is more akin to the gold rush than to the tulip crisis. Basically, during the gold rush, people and economy flocked to regions where gold was rumored to be available in large quantities. This resulted in a lot of economic activity that ultimately collapsed when it became clear there was little gold to be found. Gold remained scarce and kept its value.

Like bitcoin, gold has very little practical utility beyond some niche applications in electronics and as a way of decorating wealthy people with a severe lack of good taste. Its value is primarily based on the notion of scarcity. The notion of money is based on trading goods and services (i.e. stuff that results from economic activity) for something abstract that has the properties of being scarce and somewhat stable in value. Actually, the seventeenth century is quite illustrative regarding this as well as the discovery of large quantities of silver in South America by the Spanish wreaked havoc on the value of the associated coinage.

My favorite author Neal Stephenson has written several novels that have currency as a central theme. I’m a big fan of his work and would recommend dedicating substantial amounts of time to digesting his oeuvre to anyone who is not afraid of picking up novels of around a thousand pages each. His Baroque cycle, a historical science fiction trilogy set in the seventeenth century, is all about emergence of many modern economic concepts such as bank notes, stock markets, etc. The Cryptonomicon is partly about cryptographic currency backed by gold (sounds familiar?) and the both the Diamond Age and Snow crash feature bitcoin like digital currency that has largely displaced conventional currency and in the process also has transformed society as governments no longer control the flow of money and consequently are starved of taxes. Perhaps these latter two novels are the best way to think of bitcoin as it is obviously influenced by these novels (and similar ones) and because it has been explicitly designed to disrupt the monetary system in a similar way.

Perhaps it is better to step back and consider this design. Bitcoin is all about artificial scarcity. First of all there is a finite amount of bitcoin: there are only 21 million of them and not all of them have been ‘mined’ yet. This number is important in the sense that it is very different from e.g. dollars of which there are trillions in circulation and of which more are printed constantly. This cannot happen with bitcoin. It’s more similar to gold than to dollars in the sense that there is a finite amount of gold on this planet of which we have harvested most of the easily accessible bits by now.

Bitcoin mining is the process by which bitcoins come into existence and it is the source of much confusion and bullshit in the media. The best way to think about it is as solving hard mathematical problems that require increasing amounts of computer infrastructure to resolve. People willing to invest in such infrastructure can harvest fresh bitcoin, until it runs out of course. The process of mining is similarly hard to mining for gold and gets progressively harder, just like finding new supplies of gold in the earth is quite hard. This is by design. The technicalities of this mining process are a lot harder to understand than digging for gold but fundamentally it is the same, down to the notion of people making good money of selling the proverbial shovels (i.e. computer hardware). The important thing to realize is that there is a finite amount of it and once that has been mined, we’ll have to do with 21 billion bitcoins.

Assuming the many experts that have vetted the technicalities are right, there are no known ways to compromise either the mining process or the hard cap of 21 million bitcoins. Only compromising the technology would cause the bitcoin bubble to burst. Assuming that is impossible (and that’s the big question), the bubble won’t burst and bit coin could be here to stay.

So, lets look at its value. The big news this week was that bit coin has crossed the 1000$ valuation mark. That sounds great for people who bought it in the days that it was worth mere dollars and there are indeed plenty of stories of people who have made (or lost) a fortune in bit coin. Given the hard cap of 21 million bitcoins, the current size of the bitcoin economy is around 10 Billion when measured in dollars (half of mined 21 billion bitcoins). That’s not a lot considering the total size of the world economy is in the order of about 80 trillion dollar. And this brings me to the crucial point: if bitcoin starts replacing conventional currency in any significant way, its current valuation is going to be peanuts. Lets round up the world gross product to 100 trillion. Surely, growth, inflation, etc will cause it to be close to that soon anyway and it is a convenient number. Now assume that one thousanth of the world economy is going to use bit coin at some point in the future. That would require the exchange rate to be about ten times it current valuation, i.e. a 100 billion rather than 10 billion or a nice 10000K for a single bitcoin. If you expand that to a single percent of the world economy, the exchange rate would be closer to 100K. I could see that happen, all it takes is more people using it.

People investing in bitcoin as a way to get rich are speculating on the growth of the bit coin economy proportional to the rest of the economy. There are a lot of question marks around bitcoin still that have to do with legislation, government control, etc. My view on this is simple: there’s nothing stopping national banks keeping stashes of bitcoin around in the same way that they are keeping gold around to back the value of their currencies (or at least pretend to do so). Indeed, assuming they would do that, it would vastly boost the legitimacy of bitcoin as a currency and thus help to ensure that the value of its economy increases. Ultimately the value of money is a function of economic activity. So this should lead to some notion of stability in the bitcoin world. The current bitcoin market is volatile because there are very few bitcoins around and a handful of players have disproportionally large amounts of them. These few players can influence the supply and demand and there are some strong hints that their speculative behavior is currently causing these wild fluctuations in valuation.

Consider for a moment the hypothetical situation that the US federal reserve was robbed by a bunch of evil crooks who could destroy the economy at will simply by buying/selling gold (which is what national banks do on a pretty large scale). That’s essentially the plot of Goldfinger. And it is sort of the equivalent of shady characters getting their hands on and deciding to buy/sell bitcoin in large quantities. That’s both disruptive and disturbing. National banks wielding such power is one thing but at least they are somewhat kept in check by their governments (which in some cases can be pretty shady as well) but leaving such power to criminals, drug dealers, etc. might not be in the interest of society. So, a big problem would be somebody owning a 1000000 bitcoins today, which is a small fortune today already but insignificant to the economy as a whole. Suppose this person just sits on this stash while bitcoin revolutionizes the economy as we know it over the next few decades or so. Fast forward to 2030 and this person, who is now a very rich billionaire (equivalent of Bill Gates), decides to spend/sell all of it. You can cause quite a bit of trouble spending billions of cash. However, mostly people hoarding cash is bad for economies and people spending it is actually good since it increases economic activity. Ultimately it is like having a huge stash of gold and suddenly deciding to spend it. It would temporarily destabilize the value of gold but given that gold continues to be scarce overall, it would ultimately recover as well. In the end people like Bill Gates have little interest in destabilizing the economy and arguably his spending behavior is actually a lot more beneficial for society than e.g. the US spending behavior in the middle east. Bad things could happen but bad things happen today as well. That’s simply the nature of power (and money is power).

So, I see very little reason to be afraid of bitcoin. I believe the current financial system manages to be corrupt and evil without bitcoin just fine. Ultimately wealth is a reflection of economic power and activity. If bitcoin is successful, it will naturally accumulate with the same people who control our gold supplies today. So in that sense nothing will change. What will change is the role of governments and taxation. Basically governments tax wealth and income. Bitcoin won’t change that. But the way they tax will have to evolve. In the old days. The tax man would come and literally collect the coinage and you had little choice but to hand it over. Nowadays, taxation is based on declared income, VAT, etc. which basically boils down to the government taking a percentage of income of companies and individuals and being very anal about auditing their books. In the bitcoin world, transactions are both auditable and anonymous. They are anonymous in the sense that they are not explicitly tied to people (currently). However, auditing is built in to bitcoin in the sense that each transaction is an event that is connected to all the transactions that came before that. All the government needs to know is which transactions originated from who and when, which is simply something they can demand people to declare. Hiding certain transactions is of course possible but it would be impossible to spend bitcoin without disclosing its transaction history (i.e. where did you get it). It’s similar to a bankrobber trying to spend stolen hundred dollar bills with known serial numbers: kind of risky. I wouldn’t be surprised to see taxes evolve to utilize this bitcoin feature.

Bitcoins and similar cryptographic currencies solve some real problems. They make banks obsolete as a means to conduct transactions. Bitcoin transactions require no middle men. That’s a good thing in my view since the current banking system (here in Germany particular) is very inefficient and I see little reason for having to rely on them in the future. This convenience will drive adoption. Ultimately this is how gold became valuable as well: it was more convenient to hand out small gold coins than e.g. a truck load of manure or ten goats. Ultimately, the value is proportional to the amount it is used in economic transactions. Bitcoin could merely be the first of many digital currencies. In that case, it might never become a dominant currency and you’d be ill advised to bet on its value increasing. On the other hand, it’s good enough now and might benefit from early adoption. Probably a lot of countries currently dependent on overly inflated currency would be better off depending on bitcoin and there are some signs of people in such countries actually using bitcoin quite heavily already. On the other hand, bitcoin could prove to be a lot more stable than bits of paper with the former US president’s faces printed on them.

I certainly wouldn’t mind owning a few percents of a percent of sizable chunk of the world’s economy. But I’m too risk averse to bother with speculating. Ultimately, I didn’t do a startup during the dotcom bubble (fresh out of college at the time), I didn’t buy shares in alternative energy companies a few years ago when I honestly believed the hype around them (most have gone bankrupt) and I didn’t act on my hunch that this bitcoin guys might be onto something last year. I did buy into some worthless pension schemes a few years ago and thankfully never acted on peer pressure to get a mortage and a house in the Netherlands (which would have meant I’d be in debt now on a house that is worth substantially less than a few years ago). I could see myself using electronic currency in the near future though simply because it is convenient. In that case, I’d actually want it to be stable coinage with somewhat predictable and reliable value. Bitcoin can’t provide that yet but it’s arguably a lot better already than some currencies in use today. Owning a hundred bitcoin today would be very stressful because having a 100K $ knowing it could be worth only half that tomorrow would be very stressful as well. What worries me today is the suspicion that my pension is going to be worthless and that the value of my savings is deflating as well.