While we have never been a fan of so-called digital crypto currencies, they have mostly remained outside the realm of traditional investments. That may change very soon. The Winklevoss twins, through the Winklevoss Bitcoin Trust, appear to begetting close to listing a bitcoin ETF on NASDAQ. This would make “investing” in bitcoins accessible to just about every investor.
I certainly don’t begrudge the Winklevoss twins for cashing in on the bitcoin craze. My problem is with bitcoins themselves. The bitcoin will be a failure as a currency due to several inherent flaws that make it unsuitable for use in commercial transactions over the long run. For that reason, the Winklevoss Bitcoin Trust and by extension bitcoins are our Dumb Investment of the Week.
Understanding Modern Money
To understand the flaws in bitcoin, we first need to understand why something would be used as a currency and what gives currency its value. Let’s use the US dollar as an example.
The most important aspect of the US dollar that gives it value is that you are required to satisfy your tax obligations to the US government using dollars. This fact virtually guarantees dollars will always be in demand, as most citizens and businesses operating in the US will need dollars at some point.
A currency also needs to be easy to acquire to make it useful. Dollars are widely available, and the US government keeps adding dollars to the economy via deficit spending. Deficit spending usually carries with it a negative connotation, but that is not the case. The issuance of a currency also needs to keep up with a growing economy. As the population grows and productivity increases (hence more assets are created), ever more dollars need to be placed in circulation.
The value of a currency also needs to be stable. It is very difficult to conduct business when the value of the means of payment is fluctuating. For instance, suppose XYZ Company wants to upgrade its manufacturing equipment. The lead time to get the new equipment is one year. If the value of a currency is stable, then the equipment manufacturer can easily give XYZ Co. a quote and expect it to sign a contract.
Suppose the cost of the equipment will be $10M. In a low inflation environment like we have, the cost for the equipment a year from now might still be $10M. If inflation reaches the Fed target rate of, say, 2%, then perhaps the company would charge $10.2M. Even high inflation, provided it is steady, isn’t a problem as it can be planned around. Say inflation was a steady 10%. The company can just charge $11M. While high inflation makes people uncomfortable, it doesn’t hinder commerce so long as the rate of change is steady and predictable. If the price of goods and services rises by 10% as long as your salary rises by 10% as well, then there are no ill effects. Wild swings in the value of a currency or unpredictable inflation that causes problems. High inflation rates that are steady, while uncomfortable, can be planned around.
Seeing Bitcoin Deficiencies
Bitcoins have almost none of these properties. Bitcoins, like gold or silver, have no intrinsic value as a currency. There is no entity that requires a large group of people to pay bitcoins each year or face jail time.
In fact, the bitcoin is worse than precious metals as a store of value. While some precious metals, such as gold, can derive some value from industrial applications or for jewelry (particularly in India for cultural reasons) bitcoin has no alternative uses. If the “store of value” premium assigned to gold by gold bugs vanishes one day, then gold will still have some value due to its ancillary uses. Not so with bitcoin.
The chart below shows how volatile bitcoin values are.
(Chart from coindesk.com)
In fact, bitcoin is so volatile no one is even sure what one bitcoin is worth. The price of one bitcoin varies depending on which exchange you use.
Below is a one-hour price fluctuation chart from Friday May 9th. The value of a bitcoin ranges from $440 on BTC-e up to $152 on bitstamp. Also, the price of bitcoin fluctuated greatly in just the span of an hour.
(Chart from coindesk.com)
It’s absolutely ludicrous to think that something with a value as unknown and as unstable as bitcoin has any value as a currency.
The other issue that makes bitcoin unsuitable as a currency is that only a finite amount of bitcoins will be available. Currently, approximately 11M bitcoins exist and around another 10M coins are able to be “mined,” bringing the maximum possible number of bitcoins in circulation to 21M. This finite supply means bitcoin has an enormous deflationary bias built in to the currency.
The limited amount of bitcoins available means that as global population and productivity increases, the supply of bitcoins will not be able to keep pace. For example, suppose the world consists of 100 bitcoins and 10 units of assets. In that scenario 10 bitcoins equal one asset. As productivity improves and population increases, the world will contain more assets but the bitcoin supply will stay constant.
Now imagine we have 20 assets and the same 100 bitcoins. Ten bitcoins now equals two assets. At first glance, this seems to be a positive. Bitcoins will stay scarce and become more valuable, right? Not necessarily. As deflation sets in and bitcoins become more valuable, there is more incentive to hoard bitcoins rather than use them in commerce. As commercial bitcoin transactions dry up, the value of bitcoin as currency will decline precipitously. If bitcoins don’t have value as a currency, then what are you left with? Just illusory data on a computer somewhere.
Bitcoins are a digital Ponzi scheme, not a digital crypto-currency. Investors would be wise to steer clear of bitcoins and any other digital currencies.