Bitcoin: bubble or money?

What exactly is this thing that now costs the same as quite a nice TV — more than a return ticket to New York?

On Saturday the price of one Bitcoin reached an all-time high of US$2000.

On Saturday the price of one Bitcoin reached an all-time high of US$2000; at the time of writing, two days later, it is nudging US$2100, or A$2,800, and is not far off double the price of that more traditional alternative currency, gold.

Count me wide-eyed and nonplussed. What exactly is this thing that now costs the same as quite a nice TV — more than a return ticket to New York? And is it a bubble?

Bubbles are notoriously hard to identify in real time. When the item in question has fallen by 50 per cent, or better still returned to zero, it can safely be declared to have been a bubble. In the meantime it is merely a puzzle.

When Bitcoins rose in price from $1 to $100 there were plenty of sage observers saying it was a bubble; likewise when it did another 10-bagger from $100 to $1000. But demand continues to exceed supply, such that the price is close to tripling in 2017.

Which raises two questions: what demand? And what supply?

In some ways the second is easier to answer than the first. Bitcoins are mined with computers, lots of them, doing insanely complex algorithmic calculations. In fact it’s now so difficult and competitive that special hardware called Application-Specific Integrated Circuits (ASICs) are used because using old CPUs, or even the first generation of ASICs, costs more in electricity consumption than the Bitcoin mined is worth.

Apparently the cost of mining a Bitcoin is currently US$1200, which provides a better margin than mining gold and explains why there’s such a rush on to “dig” them up.

It also explains why there is a fairly earnest effort at emulation and substitution going on: Wikipedia lists 24 other crypto-currencies, the most recent being Zcash, which was materialised in 2016 by one Zooko Wilcox and is described as “the first open, permissionless financial system employing zero-knowledge security”.

“Zero-knowledge” sounds like the one for me. Zcash currently sells for a snip at US$112.23 each, having reached US$1800 soon after it listed last October, so not a good one for the stags.

But back to Bitcoin, the market leader. There are two things that distinguish it from gold and help explain its superior price performance: first, the Bitcoin network automatically adjusts the difficulty of mining it every two weeks or so, making it harder so that the rate of “mine production” is kept steady as more and more energy and computational power is employed around the world and second, the total number of Bitcoins is to be capped at 21 million.

I read that 14 million have been mined so far, and counting. What happens when the number of 21 million is reached? Now that is an interesting question for monetary theorists, especially those within the hallowed walls of the world’s central banks, where there is no limit to the amount of dollars, euros and yen that can be mined, and where hardly any electricity at all is consumed in “mining” billions of them each week.

It used to be that currencies issued by central banks had to be backed by gold actually dug up out of the ground and refined, and before that silver as well, but those archaic shackles were finally removed on August 15th, 1971, since when the value of a dollar has collapsed to be one-sixth of what it was then.

So in one sense the demand for Bitcoins can be explained simply by the desire of many for a currency that can’t be debased by politicians and central banks: whose supply is limited and the difficulty of creating it gets harder all the time, rather than easier as economic principles are bent to order.

As a keen, heavy investor in Bitcoin was quoted as saying last week: “I think that something has to replace the current monetary insanity. It may or may not be Bitcoin. I don’t know what it is. I’m worried about the system — the integrity of the system. You can’t navigate that by working within the system. You have to be outside the system. Bitcoin is outside the system.”

That it is. But is it useful, as opposed to being a speculation on the insanity of the current monetary system, a role usually reserved for gold?

Well, it is useful for paying ransoms, particularly in the new digital kidnappings where someone locks your computer and demands Bitcoins to unlock it.

That provides a hint about some of its other non-investment uses, many of which involve some kind evasion of scrutiny.

But there is also a long list of law-abiding online retailers and service providers that accept Bitcoins as payment, including Microsoft, Subway, Bloomberg, Webjet, and Yacht-base.com, a Croatian yacht charter business.

How they all handle the rapidly rising price of Bitcoins can only be guessed at, although while it’s rising there is a nice profit between sale and banking the proceeds. Then again, are Bitcoins banked? I suspect not.

Yes, your correspondent remains wide-eyed, awe-struck and more than little bit left behind.

Does the price of $2800 per Bitcoin make it a more substantial alternative currency, or a speculative bubble that will soon be just a memory, filed away with tulips?

I’m afraid I simply don’t know.

Alan Kohler is Publisher of The Constant Investor