Is Bitcoin A Bubble?

One key hallmark of Bitcoin’s price rise from the beginning of 2013 to now, where it has just crept above $240 a coin — up $100 a coin from the last time I wrote about Bitcoin — has been the oft-repeated mantra that Bitcoin is in a speculative bubble, and its price may be due to imminently collapse. This has spawned article after article after article after article — people were calling Bitcoin a bubble at $30 a coin, at $60 a coin — yet the price keeps climbing (and those who were discouraged from investing at lower prices missed out on spectacular gains). It is certain that at some stage the sellers will outnumber the bidders and the price will fall or crash. But when?

I ended my last article on Bitcoin joking that Bitcoin had a much better chance of being part of the monetary future than Groupon did being part of the future of commerce, and that I wouldn’t be surprised to see Bitcoin at some stage trading at Groupon’s record market cap — enough to price Bitcoin at $2,000 a coin. But this was a joke. Bitcoin and Groupon are fundamentally different investments; Bitcoin is an experimental deflationary crypto-currency instrument and anonymous payments system, while Groupon is the equity in an experimental company. That means Bitcoin is a whole new asset class. And not a fantasy asset class, but one that is rapidly permeating the spheres of human consciousness, an idea that is replicating and multiplying at a rate far beyond its original audience of crypto-anarchists, heterodox monetary theorists, and black marketeers.

I don’t really see Bitcoin (and its crypto-currency siblings) facilitating trade a great deal in the future (although, its deflationary-nature might make it attractive to merchants who wish to hoard it). During Bitcoin’s recent run (or more accurately, hyper-deflation) Bitcoin’s velocity has actually fallen sharply as its rising value has encouraged hoarding. Gresham’s Law implies that whenever possible Bitcoin’s deflationary nature will subordinate it to fiat currency for transactions. State-backed currencies tend to depreciate year-on-year, encouraging spending and discouraging saving. That is treated by central bankers as an imperative of monetary policy. Yet Bitcoin’s deflationary nature encourages the opposite, implying that Bitcoin is not a threat to state-backed fiat but a complementary currency, an intangible, anonymous, global and infinitely mobile counterpart to tangibles like gold.

Gold remains a part of the global financial system, a savings instrument alongside its tiny role as an industrial metal and its larger role as jewellery. Credit-Suisse estimated that total global financial assets in 2012 were $223 trillion, of which gold makes up 0.6%, translating to a $1.338 trillion market cap for gold as a financial asset, (although a larger amount of gold — around $8 trillion total at current prices — exists in other forms like jewellery).

There are no fundamental ways to estimate the value of assets like gold or bitcoin, and their values are entirely in the eye of the beholder. But we know Bitcoin is presently vastly outperforming gold as a speculative savings vehicle, and in spite of the fundamental differences (particularly that one is tangible, and one is not) this may drive more and more investors — including institutional investors and funds looking to diversify into something slightly futuristic — into Bitcoin. If Bitcoin’s market cap were to rise to equal that of gold’s as a percentage of global GDP today, that would imply a price of $160,650 per Bitcoin, far, far higher than any price target I have yet seen. Even if Bitcoin were only to rise to 10% of gold’s market cap, that would imply a Bitcoin price of $16,065, still far higher than any price target I have seen. Even at 1% of gold’s market cap, Bitcoin would still fetch $1607 per coin, an almost-sevenfold increase over today’s price.

And gold is by no means a widely-held asset in today’s global financial system. If Bitcoin grew to 1% of the global financial system today each each coin would reach $267,600 in price.

These are, of course, fantasy figures based on back-of-an-envelope calculations, and should not be taken seriously. But what they show is that if the idea of Bitcoin continues to flourish — and if fund managers, and institutional investors begin to hunger for a slice of yield — then there is more than enough liquidity out there today to drive Bitcoin far, far higher.

On the other hand, if Bitcoin is outlawed worldwide by governments (perhaps due to concerns over money laundering and tax evasion) then of course any chance of it beginning to attract any such levels of interest are nil.  But the current government approach to Bitcoin so far appears to be one of attempted regulation rather than outright warfare.

At some stage Bitcoin may be supplanted by competitor crypto-currencies, but so far it is by far the most widely-adopted, and cryptography experts agree that its cryptography is sound, so there is no reason to assume that this may occur anytime soon. But judging by the birthrate and deathrate of social networks in recent years, a fast birthrate and deathrate for crypto-currencies is by no means out of the question. Technology is a fast-paced world where yesterday’s prize-pig is today’s turkey, and already there exist currencies built on similar technology to Bitcoin trading at much lower levels — Litecoin, Namecoin, Freicoin, PPCoin, Novacoin, etc. Whether these act as supplements or competitors remains to be seen, but it may be helpful to remember that while social networking sites today remain hugely popular, the early leaders in that field like MySpace and Friendster are nowhere to be seen. Is it possible that Bitcoin is the MySpace of decentralised crypto-currencies, and that the Facebook and Twitter are just around the corner? Yes — perhaps a platform with a more consumer-friendly interface than Bitcoin will come to dominate the field, making up a sizeable chunk of global financial assets, and Bitcoin itself will dwindle.  Certainly, the source code is available to larger organisations (Facebook? Google? Amazon? Banks?) who may wish to experiment with their own decentralised crypto-currency systems.

It is really hard to say what ultimately will occur, but Bitcoin does demonstrate the principle that anonymous, deflationary crypto-currency can be an attractive complementary proposition in a world where inflationary state-backed fiat currency has become the norm. I would caution that holders of Bitcoins — particularly those sitting on large long-term profits — should seek to diversify both into real-world assets like real estate, productive assets like farmland and factories, and index funds, as well as into new crypto-currencies as they emerge, particularly ones built with more consumer-friendly interfaces that may come to dominate the market. Bitcoin could easily end the year below its current price, but as Bitcoin grows in the public awareness this is decreasingly likely. In the long-term, a market cap target of 1% of gold’s market cap (currently, that would yield a price of $1607 per coin) seems viable, especially if larger players including institutions begin to experiment in the strange new world of crypto-currency.

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The Burden of Government Debt

There has been an awful lot of discussion in recent months about whether government debt is a burden for future generations. The discussion has gone something like this: those who believe government debt is a burden claim that it is a burden because future generations have to repay taxes for present spending, those who believe that it is not claim that every debt is also credit, and so because the next generation will inherit not only the debt but also the credit, that government debt is not in itself a burden to future generations, unless it is largely owed to foreign creditors.

It is relatively easy to calculate what the monetary burden of government debt is. Credit inheritance and debt inheritance are not distributed uniformly. The credit inheritance is assumed strictly by bondholders, and the debt inheritance is assumed strictly by taxpayers. Each individual has a different burden, equalling their tax outlays, minus their income from government spending (the net tax position).

For an entire nation, everyone’s individual position is summed together. In a closed economy where the only lenders are domestic, the intergenerational monetary burden is zero. But that is by no means the entire story.

First, debts to foreign lenders are a real monetary burden, because the interest payments constitute a real transfer of money out of the nation. Second, while there may be little or no debt burden for the nation as a whole, interest constitutes a transfer of wealth between citizens of the nation, specifically as a transfer payment from future taxpayers to creditors. This adds up, at current levels, to nearly half a trillion of transfer payments per year from taxpayers to creditors. So while the intergenerational burden may technically add up to zero for the nation, it will not for individuals. The real burden is huge transfers from those who pay the tax to those who receive the spending, and those who receive the interest. So who loses out?

Here are the figures for 2009 showing net tax position for each income quintile:

Bottom quintile: -301 percent
Second quintile: -42 percent
Middle quintile: -5 percent
Fourth quintile: 10 percent
Highest quintile: 22 percent

Top one percent: 28 percent

The negative 301 percent means that a typical family in the bottom quintile receives about $3 in transfer payments for every dollar earned.

What this data does not show are the reverse transfers via interest payments. There is no data (that I can find) on treasury interest payments received by income quintile, but assuming that the top quintile dominates income from interest (as they dominate ownership of financial assets, owning over 95% of all financial assets) this leaves the lower income quintiles benefiting from transfer payments, the top quintile benefiting from interest (as well as policies like bank bailouts, corporate subsidies, and quantitative easing, whose benefits overwhelmingly benefit the top quintile), and squeezing the taxpaying middle quintiles who receive neither the benefits of interest payments, nor significant welfare transfers.

To misquote George Orwell, when it comes to the national debt and who takes its burden, some pigs are definitely more equal than others.