I have been watching Bitcoin’s price advance with trepidation. In just six months its value has quintupled; it has risen more than 10-fold since last December. Bitcoin started 2017 at just below $1000 and by the end of November 2017 it hit $11,000. It proceeded to surpass $16,000 a few days later.
This to me is reminiscent of two other asset classes that also had a meteoric, for the time, growth that eventually did not end well. These two other asset classes which, like Bitcoin, are hard to value are gold that overnight quadrupled in value between 1979 and 1980 and the dotcom companies that reached astronomic values in 2000.
In both cases, we all know what happened.
Gold fell by more than 50% by 1981 and most dotcom companies went out of business in the same year. The technology stock-driven PowerShares QQQ ETF fell from 109.50 on March 1, 2000 to 20.72 by September 1, 2002.
Bitcoin came into life in the wake of the 2008 financial crisis that led to an explosion of the liabilities of central banks. For example, the Fed’s balance sheet expanded from about $850 billion prior to the 2008 crisis to more than $4.4 trillion by August 2014. At the same time, debt issuance by private and public entities rose sharply and brought into focus the realization that global economies had been living beyond their means. Inflation and devaluation of fiat currencies was feared. Bitcoin provided the means to avoid governments and central banks.
The price of Bitcoin, for example, rose by 57% within a week after the government of Cyprus imposed a one-off levy on bank deposits. The decrease in the trust of the banking system caused an increase in the demand for cryptocurrencies, like Bitcoin.
Bitcoins embody two innovations: blockchain technology – a public ledger that contains all transaction records since inception, and decentralized governance – it is governed by “miners” who are incentivized to maintain a stable supply of Bitcoins.
The theoretical roots of Bitcoin can be found in the teachings of the Austrian School of Economics and particularly the writings of Friedrich von Hayak who believed that private banks should have the right to issue their own currencies.
Like gold, central banks cannot print Bitcoins. And not unlike the rarity of gold, the supply of Bitcoin is fixed to 21 million Bitcoins and is determined by an algorithm.
New Bitcoins are created after performing computationally intensive tasks that are necessary for the Bitcoin system to function. However, only a limited supply of bitcoins is “mined” every year.
In light of increased demand for Bitcoins due to the hype, media reports of rising Bitcoin prices, fear of missing out and uninformed speculators and the feedback loop that ensues, a severe short term imbalance between demand and supply has been created driving bitcoin prices skyward, spawning a fertile ground for the formation of a bubble and, at the same time, putting in place the forces for the eventual popping of the bubble.
Sooner or later Bitcoin traders will have to ask themselves two questions.
First, what is the value of a Bitcoin? And second, what does it give you a right to? Like gold and dotcoms, Bitcoins are difficult to value as they produce no cash flows.
When I teach valuation in my classes at Ivey, I define value as economic or fundamental value, which relates to the ability of an asset to produce a stream of after tax cash flows. What are the cash flows here? None.
Of course, Wall Street and Bay Street strategists always come up with ways to value assets like these trying to bring some sort of valuation discipline to an asset that has no inherent value while at the same time arguing that things are different this time and new valuation models are needed adopted to changing times. It has happened with gold in 1980, dotcoms in 2000 and Bitcoin right now.
If history has taught us anything, we know what will happen next. The Bitcoin bubble will pop. We do not know when it will pop, but it will.
As Keynes used to say the markets can stay irrational longer than one can remain solvent. What is happening to Bitcoins is not rational – how can it be when Bitcoins cannot be valued. As there is no way to value Bitcoins, there is nothing to guide or help a buyer or seller make rational decisions.
Every generation has to learn things the hard way. It is now the turn of millennials, who love everything digital, and Bitcoin, unlike gold, is a digital currency, to learn the risk of fads, be they digital or analog.