I have been watching Bitcoin’s price advance with trepidation. In just six months its value has quintupled and it has risen more than tenfold since last December. It started 2017 at just below $1,000 and by the end of November it hit $11,000, proceeding 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 didn’t end well. And, like Bitcoin, they’re hard to value. The assets classes are gold, which quadrupled overnight in value between 1979 and 1980, and the dot-com companies, which reached astronomic values in 2000. In both cases, we all know what happened. Gold fell by more than 50 per cent by 1981 and most dot-com companies went out of business in the same year.
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Bitcoin came to life in the wake of the 2008 financial crisis that led to an explosion of the liabilities of central banks. For example, the U.S. Federal Reserve’s balance sheet expanded from about US$850 billion prior to the 2008 crisis to more than US$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. The 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 per cent 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.
Bitcoin embodies two innovations: blockchain technology, a public ledger that contains all transaction records since inception, and decentralized governance, as it’s governed by miners who are incentivized to maintain a stable supply. Its theoretical roots can be found in the teachings of the Austrian School and, particularly, the writings of Friedrich von Hayek, who believed that private banks should have the right to issue their own currencies.
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Like gold, central banks can’t 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 the increased demand for Bitcoins due to 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 supply and demand 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 that bubble.
Sooner or later Bitcoin traders will have to ask themselves two questions: What’s the value of a Bitcoin? And what does it give you a right to? Like gold and dot-coms, Bitcoins are difficult to value as they produce no cash flows.
When I teach valuation in my classes at Western University’s Ivey Business School, I define value as economic or fundamental value, which relates to the ability of an asset to produce a stream of after-tax cashflows. What are the cashflows here? None.
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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 to adapt to changing times. It happened with gold in 1980, dot-coms in 2000 and Bitcoin right now.
If history has taught us anything, we know what will happen next. The Bitcoin bubble will pop. We don’t know when it will pop, but it will.
As John Maynard Keynes used to say, the markets can stay irrational longer than one can remain solvent. What’s happening to Bitcoin isn’t rational — how can it be when Bitcoins can’t be valued? As there’s no way to value Bitcoins, there’s nothing to guide or help a buyer or seller make rational decisions.
Every generation has to learn things the hard way. It’s 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.
This article originally appeared on Benefits Canada’s companion site, Canadian Investment Review