The bitcoin bubble will likely burst, and here’s why

As featured in The Boston Globe | January 3, 2018

It is hard to see bitcoin’s price surge as anything other than a bubble that will ultimately collapse. Bitcoin’s ostensible social function as an anonymous, nongovernmental means of payment carries big risks of its demise. And while blockchain, the platform that records bitcoin transactions, may well have staying power, there is no reason to believe it needs to rely on bitcoin for its success.

Bitcoin is billed as a virtual currency that is independent of government or any other centralized authority. Its strengths are that it enables anonymous transactions and safety from taxation and confiscation by the state. Blockchain is also supposedly robust to transaction failures that can hit a centralized clearinghouse.

As has been widely reported during the recent surge in bitcoin prices, new bitcoins come into circulation in return for investments of computer time (termed “bitcoin mining”) linked to updating the decentralized blockchain ledgers that update the ownership of bitcoins. The bitcoin basic algorithm is designed to limit the new virtual coins that come into circulation through mining, thereby ensuring the scarcity of bitcoin that ostensibly gives it its value.

There are now 16.8 million bitcoins in circulation. With a current price of around $14,000 per bitcoin, they are worth about $240 billion, up from $16 billion at the start of 2017.

What justifies such a surge in value? The argument is that bitcoins have value for the same basic reason that US dollars have value: a belief that others will accept bitcoin in payment for goods and services. Otherwise, fiat currencies (those not linked, say, to gold or silver) have no intrinsic value. Their market value depends on the public’s sentiment that they indeed have value.

Bitcoin’s promoters claim that bitcoin will outshine the dollar because it offers anonymity as well as safety from reckless monetary policies (since the supply of bitcoins is determined by an algorithm rather than a politicized central bank that may choose to print money).

These arguments are clever. They could be correct. On balance, they are probably misplaced. The dollar and other national currencies are legal tender that can be used to extinguish a private debt or a public obligation such as a tax. No governments accept bitcoins for taxes, and none are likely to do so in the future, as that would forfeit the government’s seignorage (resources the government claims through its monopoly on legal tender) and would lessen its control over the money supply. Nor is any individual or business obligated to accept bitcoins in payment for debts in national currencies.

Bitcoin’s anonymity is also its practical weakness. Governments insist on being able to trace financial transactions. They fight tax evasion, economic crimes, and terrorism by following the money. Some governments, of course, also monitor the activities of their political foes in the same way.

Governments are not likely to give up such prerogatives easily. Many observers claim (though without much hard evidence) that bitcoin transactions are heavily directed toward human and drug trafficking, tax evasion, and other illicit activities. Whether or not that’s true, it surely could be, and will likely become the leading justification for suppressing the trade in bitcoins, threatening its long-term value.

Bitcoin supporters emphasize the remarkable innovativeness of blockchain, the decentralized ledger that tracks the flow of bitcoin trades and updates the record of ownership. Many businesses and organizations are indeed turning to blockchain or to more updated variants as innovative ways to record financial transactions, votes, contracts, and other claims, without the need for a government or central clearinghouse.

Yet bitcoin owns no patent on blockchain or other decentralized ledgers. The creativity of the methodology has no bearing on the market price of bitcoins. One can marvel in the idea of blockchain without believing that bitcoin will retain its current market value.

It’s hard to see any real case at all for the 14-fold increase in bitcoin prices during 2017, or the 30-fold increase since the start of 2016. Actual transactions in bitcoin remain very small. Only a few hundred thousand merchants supposedly accept bitcoin, and many of those businesses are shadowy or worse. Many other blockchain-enabled cryptocurrencies have recently been floated, or so we are told, and there is no apparent reason why bitcoin should dominate over the others. Perhaps some cryptocurrencies will find temporary niches in drug trafficking, while others will be used for smuggling, and still others for tax evasion.

Governments are beginning to crack down on bitcoin. China recently imposed stringent barriers to transactions, and South Korea is reportedly considering similar steps, in part because much of the recent bitcoin frenzy seems to involve young Koreans. After a long hands-off period, US financial regulators are also starting to show concerns over the lack of regulation.

As governments tighten their grip, bitcoin prices will most likely fall, and perhaps collapse, though the timing is impossible to judge. Bitcoin seems too prone to illicit use and too vulnerable to government regulation to survive for the long term.

Bitcoin also suffers from a serious design flaw. The “mining” operations are now using so much computing time that the resulting electricity use (and carbon emissions) amount to significant social costs. While such design flaws are probably correctable, the very act of tampering with bitcoin could kill the confidence of its users.

Why, then, did bitcoin soar in value this past year? Why did tulip prices soar in Holland in 1636 only to plummet the next year? Why did shares in South Sea Company soar in London in 1720 before collapsing? Why did Pets.com launch at $14 a share in the dot-com bubble in 2000, only to collapse to 14 cents soon afterward? And why, perhaps, did the Dow rise by 25 percent this past year? The most likely answer is that the deep human desire for quick and easy wealth all too often ends as quick and easy despair.

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