Why Bitcoin might be the most perfect bubble possible

Britain Soccer Football - West Ham United v Middlesbrough - Premier League - London Stadium - 1/10/16Bubbles before the match Action Images via Reuters / Tony O'BrienLivepicEDITORIAL USE ONLY.

The bitcoin bubble could never burst but instead become digital gold. Image: REUTERS

Matt O'Brien
Reporter, Washington Post
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Bitcoin might be the most perfect bubble possible.

What else would you call something that, as of Tuesday morning, has gone up 47 percent the past week, 181 percent the past month, and 2,119 percent the past year? Not to mention the most remarkable part of this all: It has happened for no discernible reason. People have not started to actually, you know, use bitcoins much more than they did a year ago, but that hasn't stopped its price from skyrocketing from $775 back then to over $17,000 today.

The question, then, is whether bitcoin is more like digital tulips or digital gold. In other words, a bubble that will inevitably burst or one that people can talk themselves into, well, forever.

Image: CoinMarketCap

Before we get to that, though, it is worth talking about what bitcoin is. That is more complicated than you might think. On the one hand, it is a truly revolutionary technology, but, on the other, it is a truly useless one so far. Which is to say it is a virtual currency nobody buys thing with. That's not the end of the story, though. It's also a way to send things online without needing a trusted intermediary, like a bank, to verify you have not already sent it to somebody else. If bitcoin ends up having any utility, this will be why. That is because, in theory, this could let you set up an alternative financial system with a lot fewer fees built into it. Emphasis on the “in theory” part.

There are three things to understand here. The first is bitcoin is a digital currency that is not controlled by any government and which has a strictly controlled number of coins. It releases new ones on a set schedule and will continue to do so in smaller and smaller amounts as it asymptotically approaches its self-imposed limit of 21 million coins. The second is bitcoin “miners” can win these new coins by solving computationally-taxing — and incredibly energy-intensive — problems on their supercomputers. The third is that, in the process of winning new coins, these miners actually keep a public record of every single bitcoin transaction.

That last part is one of the biggest technological breakthroughs since the invention of the Internet itself. Think about it like this: Why do you need your bank or credit card company or whatever other financial institution to send money for you online? Why can't you just . . . do that yourself? The answer is they are the only ones who can confirm you actually do have the money to send in the first place. Otherwise, I would have no way to know, for example, whether the $20 you were sending me was the same $20 you had already sent somebody else — until, that is, bitcoin came along. That it has a public ledger of all its transactions means everybody always knows who does and does not have bitcoins to send. The easiest way to understand this is instead of having to pay the bank 2 percent yourself to run a transaction, bitcoin uses new coins to pay the miners to do so. It cuts out the middleman and replaces it with middlemen.

What is the problem then? Well, the same thing that makes the miners want to get bitcoins also makes nobody want to use them — their scarcity. Imagine you were Satoshi Nakamoto, the pseudonymous inventor of bitcoin. How would you get people to devote real resources toward “mining” what are inherently worthless digital tokens? Easy: the same way you make anything popular — by making it exclusive. In this case, that meant putting a hard cap on the number of bitcoins so if interest in them went up, their price would too, and by a lot.

The thing is, though, that makes people want to get bitcoins, but not spend them. After all, why would you use them if you thought they might eventually be worth $10,000 or $20,000 or even $100,000 when you could just use your dollars that you knew would lose some of their value to inflation instead? You wouldn't. You would hold on to your bitcoins less like a currency and more like a tech stock. Which, it turns out, is exactly what has happened. Bitcoin's price might have soared some 2,000 percent the past year, but bitcoin's number of transactions has only gone up 25 percent to 33 percent.

But it's not just that bitcoin's very nature makes people want to hoard them. It's that bitcoin would not be worth using, anyway. The whole point, remember, is the currency is supposed to make it cheaper to send things online. That's not what's happened. Even with its rather limited number of transactions, bitcoin's restricted number of coins means you do, in fact, have to pay fees. That's because there just is not enough data in every coin to process every transaction when it comes up. That creates a waiting line. If you do not want to get stuck in it for very long, you have to pay the miners a fee to bump yours up in the line. So much for it being an improvement over the status quo.

Now, there is a simple enough solution here that bitcoiners, however, reject. Bitcoin could create a lot more coins. That would keep its value from going up — what you need for people to be willing to spend bitcoins — and keep the system from being short on transaction bandwidth. So far, so easy. The hard part, though, is convincing everyone who already has a stake in bitcoin to do this. They, after all, tend to be the type of central banking skeptics who were first drawn to the so-called crypto-currency because it uses math to set the money supply and does not rely on anybody's discretion. They also do not want to see their investments — that is what their bitcoins are to them — go down in value. It is no wonder, then, that they have already decided not to change the system. They want to keep bitcoin just the way it is.

Have you read?

That, as I have said before, has become a Ponzi scheme for redistributing wealth from one libertarian to another. Actually, I would like to amend that a little bit: Bitcoin has now graduated to being a Ponzi scheme for redistributing wealth from one person to another.

When it started out, bitcoin had two major constituencies: techies who were blown away by its sheer technical accomplishment, and End-The-Fed types who were convinced it would replace the dollar. Now, it entices these libertarians who, for the most part, have been trading it among themselves, with early investors cashing out some of their winnings as new investors come in. The only thing that has changed recently is the hype around bitcoin and other cryptocurrencies has gotten so loud other people are noticing. There is the Dutch man who sold all of his family's belongings to buy bitcoins and then moved the family to a campsite while they wait to become rich. Or the high school dropout who turned a $1,000 gift a few years ago into over $1 million worth of bitcoins. Or, heck, even my mother-in-law, who asked my wife whether she should invest in bitcoin or an alternative cryptocurrency like Ethereum.

Nobody wants to miss out on what seems like a lifetime's worth of free money.

These things usually end poorly, and bitcoin probably won't be any different. That does not mean, though, that it can't keep going up for a while. The beautiful thing about bitcoin is people can talk themselves into believing it is worth, well, anything, and there is nothing to contradict them. It makes as much sense for bitcoin to be worth $10 as $10,000.

Still, the last few months have been particularly manic. It is not just bitcoin. It's other cryptocurrencies, too, particularly brand-new ones doing initial coin offerings, or ICOs. There seems to be so much fraud going on in these ICOs — the con artist who was the inspiration for the movie “The Wolf of Wall Street” called them “the biggest scam ever” — that it only seems like a matter of time until people panic and pull their money out of them. When they do, bitcoin might get pulled down, as well.

Even then, the bitcoin bubble would not be over. Only its tulip phase would be. What I mean by that is the type of mass frenzy that sends prices parabolically up and then down, like what happened with, yes, tulips in the 1600s. (Is it any stranger to have a bubble in flowers than it is in digital coins that are not useful unless you are trying to buy illegal drugs online?) Why wouldn't that price tulip be enough to fully pop the bubble? Because the libertarian true believers would always be around. Nothing short of increasing the number of bitcoins would convince them the currency was not destined to take over the world. So, it would go back to the way it was before: a way for libertarians to take turns making each other alternately rich and poor, as they traded it back and forth like gold. That is a bubble that, like the shiny rock itself, could go on, and on, and on, and, well, you get the idea.

If bitcoin really is the future, then it is going to look a lot like the prehistoric past.

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