Recently I've received many questions about Bitcoin and cryptocurrencies. The topic has become increasingly popular on news and social media. I've spent some time exploring the subject looking at it from a technological, economic, and social standpoint. Let me offer some insight, my opinion, and answer some of the most common questions.
What is Bitcoin? Bitcoin is a digital unit of value. It is an encrypted text file stored on the Bitcoin blockchain. The Bitcoin blockchain is an encrypted, decentralized ledger on a global public computer network. That is as technical as I'm going to get. Let's focus on the idea of a ledger. When you deposit money in your checking account or write a check against the balance, your bank keeps records of the inflows and outflows on an account ledger on their computers, and it is denominated in dollars. But it is still just an encrypted text file that represents value. We trust that we can exchange the value represented by that text file at the bank for physical currency or transfer the value to others to buy goods and services.
When you buy Bitcoin, you are exchanging Dollars for a value denominated in Bitcoin recorded on multiple, identical ledgers on privately owned computers around the world on the Bitcoin blockchain network. The currency exchange is not unlike exchanging Dollars for Euro, Yen, or any other currency. The value of a currency is a function of the currency's supply and the demand for it by others. Most people buy another currency because they need to settle a transaction in that currency. If people in Europe want to buy US Bonds, they need to buy Dollars to complete that transaction. Or if a company in China buys equipment from a US company, they need to buy Dollars to settle the transaction. Unlike other currencies, there is no demand for Bitcoin for the settlement of foreign commerce. This eliminates a natural source of support that other forms of currency enjoy.
Why does Bitcoin have value? The short answer is because people think it does. The value of anything is what someone else is willing to pay for it. From an academic standpoint, value is a function of utility and scarcity. The air we breathe has a lot of utility, but it's not particularly scarce, so it would be difficult to sell. If we are going scuba diving, we're willing to pay for air in a tank. The air has the same utility, but it's scarce where we're going. Bitcoin has technological scarcity as there is an absolute limit of 21M coins that will ever be created. The last Bitcoin will be created in 2140. From 2009 through 2020, 18M Bitcoin have been created, meaning only 3M more can be created. The limit of 21M coins theoretically gives Bitcoin scarcity. Bitcoin's utility is evolving. Some use it as a store of value. Some believe that it may be used as a medium of exchange as a cash alternative in the future. But its primary value is linked to its demand as a store of value.
Can the price of Bitcoin continue to rise? Absolutely! I have seen estimates as high as $146K per coin. However, Bitcoin is an unproductive asset. Unlike investing in a company's stock, it does not produce a product, have earnings, or pay a dividend, making it very hard to value. It is difficult to know if it is cheap or expensive. It is also impossible for it to disappoint investors by not meeting growth or earnings estimates, so it's difficult to anticipate the catalyst for a downturn. The only reasonable metric I've seen to estimate its price is a stock-to-flow ratio. Stock-to-flow models are used to evaluate the current inventory of a commodity, like gold, against the flow of new production available in a given year. Using a stock-to-flow, I would expect Bitcoin's price to rise in perpetuity; however, this model did not predict previous price declines. It can continue to rise in price as long as there is a collective belief that it will.
Is Bitcoin a currency? Technically No.
A currency is a medium of exchange that is generally accepted and used to pay taxes, debts and pay for goods and services.
· Bitcoin is not yet generally accepted as payment.
· There is no legal requirement to accept Bitcoin as payment for debt as exists for Dollars.
· The IRS has determined that Bitcoin is a property for the purposes of taxation.
WWhy do people buy Bitcoin when we already have a currency?
I've identified five reasons some are choosing to trade their dollars for Bitcoin.
1. The belief that they will be able to sell their Bitcoin to someone else at a higher price in the future. These are generally people who don't know much about Bitcoin other than it has recently gone up in price and see an opportunity to get rich quickly. This is referred to as "The Greater Fool Theory." This is the idea that regardless of the price, there will be a greater fool who will pay more than I did.
2. The belief that the expansion of the money supply by global central banks will lead to the devaluation of the US Dollar and hyperinflation. Bitcoin is seen as a hedge against inflation and a falling dollar. These are people buying Bitcoin for its long-term economic potential. Because the quantity of Bitcoin is fixed, it is impossible to produce an unlimited amount as is possible with fiat currency.
3. The interest Cryptocurrencies rose out of the financial crisis in 08-09. Some feel that the government took on too much debt to bail out Wall Street firms and large banks, that banks take unnecessary risks with people’s money and can’t be trusted. Cryptocurrencies are seen as a path to taking control of money out of central governments' hands through the adoption of decentralized digital currencies. These are people investing in Bitcoin for ideological reasons.
4. Cryptocurrencies like Bitcoin are applications that run on blockchain networks. Some believe that Blockchain networks are the next iteration of the internet. Developers and technology investors own cryptocurrencies as technology investments and fund their applications on blockchain networks with the native cryptocurrency.
5. There have been businesses that have added Bitcoin to their balance sheets. Most are actively or planning to provide cryptocurrency financial services. A few have replaced a portion of their cash reserves with Bitcoin. It isn't clear if this trend will continue should interest rates rise.
Is inflation a real concern? Inflation is the economic condition of rising retail prices or declining currency value. In the 1970's we experienced a period of hyperinflation in the US. Some are concerned that the Federal Reserve's easy monetary policy will lead to a return of inflation. There have been warnings about rising inflation since the Federal Reserve began their quantitative easing policy in 2009. Despite a decade of interest rates near zero, rising government debt, and the Federal Reserve's balance sheet expansion, inflation has remained low. Historically easy monetary policy has provides liquidity for increased economic activity leading to increased demand. The increased demand would lead to a tighter labor market. The tightening labor market would lead to upward pressure on wages. Increased labor costs would be passed on to the consumer in the form of rising prices, creating inflation. One meaningful difference now is that Central Banks all over the world are following the same path. So, when we talk about a weak Dollar, you have to ask the question, "weak compared to what?"
Why does the Federal Reserve have a 2% inflation target?
Wouldn't it be better if prices never went up?
The reality is we need some level of inflation to keep the economy moving forward. Inflation is why you buy something today, rather than waiting six months. The expectation is that things will gradually cost more in the future than they cost today, so we buy things we need today to avoid paying more for them tomorrow. The Federal Reserve has a dual mandate from Congress to maintain maximum employment and price stability. Currently, the Federal Reserve is focused on encouraging inflation and economic activity by keeping interest rates low and liquidity readily available.
Historically a driver of inflation has been increased labor costs following spikes in consumer demand. That hasn't been the case in recent years. There are currently two primary forces keeping inflation in check: globalization and lower labor demand due to increased productivity from technological advancements.
Globalization – For decades, there has been an increasing trend for companies to transfer labor-intensive activities to places in the world where labor is less expensive. We may not like jobs being exported to other countries, but it has served to keep consumer prices lower.
Technological Advancement – COVID highlighted the role of technology in maximizing the productivity of labor. People can leverage technology to do more. In manufacturing, we've seen increased use of robotics. In retail, we've seen increased use of kiosks and mobile phone applications to complete functions that once required human labor. All of these incremental changes serve to reduce demand for labor and upward pressure on wages.
One would think that there is some amount of liquidity injection from the government and the Federal Reserve to generate inflation. Given the anticipated increase in consumer demand combined with the unprecedented amount of economic stimulus, I think we have the best chance of seeing some level of inflation.
Will Bitcoin replace the US Dollar? No. I am absolutely positive that will never happen.
1. The US Government is not going to surrender control of the currency. There will be some that think that the government can't stop that from happening. They are wrong. At the beginning of the Great Depression, people began hoarding gold. This prevented the Federal Reserve from expanding the money supply to stimulate the economy. President Roosevelt signed an executive order which prohibited people from hoarding gold or silver coin or bullion or certificates, under penalty of $10,000 and/or up-to ten years of imprisonment. Americans were ordered to sell their gold to the US Govt. for a fixed price. Americans could not legally own more than 5 ounces of gold until President Ford repealed the executive order in 1974. The government does not have to ban Bitcoin to discourage its use. The Federal Reserve could issue regulations limiting regulated banks' holdings due to Bitcoins' volatile nature. Congress could change the tax rate on gains on cryptocurrencies making it less advantageous to hold. The SEC could choose to regulate cryptocurrencies as securities and treat crypto exchanges as securities exchanges. Increased regulation would increase the cost of buying and selling cryptocurrencies.
2. Due to its fixed quantity, Bitcoin is deflationary, and its use as a primary currency would wreck the economy. We exchange our time for money. Anything can be used as money; rocks, shells, beads, and precious metals have all been used as money and stores of value. If what we hold as money or a store of value is appreciating at a rate faster than the goods and services we can buy, people are incented to save their money rather than spend it. A deflationary economy is the opposite of an inflationary economy. In deflation, prices are falling, and the currency is increasing in value. People begin to delay engaging in the economy under the assumption that their money will buy more later. As consumers reduce engagement with the economy, retail demand falls, the need for labor is reduced, and unemployment rises. There is less money earned with more unemployed people, and demand falls further, requiring fewer and fewer employees. Unless the deflationary forces are addressed, a recession is likely, and a depression is possible.
Should you own Bitcoin?
I have not recommended anyone buy or sell Bitcoin. It is speculative and volatile. Its uses aren't clearly defined or proven. It has been banned in some countries, and others are considering banning or limiting its use. If you choose to invest in cryptocurrencies, you should take time to educate yourself about what you're buying and why. Buying anything just because it is going up in price is never a good idea. There is a risk that if the vaccine is successful and people begin reengaging with the economy, some may find a better use for their wealth rather than holding it in digital currency. Any weakness in the price could discourage holders who do not have a firm conviction, and a downward price cascade could ensue. This is, of course, just speculation on my part. I hope you found this helpful.