Bitcoins are on the tip of everyone’s tongue these days; probably because they quadrupled in price in the month of November.
Although they’ve been around for years, this is the first time they look like they might live up to their promise: challenging the US dollar for dominance. Should you buy them? Or are we seeing a Bitcoin bubble? I’ve been following Bitcoins since the year they were put into circulation, so I thought I would share my thoughts with you.
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A Brief Explanation of Bitcoins
How Bitcoins are created is…technical. For the sake of this article just know you have to find rare numbers with a specific property. As you find these numbers, Bitcoins are created. The more numbers are found, the harder it is to find new ones. The process of searching for these numbers and receiving Bitcoins is called Bitcoin “mining.”
In theory, the number of Bitcoins that can be created is incredibly large (should run out around 2140). In practice the supply is limited by processing power. A couple of weeks ago I priced out how much it would cost to rent a few racks of servers and run a mining application across all of them (well, one for each CPU core). My back of the envelope math showed that my rental fees would break even with the value of the Bitcoins I mined (they were worth ~$1,000 at the time). I figured it wasn’t worth my time and moved on.
You can still make money by mining, but it requires specialized hardware and a smart algorithm. Unless you’ve a lot of experience managing server farms and/or programming FPGA’s, its’ more cost effective to buy Bitcoins than mine them.
Great…now I know how they’re created, what are they used for?
The goal of Bitcoins is to be a new currency. Not just any currency though, Bitcoin transactions are anonymous and digital, which means it has the potential to be the first currency free from government intervention.
Can it be done? Is the recent price increase jusitified? Or is Alan Greenspan right: this is a Bitcoin bubble? Well…let’s start with a basic question.
What is Money?
Time for a history lesson. Virtually every basic economics class starts by explaining “money” with an example that goes something like this:
What we’re told money is
Imagine a hypothetical village with three people: a blacksmith who sells knives, a cobbler who sells shoes, and a farmer who sells pigs. If the cobbler wants knives at the same time the blacksmith wants shoes, they swap. The same if the farmer wants shoes at the same time the cobbler wants a pig.
But what if the blacksmith wants a pig but the farmer wants shoes? Well, they introduce a fourth thing called money which has a value roughly equal to a pig or a pair of shoes. Then the cobbler sells the blacksmith shoes in exchange for money and who then uses that money to buy a pig from the farmer.
There’s one slight problem with this example: It’s completely wrong.
What Money Actually Is
Never in the history of our species have we seen a money come into being in this way. What anthropologists have actually discovered is:
The blacksmith wakes up one day and realized he needs new shoes. So, he wanders on down to the cobbler and drops some subtle hints (or more likely he has his wife drop subtle hints with the cobbler’s wife) and the cobbler gives him a pair of shoes. After a socially acceptable amount of time the cobbler swings by and tells the blacksmith what nice knives he has. Of course, the blacksmith doesn’t get the hint until his wife points it out to him, but he eventually gives the cobbler a knife.
It’s the same thing as when you borrow your neighbors lawn mower and then you later lend him some sugar (great, now I’m going to have Outkast stuck in my head).
Let’s extend our example: the cobbler gave the blacksmith a pair of shoes and the blacksmith still hasn’t made good on his debt. Now the farmer wants a knife. Since it’s a small village the farmer knows the blacksmith owes a favor to the cobbler, so the farmer asks the cobbler to help him out. Magically the blacksmith gives the farmer a knife and the farmer owes the cobbler “one.”
One debt. One money. (grammar shrammar)
How Does That Scale Out?
If the village only has a handful of inhabitants, it’s not hard to keep track of a few debts between people. After all, they’re not idiots.
As the village gets bigger and bigger they realize they need something better. So, they start using things to keep track of it all. A popular way to do this was with a tally, which was a stick on which they write the amount of the debt down the side. Then they break the stick in half with the creditor keeping the longer half and the debtor keeping the shorter half. When the debt is settled, they each bring their halves, make sure the grooves match and burn them.
Interestingly enough, the longer half (kept by the creditor) was called the stock of the tally. A term that, in theory, has the same meaning today.
Tally sticks were one solution to the problem of tracking debts; sea shells, beads, necklaces, and the most familiar gold/silver were others.
It’s important to note that complicated debt systems were around far before “money.” This is the opposite of the traditional thinking that money was created and debt came later.
Money is Just a Measure of Debt
At this point, you’re probably thinking: that’s interesting Kenny (or maybe not), but why the F do we care?
In the traditional model (money being used to barter), the gold/seashells/beads have the same value as the items being sold. That makes it a commodity.
In the historically accurate model, money is a measure of debt. The item itself doesn’t have to have any value. Remember our tally stick? In today’s money it would be worth about $0.01 but could represent a debt of billions of dollars.
This has interesting implications for the good folks who want to go back to the gold standard, but I won’t go into that here.
Are Bitcoins Really “Money?”
Now the million dollar question: are Bitcoins money?
Well…is it an accepted measure for debt? Negative Ghostrider.
Outside of some now defunct illicit marketplaces and a splattering of online vendors, they aren’t used as a method of exchange.
Which means…they’re a commodity. So what is the value of Bitcoins as a commodity? I’ve been wracking my brain to come up with something valuable about them. They don’t have an physical form. They don’t conduct electricity. They’re not shiny. They’re not anything. As a commodity, their value is zip, zero, zilch.
But Wait…Bitcoins Might Become Money
If Bitcoins don’t have a value as a commodity, then their prices must be determined by their value as money.
Now we’re to the interesting part of this debate. The hope is that Bitcoins make the transition from being just a commodity and become money, used on a daily basis. Here are some reasons this won’t happen
- Regulators will stomp on them
- You have to eat
- You have to pay taxes
Let’s discuss each of these:
Regulators will stomp on them
Bitcoin proponents tout how they are untraceable and impossible to regulate.
The government might be slow, but it only takes one person to realize all they have to do is the same thing the United States did in 1933. Make it illegal to own Bitcoins. It’s simple: if they find you with Bitcoins on your computer, they toss you in jail. If you’re in China, they shoot you. The transactions might be anonymous, but you’ve still got to store them somewhere.
Not only can any government regulate their ownership, but if Bitcoins get a critical mass, they will HAVE to. There is some evidence that the recent soar in Bitcoin prices is due to Chinese wholesale adoption of them. However, China (like any major government) relies on being able to manipulate the value of their currency. They cannot allow unchecked adoption of something outside of their control. In just the last few days, we’ve seen China take steps to mitigate Bitcoin growth.
You have to eat
An entirely electronic way to buy things works great…as long as everything you need to buy is online. What percentage of your daily expenditures are web based? What incentive do physical stores have to accept digital currency?
As far as I can gather, Bitcoin proponents think a conversation like this is imminent:
If only we already had an untraceable way to pay for everyday items that is not only legal, but supported by our government. Oh wait…isn’t that what cash is?
You Have to Pay Taxes
Let’s say the government, for some strange reason, never regulates Bitcoins.
They’re not stupid enough to accept a competing currency to pay your taxes.
To get your USD into Bitcoins (and vice versa) today, you’re looking at a 5-10% commission. You could you argue that as the demand gets larger the cost will drop.
Except exchanges are getting shut down left, right, and center. The funny thing is when they shut down, they tend to keep the money. That’s the downside of having untraceable transactions…it assumes people aren’t greedy. To my mind, that’s a suckers bet.
Even if the commission drops to 2%, who in their right mind is going to get paid in dollars, convert them to Bitcoins, and then convert them back to dollars to pay taxes?
Never in the history of money have the state and money been two distinct entities. There’s a reason for that and it’s called taxes.
Wrap It Up: Is this a Bitcoin Bubble?
Who would be interested in Bitcoins as a currency? From this article we see they are people who want anonymous transactions, are comfortable carrying personal risk, and don’t pay taxes. Turns out, these are the same people who currently transact in cash, are comfortable carrying personal risk, and don’t pay taxes. We call them criminals.
Unfortunately, Bitcoins are not an accepted token of debt…nor will they ever be. So they can’t be valued as money in and of itself.
That means their only value is as a commodity. Except their commodity value is 0! They have no use in and of themselves.
Is the Bitcoin bubble going to burst soon? I have no idea. That’s the trouble with bubbles, irrationality can last longer than your bank roll.
However, I’ll leave you with a parting thought.
In my BiggerPockets podcast interview, I mentioned the cab driver test. Whenever a cab driver asks you how to buy something, the first thing you should do is sell it. Why? Cause by the time someone who doesn’t follow finance hears about the “hot new thing,” the bubble is running out of suckers.
Last week, my cab driver asked me how to buy Bitcoins.
Photo: BTC Keychain