Bitcoin: Currency Or Accidental Ponzi Scheme?

I’ve been intrigued by the whole Bitcoin experiment ever since I heard about it in 2011. I’ve never totally understood the concept to be honest, but I’ve kept an eye on it to see how it goes and, thus far, it’s been going up, up and up in value. Which might be a great thing if Bitcoin were meant to be an investment, rather than a currency.

My question is, how useful can Bitcoin be as a currency if it’s so extremely volatile? With USD, at least I have a reasonable estimate of prices and value from day to day. With Bitcoin, I might be able to buy 30 widgets one day and five just two weeks later. That doesn’t give it much value as a means of exchange for the vast majority of individuals or businesses.

Whither Stability?
Most of us value predictability more than any other attribute for a currency. We don’t want $20,000 to buy a new car one day, but only a dozen eggs six months later.

The reverse situation might seem better, until you start to think about the impact. For instance, let’s say I offer an employee 30,000 Bitcoins per year in salary and 1 bitcoin = 1 U.S. Dollar at the time we make a contract. Over the next 12 months, the value of Bitcoin increases 20-fold. By the end of the year, I’m basically paying that employee $600,000 in salary. Unfortunately, that would bankrupt most businesses. It would also make any debts virtually impossible to repay. Price stability has a lot of value for people.

Of course, this is the exact situation we find ourselves in; in fact, the true situation is more dramatic than the example above. One year ago, bitcoin cost about $4.93. Now costs a bit over $200. That’s an increase in value of around 4000%. It’s difficult to argue that some fundamentals have radically changed so much to justify such a dramatic increase in intrinsic value, which begs the question as to whether this is a bubble.

Is It Even A Currency?
I’m not totally sold on this idea that bitcoin is a “currency.” Mind you, I’ve been rooting for Bitcoin. I truly want the experiment to work; but the question of “what is a currency?” is one of those deeply philosophical questions that very few economists can agree on. It’s like asking “when does life begin?” or “what is God?” Ask 100 people and you might get 100 different answers.

Why is Bitcoin a “currency”? What makes it a “currency”? It’s not really clear to me.

Of course, one might ask the same question about the U.S. Dollar, or the British Pound, or any other currency. The Dollar has value because it’s backed by the “full faith and credit of the United States” and merchants generally perceive it to have value. But what does that mean? The Dollar is no longer backed by gold, so it’s not like I can go to the U.S. Treasury and ask for assets to replace my Dollars. The Dollar’s perception of value has its roots in over 200 years of history.

I have difficulty articulating why a U.S. Dollar is more of a “currency” than Bitcoin, except that hundreds of millions of people perceive and agree that the Dollar has value, whereas that’s not the case with Bitcoin. All that history, combined with a historical strong monetary and economic system, has created a currency with at least somewhat predictable value.

Kind Of Like An Equity Position
In a recent article, I argued that the U.S. treasuries are actually more like equity positions than debt. Since the U.S. government can create as much currency as it likes, that makes U.S. treasury debt more akin to corporate equity, since corporations can print as many shares as they like.

With corporate equity, your stock represents a claim on the assets and cash flows of the company. If a company’s equity is worth $100 million and there are 20 million shares, the intrinsic value of each share is $5. But what if the company prints 80 million more share and gives them away for free? Then, the intrinsic value of each share is $1.

I believe that the U.S. Dollar works in a similar way. It represents the assets of the United States economy and its value will generally increase if we print no more money (claims). If we create too much new money (thus more claimholders), the value of the Dollar will generally decline relative to real assets.

If Bitcoin is a “claim on assets” (and I’m not sure if it is or not), then maybe it’s working the same way. If 10 people bought bitcoins at $5, 10 people bought in at $20, and 10 people bought in at $100; maybe the intrinsic value is somewhere around $42 (5 + 20 + 100 divided by 3) and the people buying in at $5 and $20 are wealthier, while the person buying in at $100 made a poor investment -- unless there are 10 more suckers out there willing to pay $500, and then suddenly, the intrinsic value rises to $156.

If this is the case, I worry that Bitcoin may end up being a giant Ponzi scheme; albeit, I don’t believe there was any intent to set it up that way. So long as new people come in and pay more, the old “stakeholders” profit, but once there are no more people in line, the value collapses. Unfortunately, if this happens, Bitcoin’s viability as a currency will be undermined.

My Prediction
I’m not totally sure what’s going to happen here and I’ve enjoyed following the debate, because I think most people don’t know. This seems somewhat unprecedented.

Justin Fox wrote a good piece on Bitcoin at HBR: Building a Better Bitcoin.

I tend to agree with Fox’s arguments. Bitcoin was designed as a “store of value” and even worse, an “investment”, rather than a viable medium of exchange and payment. If I had to make a prediction, I believe Bitcoin will fail now that it has turned into a full-on bubble and, arguably, an accidental Ponzi scheme.

I don’t think we’ve seen the last of private currencies, however. Not with what’s happening in the euro zone, the U.S. and Japan right now. Whether it can be done effectively or not, I’m not sure, but certainly someone is going to have to deal with the issue of price stability. When the value of your “currency” increases 4000% in one year, you no longer have a “currency”; you have a speculative collector’s item and just like the baseball card bubble, this one is probably bound to crash.