Everything you need to know about the Bitcoin ‘bubble’

November 8, 2013

(btckeychain/Flickr)

The price of bitcoins rose above $300 for the first time ever Friday, sparking renewed media attention and fresh claims that the high price represents nothing more than a speculative bubble. Unfortunately, the debate over the currency's future has generated more heat than light, with both sides making arguments that don't stand up to scrutiny. To help cut through the clutter, here's a comprehensive guide to the debate over Bitcoin's future.

Is there a Bitcoin bubble?

No one knows. The value of Bitcoins has soared by a factor of 1,000 since the beginning of 2011. Today, the value of all outstanding bitcoins is now around $4 billion. So far, the volume of Bitcoin-based commerce isn't close to being large enough to justify that high valuation.

But people who are buying bitcoins today aren't doing so based on today's Bitcoin-based commerce. They're making a bet that the demand for bitcoins will go up dramatically in the coming years. The supply of Bitcoins is fixed. So if Bitcoin becomes an important part of the global financial system, its value would need to go a lot higher to accommodate the millions or billions of Bitcoin-based transactions that might occur in the future.

So the question is whether someone will develop a "killer app" that will push Bitcoin into the mainstream. If that happens, the value of Bitcoin could go even higher. If it doesn't, then sooner or later the currency's value will plummet.

What's the case for Bitcoin optimism?

A comparison with the Internet can help illustrate why people are excited about Bitcoin. In the late 1980s, the Internet wasn't a very impressive online service. It was expensive to join, complicated to use, and it featured text-based applications like e-mail and message boards that weren't obviously better than commercial online services like Compuserve, Prodigy and AOL.

But the Internet had an advantage that commercial online services did not: Its open architecture meant that anyone was free to create new online services. In 1990, a programmer named Tim Berners-Lee created a new Internet application called the World Wide Web that offered advanced features like graphics and hyperlinks. And within a few years, thousands of people had begun building Web sites on top of this new platform. Startups like Yahoo, eBay and Hotmail began to build sophisticated Web-based services. Within a few years, the Internet had vastly more content and services than the companies that ran AOL or Prodigy could hope to produce.

Bitcoin is the world's first completely open payment network, and it could spark the same type of bottom-up innovation. Mainstream electronic payment networks like Visa and Mastercard are managed by incumbent banks. If you want to interoperate with them — to become a merchant, open a bank of your own or develop a new payment technology — you have to convince these banks that you're credit-worthy, that your business plan makes sense, and that you will comply with their policies and procedures. That limits who can innovate and what kinds of business models they can try. In contrast, the Bitcoin network works like the Internet: There are no restrictions on who can join or what kinds of applications they can build.

Wait, you're talking about Bitcoin as a payment network, but I thought the point of Bitcoin was as an alternative to the Federal Reserve and its inflationary fiat money.

Some Bitcoin enthusiasts think that, but they're wrong. Allegedly, the problem with the dollar is that it loses value over time. Bitcoin supporters sometimes point out that the dollar has lost more than 90 percent of its value over the last century.

But that seems silly when we remember that Bitcoin has been known to lose more than 90 percent of its value in a matter of weeks. Whatever virtues Bitcoin has, stability of value is clearly not one of them.

You say that anyone is free to build new services using the Bitcoin network. But what specifically are you talking about? The only significant applications I've seen are gambling, drug deals and speculation on the future price of Bitcoin. That's hardly a promising start for a new financial system.

There's no good data on how people are using Bitcoin, but anecdotally it does seem like gambling, speculation and drug deals account for a sizable fraction of Bitcoin transactions. But other applications are possible, and we're starting to see some of them appear already.

For example, in September, the Bitcoin startup Bitpay announced that it had signed up 10,000 customers, up from just 1,000 a year before. Bitpay makes it easy for merchants to accept Bitcoins by automatically converting Bitcoin payments into dollars and depositing them into vendors' conventional bank accounts. And merchants like accepting Bitcoins because the Bitcoin network doesn't have "chargebacks," the process whereby credit card users dispute transactions to demand their money back.

Other applications for Bitcoin are more speculative, but they could wind up being big markets. An obvious one is international payments. Right now, to transfer cash from one country to another, you generally have to use an expensive wire transfer service like Western Union. Startups could use Bitcoin to build a decentralized, global system for international money transfers that is both cheaper and more convenient than what's available today.

Also, it's important to remember that one country's illicit application can be another country's civil liberties. Imagine a political dissident in Iran or China who wants to sign up for VPN service to help them evade domestic censorship or to sign up for Western Web hosting service to create an uncensored blog. Doing that kind of transaction with a conventional credit card is too risky, since the authorities can trace the transaction back to its source. It may be much safer to trade cash for Bitcoins in the local underground market, and then use bitcoins to pay for online services. There are already lots of VPN services that accept bitcoins.

But the most important applications may be ones that are hard to predict today. For example, conventional payment apps like Square have to comply with rules established by established credit card networks. A Bitcoin-based payments app could offer security, convenience or cost advantages that the rules of the conventional banking system prevent Square from offering. It's hard to predict the specifics, just as it would have been hard to predict YouTube or Facebook in 1990. But it's not crazy to think that someone will figure out how to use the Bitcoin network to build services that might not work on conventional payment networks.

That sounds great in theory, but Bitcoin is not user-friendly at all. You have to run weird software, and if you screw up, your money is gone forever. Even if people come up with innovative uses for Bitcoin, are ordinary consumers really going to go through the hassle?

It's true that Bitcoin could be more user-friendly. But the Internet analogy suggests that this might not be as big of a problem as it seems.

The Internet of the 1980s was every bit as intimidating to use as Bitcoin is today. But over time, people built more sophisticated and user-friendly services on top of the basic infrastructure provided by the Internet. Tim Berners-Lee invented the World Wide Web, allowing people to browse the Internet using a familiar point and click interface. PC makers like Apple built PCs with built-in modems and user-friendly software to help them get online more easily. Technology companies built user-friendly Web applications like Facebook and Gmail. Most recently, smart phones and tablets have made the Internet accessible to millions of users who found PC computing too complicated.

Bitcoin is likely to go through a similar process. Originally, Bitcoin was exclusively a sandbox for tech-savvy nerds. Today, using Bitcoin is still a lot less convenient than conventional financial networks, but startups like Bitpay (which helps merchants accept bitcoins) and Coinbase (which helps users acquire and spend them) are making it more accessible to mere mortals. That process will continue, with startups exploring new ways to make the system more secure, convenient and user-friendly.

Okay, what's the case for Bitcoin pessimism?

The most serious risk is that Bitcoin never finds its killer app — that it remains a niche currency used by nerds and drug dealers. That's a very real possibility, as right now most applications of Bitcoin are still speculative. And if no killer app is developed, then eventually the value of bitcoins will collapse.

Another major risk is hostility from governments. Bitcoin doesn't fit comfortably in established regulatory categories, and because no one owns the Bitcoin network, there's no one who can be ordered to modify the network to work more like conventional payment networks. There's some danger that regulators, especially in the United States, will conclude that Bitcoin is primarily a platform for illicit activities such as drug dealing and money laundering. They wouldn't succeed in eliminating the currency, any more than Hollywood has succeeded in shutting down online piracy. But they could push Bitcoin underground and prevent legitimate businesses from using the technology.

But so far, policymakers have taken the opposite tack. While the government has aggressively prosecuted individuals who have used Bitcoin for illicit purposes, they've been careful to say that they have no quarrel with the underlying Bitcoin technology. Leaders of the Bitcoin community have emphasized that they're anxious to work with policymakers to comply with applicable regulations to the extent that they're able to do so.

A final threat is that Bitcoin could be superseded by another virtual currency. Leading candidates include litecoin and Ripple. Right now, that doesn't seem like a major threat. Bitcoin enjoys what economists call "network effects": the currency with the largest user base is the most useful, further entrenching its status as the most popular. So far, there's no sign of Bitcoin losing ground to these newer alternatives.

What about Bitcoin's deflation problem? I've read that the fixed supply of bitcoins makes Bitcoin deflationary. And deflation has terrible economic consequences, right?

It's true that unduly tight monetary policy can be economically ruinous, as the experience of the Great Depression makes clear. But deflation is only harmful when a currency is used as what economists call a "unit of account" — that is, the unit with which peoples' salaries, mortgages and other long-term financial commitments are denominated. If the United States decided to abandon the dollar and begin using the Bitcoin as the unit for all major financial transactions, then deflation would be a serious concern.

Fortunately, no one expects this to happen, and Bitcoin doesn't have to become a unit of account for it to succeed as an alternative currency. People can continue quoting prices in conventional currencies such as dollars or euros, and convert these amounts to the equivalent number of Bitcoins at the time of payment. Many merchants already do this.

As for the idea that the rising value of bitcoins will cause people to hoard Bitcoins rather than spending them, that's based on flawed reasoning. If everyone holding bitcoins expect their value to rise dramatically in the future, then the price will rise now, until some Bitcoin holders are willing to part with their Bitcoins.

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Andrea Peterson | November 8, 2013