Over the last year I wrote many articles about the Bitcoin attempting to discredit the claims that the Bitcoin is a viable currency. After a year of volatile price swings, the data is finally available and obvious enough that the concept of the Bitcoin as a currency is finally starting to fade. This article titled "Why I Lost Faith In Bitcoin As A Money Transfer Protocol" does a great job highlighting why the Bitcoin won't ever be a viable currency.
The first flaw is its very foundation. The Bitcoin is founded in the misguided Libertarian ideology that central banks are evil and that transactions should be conducted in secret allowing them to avoid taxation.
This whole debate reappeared when Charlie Stross stated that "Bitcoin looks like it was designed as a weapon intended to damage central banking and money issuing banks, with a Libertarian political agenda in mind - to damage states ability to collect tax and monitor their citizens financial transactions."
Ironically Article 1 Section 8 Clause 5 of the US Constitution, a document the Libertarians claim to support, clearly gives the Federal Government the right to "coin money and regulate the value thereof." Counterfeiting was also a crime punishible by death. Article 1 Section 8 of the US Constitution defines the enumerated powers of the Federal Government, powers that must be paid for with taxes. I'm all for smaller government and greatly reducing its size and limiting its scope, but I'm for doing it the proper way, through the democratic process, not through deceitful and nefarious methods intended to destroy our monetary system.
The counterfeiting of money is one of the oldest crimes in history. At some periods in early history, it was considered treasonous and was punishable by death.
Our Founding Fathers understood the importance of a stable and secure monetary system as the basis for a sound economy. George Washington chartered the First Bank of America which lasted through the administrations of Washington, Adams and Jefferson. James Madison, the author of the US Constitution, chartered the second Bank of America. A sound monetary system has been and continues to be the foundation on which the US economy depends. The claim that the Federal Reserve has failed simply ignores the fact that the world has chosen the US Dollar as its reserve currency, something that would never happen is the claims of the "End the Fedders" were even remotely accurate. The US Dollar is the bedrock of the entire global financial system. That can hardly be considered a failure.
The other problem this anti-central bank foundation has is that if you are going to "End the Fed," you have to have something to replace it with. If the supporters of the Bitcoin think that it is a viable alternative to the Federal Reserve they are wrong on an epic scale. Last year proves this point beyond any resonable doubt.
Yet, in a month's time, the value of a bitcoin went from $200 to more than $1,000 on all the exchanges. In other words, it is as volatile as it can get. Right now, there are only around 12 million of bitcoins in circulation, and many Bitcoin holders are recent converts that buy and sell every day. So how could you think about using bitcoins to pay the rent? You could simply hold your bitcoins and expect to triple your wallet value in a couple of weeks instead.
That's why I believe Bitcoin isn't the next world currency. Bitcoin's true purpose is not what everyone originally expected - you won't buy a pizza in bitcoins anytime soon. Moreover, Bitcoin won't be able to remain an unregulated currency for long.
The whole problem with the Bitcoin is that it is designed to fix a problem that really doesn't exist, and its solution is infinitely worse than the problem. The "End the Fedders" believe that the Federal Reserve creates inflation, inflation is bad and therefore the Federal Reserve is a destructive force for our economy. Nothing could be further from the truth, but don't try explaining that to an "End the Fedder," there is a religious fervor around this topic that makes rational debate virtually impossible. I call the "End the Fed" movement the global warming of the Libertarian Right. Once issues become politicized, facts and reason become relevant. If people will believe something, and if there is political gain to be had, the truth becomes the first victim. A lie told often enough becomes the truth. The bigger the lie the better.
First, mild, predictable and stable inflation is not bad, in fact those are the ideal conditions for economic growth and stability. The markets and economy thrive is low inflation environments. The "End the Fedders" love to repeat "facts" like the US Dollar has lost 95% of its value since the founding of the Federal Reserve in 1913. That sounds awful until you analyze that statement. First, that is only true if you earned a US Dollar in 1913, buried it in your backyard and dug it up 100 years later. No one does that. People rarely hold money outside the banking system, and when they do it is usually in order to facilitate transactions. That means the impact of inflation on a US Dollar is usually limited to the time money is held in someone's wallet or purse which usually is a few days at best. Most people live paycheck to paycheck so the impact of inflation on an actual US Dollar is negligible. Had someone earned a US Dollar in 1913 and placed it in a savings account, the interest earned over the next 100 years would have been more than enough to compensate them for inflation. Over time wages have tended to outperform inflation so the standard of living over the last 100 years have greatly outperformed the cost of inflation, and standard of living is the true measure of a successful economy, not whether or not the currency held its value or how low inflation is.
Second, the "End the Fedders" act as if you can simply choose to have zero inflation. That belief totally ignores just what inflation truly is. Ask an "End the Fedder" and they will tell you that inflation is "printing money." That may be the definition they choose to accept, but it has no relationship to reality. The only definition of inflation that matters to the economy, the markets and investors is the rate of inflation discounted in bonds and other financial instruments.
Regardless of how much money is being printed, if the markets don't perceive the additional money as resulting is increasing demand to the point that it outpaces supply, resulting in an AGGREGATE increase in prices across the economy, then to those who matter, inflation doesn't exist. This belief that printing money is inflation, even when bond rates are at or near 0% is analogous to the global warming scientists getting trapped in ice trying to prove that Antarctic sea ice is disappearing. No matter what the evidence or fact, the belief doesn't change. Global warming is causing more ice and colder temperatures, printing money and inflation are causing 0% interest rates. Clearly there is something wrong with those theories, but facts don't matter when politics is involved.
Facts are inflation is an AGGREGATE increase in prices. At any time, some items are increasing in price, other items are falling in price, but in aggregate, the overall price level increases. No matter what the monetary system, some items' prices will increase and others will be decreasing. A basket of goods today costs more than the identical basket some time ago, that is inflation. Even if the money supply was fixed, the individual price of an individual item is determined by supply and demand for that item, so individual prices could be increasing or decreasing at any time for any good, regardless of the monetary system. Case in point, since 2011 gold prices have fallen, but the monetary base has greatly increased. To an "End the Fedder" that counts as inflation. Clearly there is something fundamentally wrong with that theory.
Third, if the US Dollar losing 95% over 100 years is justification to "End the Fed," then the Bitcoin and gold/SPDR Gold Trust (NYSEARCA:GLD) don't even get out of the starting gate. Over a 14 day period the Bitcoin lost 70% of its value. Gold lost about 30% just last year. Silver/iShares Silver Trust (NYSEARCA:SLV) has lost over 50% of its value since 2011. While it is true the Bitcoin did recover from this sell off, that is no consolation to those who transacted for Bitcoins during that period. Additionally, I expect that the Bitcoin will be worth about as much as a Cabbage Patch Doll, pet rock, POG, Tickle Me Elmo or Mood Ring within the next few years. Bitcoin is a fad, a very dangerous and risky fad, but a fad all the less.
Forth, the fatal flaw of the Bitcoin is that it is intentionally deflationary. That is a counter intuitive concept, and why the Bitcoin believers are so convinced of their beliefs. On its surface it doesn't appear to make sense that a mildly inflationary currency is superior to a deflationary currency. What is wrong with a currency that not only holds its value, but actually strengthens over time? The best analogy is when Doc tells Lightening McQueen that to turn left you have to turn right. On its surface, that seems to make no sense what so ever, but in fact it is the right thing to do.
The reason a deflationary currency is so bad is ironically because of all the reasons and Bitcoin supporters claim are its strengths. The Bitcoin is deliberately designed to eventually have a perfectly inelastic supply, meanings that there is a finite amount. Supposedly, after a certain period of time no more Bitcoins will be "mined." That sounds ideal on its surface. No longer will the Fed be able to "print money out of thin air." If "printing money out of thin air" and inflation are bad, why not just create the opposite? Create a currency that can't be printed out of thin air and is deflationary. That is the logic, and that is bitcoin.
That sounds perfectly logical until you examine it.
1) The US Dollar and its fiat structure isn't inflationary. It is managed to maintain price stability. Yes there is a moderate inflation built into the model, but that is basically insurance to prevent deflation. Given the choice between 2 evils, inflation in infinitely preferable to deflation.
2) The Bitcoin is deliberately deflationary. Once again that sounds like the ideal currency, but it isn't. Economies collapse under deflation. The quantity theory of money defines how a monetary system functions. MV=PQ, M=Money Supply V=Velocity of Money and P=Price level and Q=Real GDP. With the Bitcoin, M is fixed and for this example V is also fixed. As the economy grows, i.e. Q increases, if both M and V are fixed, the only way for the equation to remain in balanced is for P, the price level, to fall. With money supply and velocity fixed, economic growth creates deflation. Deflation is the intended outcome of a monetary system based upon a fixed money supply. Problem is, try running an economy based upon deflation, it doesn't work. Real interest rates continually increase, sales revenues are often less than the cost of goods sold, inventories continually lose value and fixed wages continually increase without a compensating increase in productivity. Bottom line, a deflationary economy returns less than what is put in...by design.
3) In reality, under the deflationary Bitcoin V isn't likely to be fixed, it is likely to decrease, compounding deflation. If you just watched your Bitcoin go from $200 to $1,000 in a matter of weeks, are you going to be in a rush to spend it? Every day you don't spend it can make you a fortune. The extreme price increases are an incentive for people to horde Bitcoins, not spend them.
4) No banking system could ever function using a Bitcoin and loans would be effectively impossible. Imagine someone taking out a loan for 1,000 Bitcoins when it traded at $200 so they could buy a $200,000 home. A few weeks later that 1,000 Bitcoin loan is going to cost $1,000,000 in US Dollars to pay back. Imagine stores and restaurants that accept Bitcoins, they will have to have a real time pricing system for all their goods, services and menu items. One minute a Big Mac may cost 3/200 of a Bitcoin, and a few minutes later 6/200 of a Bitcoin, and a few weeks later 3/1,000 of a Bitcoin. The insane volatility guarantees its ultimate failure.
5) Stores won't except Bitcoins unless they are immediately converted to cash or hedged. That is exactly what Virgin does when they accept the Bitcoin. They immediately convert it to cash, so what is the real benefit? They might as well just asked the person to convert their Bitcoin themselves and give them the cash. Basically by accepting the Bitcoin and then converting them to cash Virgin can appear to be cool and hip to the public, but in reality they are simply taking US dollars. They aren't willing to take the risk of holding a Bitcoin, but don't seem to mind encouraging the public that has no understanding of the risks involved or how to hedge to take those risks.
He said Virgin Galactic has transferred the bitcoins it received in payment today into U.S. dollars in order to lock down a fixed price at which to deliver a possible refund if one were asked for. Potential space travelers have the right to change their minds up to three months before departure, he said. It costs $250,000 to fly to space with Virgin Galactic.
6) Merchants will never be able to take just Bitcoins over the long-run. Imagine Walmart (NYSE:WMT) buying an inventory when the Bitcoin was worth $1,200, and then in a matter of days watch the Bitcoin get cut in half. 5 to 10% margins on items simply won't cover the risk of transacting in Bitcoins. A two week period of Bitcoin collapse could bankrupt Walmart, let alone Joe Mom and Pop. Yes, I'm sure people are saying right now that I am wrong and that plenty of merchants have survived on nothing by Bitcoins. I saw a couple of pre-teen Bitcoin millionaire on CNBC just the other day, and yes, some people will and are getting filthy rich, but trust me, the day of reckoning will eventually be here, it is only a matter of time.
7) Whether intentional or not, the Bitcoin is designed to be the ultimate bubble creator. I wrote about that back in July, and the Bitcoin has proven me correct way beyond my wildest imagination. Back then the Bitcoin traded around $200. When I first wrote about the Bitcoin it was $140. Facts are, as long as interest in the Bitcoin exists, it is virtually guaranteed to go higher. Just like the Dutch Tulipmania, the Bitcoin bubble has the potential to reach extraordinary heights, but make no mistake, Bitcoin is a bubble machine, and all bubbles will eventually burst. I heard similar confidence out of the gold bugs when gold was $1,900/oz, and the owners of beenie babies as well.
8) With near 99.999999% certainty, the Bitcoin bubble will eventually burst, and investors/gamblers that come late to this high stakes game of musical chairs are almost certain to lose fortunes. The maximum number of Bitcoins is set at 21 million. Simply do the math and plug that number in for M in MV=PQ. M1 is $2.6 trillion dollars, the US economy is $17 trillion, WMT has annual sales of almost $500 billion, 21 million is laughable when things are put into perspective. Clearly the geniuses behind the Bitcoin forgot a few zeros. Maybe they didn't read the fine print that GDP numbers are rounded to millions. They must have thought our GDP was only $17,000,000, and based their calculations off that. Much like the NASA scientists that failed to convert the Mars Lander computations to metric from feet, Bitcoin programmers have made a fatal error in their programming, only this time is won't be a spaceship that crashes, it will be some people's life savings.
9) Even the best argument for the Bitcoin I've seen doesn't hold up under examination. The best argument for the Bitcoin I've seen is for it to be a global standard for transaction free currency exchange. Use a Bitcoin and avoid those annoying and expensive FOREX Kiosks at the Airport. Yep, the Bitcoin can help you avoid transaction fees, but a 1 or 2% charge in nothing compared to the damage holding onto a Bitcoin can do. Bottom line is, to transact in Bitcoins, you must hold a Bitcoin, and in the time it takes you to fly to Paris with your virtual wallet in hand, you may land with 50% less, or more for that matter. Once again, the insane volatility once again eliminates the use of a Bitcoin for anything except transactions that are instantaneous, not only in acquiring the Bitcoin, but also converting it to local currency. If the people involved in the transaction are required to hold the Bitcoin unhedged for any period of time, the Bitcoin is simply too risky to function as a global transaction free universal currency conversion vehicle.
Overall, it was a painful experience, even more painful than using traditional foreign exchange services. But more importantly, I don't see how I could trust Bitcoin as a money transfer protocol with such a high volatility. Fees were much lower, but it doesn't matter if you don't know how much money you will get on your bank account in the end.
A couple of weeks ago, Bitcoin's value went from more than $1,100 to around $650 in a few hours, because of a new rule in China. You can't use Bitcoin for serious amounts of money if there is a chance of losing 40 percent of your money overnight.
As long as Bitcoin remains a young and volatile currency, Bitcoin's mechanisms will remain beautiful on paper. Using it for real world transactions would be crazy
10) Another fatal flaw of the Bitcoin is that for it to be a global currency, you have to be able to acquire a Bitcoin. Besides the fact that many in the world don't have access to a bank, let alone know how to use a computer of smart phone, there are over 6 billion people in the world and there will be a maximum of 21 million Bitcoins. At best every person of the face of the earth could hold a small fraction (approx 1/300) of a Bitcoin. Over time as population grows and virtual wallets get lost, that number will even worsen.
Once again, the geniuses behind the Bitcoin just seem to have failed to think this through, or maybe forgot to add a few zeros. This complete failure to demonstrate an understanding of even the basics isn't much different from the "experts" that gave us global warming. The earth emits radiation around 10 microns consistent with 18 degrees C, CO2 absorbs radiation around 15 microns with -80 degrees C. The very basis of the greenhouse gas theory doesn't work when applied to CO2, the lines simply don't add up, but that doesn't matter, those behind the consensus are counting on people not understanding the basics.
Just because people can be convinced of something doesn't make it the truth, it just means some people will resort to any tactic necessary to push an agenda. Note how the red bar totally misses the bands that CO2 absorbs. That isn't my graphic, it comes from a text book that obviously isn't used in the climate sciences. It's easy to reach a consensus when the people you are dealing with don't even bother to understand the basics of the topic they claim to be "experts" in. Right now there is a consensus that the Bitcoin will be worth more tomorrow than today, so it is holding its value. Sooner or later that "consensus" will be shattered by a sharp dose of reality, much like those climate scientists that got trapped in Antarctica trying to prove the ice was disappearing.
In conclusion, people should not be surprised that the Bitcoin is forming a bubble, by intent or not, that is what the Bitcoin is designed to do. When you think Bitcoin, think MV=PQ, and you can see why theoretically the Bitcoin could easily reach $1,000,000 or more. From that article it proves that I am not the only one that has reached the conclusion that this is designed to be a bubble machine.
I have explained why Bitcoin is the "perfect asset bubble." (Because there is no real way to value it.)
I have explained why Bitcoin speculators are just laughing at everyone who thinks they are idiots for buying Bitcoin. (Because Bitcoin's price could theoretically rise 1,000%, 10,000%, 100,000%, or more, whereas the most you can lose on your Bitcoin investment is 100%)
Facts are, the Bitcoin is in the process of forming a bubble, facts are it is designed to do that, facts are it may have much higher to go, facts are every bubble in history has eventually burst, facts are the Bitcoin will be no different and facts are a lot of people are going to get hurt. The problem I have with the Bitcoin is the same problem I have with the gold bugs, they use dishonest, misguided and flawed theories to defend their position. Some even have nefarious objectives as mentioned in the article sourced at the start of this article. The Fed is not evil, QE did not cause inflation, inflation is not printing money and the Bitcoin has zero chance of becoming a viable currency. If losing 95% over 100 years disqualifies the US Dollar as a viable currency, that standard certainly rules out the Bitcoin and gold. If the gold bugs and Bitcoin believers simply apply the same standard they hold the US Dollar to they will recognize that their choice of currency is infinitely less qualified than the currency they are attempting to undermine and replace.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.