You probably didn’t hear about it on the evening news or read about it in your local newspaper, and the president didn’t Tweet about it, but one bitcoin is now worth twice as much as an ounce of gold.
“What is a bitcoin?” you ask. Good question. A bitcoin is a “crypto-currency” that exists only in cyberspace. It was developed and launched in 2009 by an unknown programmer or group of programmers (no one is quite sure) using the name Satoshi Nakamoto. The intent was to create a form of money that is not controlled by a central authority like a government or central bank and therefore not subject to political manipulation, replication, taxation or confiscation.
Initially bitcoins appealed primarily to computer geeks and libertarians hoping to break the monopoly of governments on money creation. When bitcoins were first introduced one could be purchased for as little as six cents.
But as more merchants and financial institutions began accepting bitcoins, their value increased, and by 2012 they were selling in the range of $5 to $25.
Imagine you had purchased 1,000 bitcoins for $5 each in 2012. Today, just five years later, those coins would be worth $5 million.
But the road to parity with gold was a bumpy one. Back in 2014, bitcoins’ value soared to nearly $1,000 as drug dealers and other black marketers were attracted to bitcoins, which enabled them to keep their anonymity and to circumvent the banking system and government regulators as they engaged in their nefarious financial transactions. (The transaction history of each bitcoin is public record, but the owner is identified by a number or “key” that only the owner knows.)
In such a thin market, a few large transactions can cause wide price swings, and the value of a bitcoin soon dropped back to around $200. This volatility caused many serious investors reconsider their commitment to bitcoins.
In economics, to be considered “money,” something must serve three functions: it must be a medium of exchange (you can use it to purchase other goods); retain its value over time; and be a standard of account by which the value of other goods are measured. Bitcoins were not particularly good at any of these: they were not widely accepted by merchants; their value was too volatile to be a reliable store of wealth; and nobody kept their books in bitcoins.
But this has been changing. Today, one can use bitcoins to make purchases from an increasing number of merchants, such as Dell Computers, overstock.com and even Subway sandwich shops. Third-party payers who will convert bitcoins into dollars for a nominal fee have sprung up. This enables people to use their bitcoins just about anywhere credit cards are accepted.
As the number of users and acceptors has increased, much of the exchange rate volatility has gone out of the bitcoin market.
Unlike in 2014, the current surge in the price of bitcoins appears to be driven by large institutional investors, especially in Asia. Japan and the Philippines have recognized bitcoin as legal tender, and are set to drop any relevant taxes on traders and investors; political tensions in Korea have created a flood of new investors; and the Chinese government is reported to be acquiring bitcoins to bolster that country’s banking reserves.
Forbes magazine has reported that the bitcoin has become so mainstream investors now see it as a new asset class and hundred-million-dollar hedge funds are being created to acquire bitcoins. Germany’s largest financial news network, Finanzen.net, now lists the bitcoin among the seven major reserve currencies it considers to be the basis of the global economy.
One aspect of bitcoins that appeals to investors is their limited supply. The complex mathematical function through which bitcoins are created will allow no more than 21 million coins to be created, and 15 million of those are already in circulation. This means that as the demand for bitcoins increases, the price is almost certain to rise.
I am not suggesting that anyone cash in their 401K and buy bitcoins. The old maxim for investors is to buy low and sell high, and $2,500 for a bitcoin seems like a very high price to me.
It is possible that the surge in the price of bitcoins is a speculative bubble like the tulip bulb craze in 17th century Holland, when speculators drove the price of tulip bulbs to absurd heights until the bubble finally burst and the price of tulips suddenly collapsed.