Those that dont understand the fundamental value proposition of bitcoin and crypto-currencies are out in force today, due to the Chinese decision to shut Bitcoin exchanges. This is interesting for many reasons, most important of which is that the Chinese move was predictable and, if anything, might make crypto-currencies more valuable in the long run. That said, before I explain how and why that might be true, permit me a little rant.
I am always amazed by the capacity of people, lacking expertise or knowledge of specifics, to make authoritative conclusions about why markets move the way they do. During the Internet bubble, I got tired of hearing this time its different or its a new paradigm for valuation when describing why companies SHOULD trade at 100 times sales, despite no profit and no path to grow. During the run up to the financial crisis, I could not understand how national housing prices could reach levels where the only way the average person could afford a house was to perpetually re-finance.
Yet, in both situations, TV commentators and well-known analysts kept up the bullish siren song until the bitter end. Then, in the aftermath, in many cases, despite the firehose of liquidity being sprayed by central banks into the asset markets, those same people took a long time to understand why assets were no longer falling…
I have reserved judgement on crypto-currencies until recently, when I finally took some time to learn about the dynamics of the market. From my Austrian Monetarist view of economics, I was slow to comprehend why an asset with no real backing would increase in value so rapidly, basically when the rationale was the same reason that many people invest in gold. After all, not only does every story about BitCoin, picture golden coins with a B on them, but the story behind the asset is the same. Both assets are plays to profit from those losing confidence in the worlds central banks, who have printed trillions of dollars of extra fiat currencies.
The argument is that dollars, euros, pounds, yen, etc, have nothing backing them anymore, besides a government with a printing press, so lets back a new global currency. Lets pick one that can facilitate trade in the modern world, that uses modern technology to ensure there IS NO PRINTING PRESS, that can ensure the validity of transactions and that has the key characteristics of money. (Impossible to counterfeit, durability, divisibility, portability, limited supply, uniformity, and acceptability). Amusingly, the fiat currencies of the world no longer have a limited supply and most countries have rules against portability as well. Gold, of course, meets all of these characteristics, which is why it (along with silver) has been considered money for thousands of years. (It is also why, in the 1930s, when the US lost control of the dollar due to excessive government spending, they confiscated and banned the use of gold. Of course that excess spending pales in comparison to the global liquidity deluge we have experienced in this era, but that is another story)
The jury on individual crypto-currencies is still out, however, as acceptability is arguably the key to their valuations. (for all the crypto-currency die-hards reading this, pardon the pun) What is impossible to argue, however, is that the evolving technology, whether by smart contracts such as Ethereum and others, or verifiable crypto-currencies like Bitcoin, has created a framework for a modern monetary system that threatens central bank control. That technology also has the potential to remove a lot of frictional cost in the global economy caused by difficulty in verifying and processing transactions. Thus, it is easy to understand the excitement on the overall value and potential for the technology, but that, of course, does not necessarily translate to individual assets, many of which seem absurdly valued.
Getting back to the China story, the pundits dont typically understand the fundamental value that I just described. They look at China, whose governments greatest economic fear is losing control over their own currency, and seem surprised that they would act to restrict Bitcoin, despite the fact that it threatens central bank control. Put simply, if Chinese citizens and companies were allowed, in perpetuity, to trade bitcoin freely against either Renminbi or other fiat currencies, how could the government use their currency to influence trade? As long as Bitcoins value was limited, it was not much of a threat, but as it gained traction, they probably determined that it needed to be stopped.
So, the real question is if the US, UK, European and Japanese central banks will act in the same manner. If they dont (or cant, for constitutional reasons) act to invalidate the emergence of crypto-currencies as a medium of exchange, do they have risk? I would argue that it is possible, but is also a long way off since those central banks allow their currencies to trade freely against other currencies and assets. (Unlike China). Therefore, crypto-currencies act, at least in the short term, as a conduit between currencies, rather than an alternative to currencies. It will only be, at some time in the future, when companies pay workers in crypto-currencies AND those workers buy goods, services and assets in crypto-currencies, that central banks have something to fear. Until then, compensation, taxation and trade will continue to be based on the fiat currency regime.
To be clear, and by way of conclusion, I have no idea whether todays crypto-currencies will go up or down in the short or intermediate term. They have had a parabolic move, but the total market is still a tiny fraction of the value of currency markets. At some point, I do think that a move towards ubiquitous blockchain powered currencies and transaction is inevitable, and that could result in much higher valuations for the winners in the space. Consider that, in the internet bubble, very few of the companies trying to reinvent the information economy survived to have ANY value. I suspect the same thing will happen in the crypto-currency world. Those internet companies that did survive, however, have created a remarkable impact in the past 20 years. Companies such as Google, Amazon, Apple, Microsoft, Facebook, and others have power rivaling governments and have transformed the daily lives of both consumers and businesses globally. Their impact on the global economy has been incredible, and their market capitalization dramatically exceeds those of the thousands of Pets.Com companies that failed.
It is too early to tell, however, if Bitcoin or Ethereum (or others) are going to be the equivalent of Google or will be the equivalent of Pets.Com, but the one safe bet is that a lot of money is going to be made by those that predict the answer correctly…
