March 28, 2013 | By Tekoa Da Silva
Publisher’s Note: One of the hardest working young college graduates I’ve met in recent years, Patrik Korda, was kind enough to contribute an essay shown below regarding the issue of “Bitcoin”.
For context, Bitcoin is a newly formed digital currency which has rapidly grown in popularity (as well as in price) following the Cyprus banking system collapse. The chart below is the price performance of Bitcoins, which have seen a market cap expansion of almost 20x—from about $50mm to roughly $1B where it stands today—in less than one year.
(click to enlarge)
Bitcoin Bubble 2.0
By Patrik Korda
‘It is also important to make certain that our efforts are directed at the decisive core of the problem and not on distracting side issues. The more complex the difficulties we face, the more important it becomes to bear this in mind, for it is human nature to try to evade what we cannot cope with‘
– Bernard Baruch, My Own Story
A conversation with a typical bitcoiner usually leads into a whole series of ignoratio elenchi after ignoratio elenchi revolving around technological jargon. Thus, I think it would be useful to start this article off with a parable set in the past. Suppose that during the 1970′s, when consumer price inflation was an actual problem, someone went ahead and developed an alternative currency. Of course, there were no computers in the average household, no internet, and no peer-to-peer during that stagflation.
An entrepreneur named Wei Boyang sets up to take advantage of the situation. His proposal is to print a total of 1,000,000 units of what he calls coinstamps. He goes through great measures to insure that there would be no coinstamp counterfeits in the future, using various methods such as signing each stamp, classified materials, codes, et cetera. For the sake of argument, the coinstamp truly is counterfeit-proof. The only entity that could create more coinstamps is Wei Boyang. However, Boyang just happens to be a really nice guy, and having read Lord Acton, he even goes so far as to cut off his hand in order to make sure he cannot make more coinstamps.
Some may cry aloud that coinstamps have no intrinsic value or that they are not backed by anything. Wei Boyang, having also read his Carl Menger, points out that there is no such thing as intrinsic value. Value, explains Boyang, is a subjective phenomenon. Moreover, Boyang argues that it is actually a good thing that coinstamps are not backed by any commodity. If they were backed by something, such as platinum, then the underlying asset could easily be seized. Moreover, since there is no underlying asset to coinstamps, there are no storage fees and transfers are far cheaper than they would otherwise have been.
With inflation approaching double-digits, people who are worried about gold or silver confiscation start to pile into coinstamps. Similarly, investors who are worried about holding the least bad fiat currencies such as the Swiss Franc or the Deutsche Mark due to potential inflation in order to help exporters, also start to pile in. Coinstamps truly seem to be a stroke of genius. People start using them as a means of payment worldwide, even for long-distance transactions. The Federal government is unable to do anything meaningful about coinstamps because it does not have the resources to check every envelope that happens to be mailed. Moreover, since the stamps are so light and thin, lots of people mail them discreetly inside of other items, just to be on the safe side.
By all measures, coinstamp seems to be a hit. Through various ingenious methods, Wei Boyang helps prevent counterfeiting of the stamps. Moreover, Boyang ends up being labeled a domestic terrorist and arrested, which has the unintended consequence of increasing the popularity and awareness of coinstamps, leading people start piling in big time. There is but one problem, other fellows such as Jean de Meung, Johann Georg Faust, and Tycho Brahe also get in the game. While they are unsuccessful at counterfeiting coinstamps, they are successful at copying the protocol and making their own version. Although different in name, the knockoffs are virtually the same in substance. Jean de Meung makes meungstamps, making only 1,000 units, with his own fingerprints on every meungstamp as one of the security measures. Subsequently, he burns off his fingertips as part of a rigorous public relations campaign. With coinstamps trading at $750/cs, the new protocols start to gain traction. Since Wei Boyang wants nothing to do with the government, he has no patents on his invention. The fact that he was first to develop the alternative currency makes no difference to those flocking into the more affordable protocols. The lack of a moat on the scheme eventually sends the entire house of cards collapsing.
Back to Reality
While bitcoins cannot be hyperinflated in name, they certainly can be hyperinflated in substance. Already, there are numerous knockoffs such as namecoin*, freicoin*, and litecoin* in place. This is a particularly valid point because bitcoin is a starfish i.e., it is fully decentralized. As put by Ori Brafman and Rod A. Beckstrom, ‘The starfish doesn’t have a head. Its central body isn’t even in charge. In fact, the major organs are replicated throughout each and every arm. If you cut the starfish in half, you’ll be in for a surprise: the animal won’t die, and pretty soon you’ll have two starfish to deal with‘*. After Napster went under, Niklas Zennström (the creator of Skype) stepped in with his creation called Kazaa, which had no central server that could be shut down. Eventually, the peer-to-peer programs got more and more numerous, including Kazaa Lite, eDonkey, eMule, BitTorrent, et cetera. While this may be good news for people who like to download and share content for free, it certainly is not for people who are under the impression that bitcoin is a hedge against inflation.
Does bitcoin jive with the Austrian stand on money? The only way to find out is to read what the Austrians had to say. Let’s start with Carl Menger. In Principles of Economics, Carl Menger made the point that money, a medium of exchange, has always tended to be the most saleable commodity of the time. Menger wrote, ‘In the earliest periods of economic development, cattle seem to have been the most saleable commodity among most peoples of the ancient world‘. This is perfectly understandable in a world where barebone subsistence is a reality for most people and the structure of production is virtually nonexistent. As society progressed, however, cattle became less and less marketable. Menger goes on to write, ‘With the progress of civilization, therefore, cattle lost to a great extent the broad range of marketability they had previously had with respect to the number of persons to whom, and with respect to the time period within which, they could be sold economically…They ceased to be the most saleable of commodities, the economic form of money, and finally ceased to be money at all‘
As civilization progressed, Menger states that ‘peoples who were led to adopt a copper standard as a result of the material circumstances under which their economy developed, passed on from the less precious metals to the more precious ones, from copper and iron to silver and gold, with the further development of civilization, and especially with the geographical extension of commerce‘ Gold won out due to a variety of reasons, such as being durable, amalgamable, malleable, divisible, homogeneous, and rare. Yet, the primary reason that gold won out is because it was the most saleable of commodities. As Menger goes on to write, ‘Gold nuggets extracted from the sands of the Aranyos River by a dirty Transylvanian gypsy are just as saleable in his hands as in the hands of the owner of gold mine, provided the gypsy knows where to find the right market for his commodity. Gold nuggets can pass through any number of hands without any decrease whatsoever in marketability. But articles of clothing, bedding, prepared foods, etc., would be suspect and almost unsaleable, or at any rate of greatly depreciated value, in the hands of the gypsy, even if they had not been used by him, and even if he had, from the beginning, acquired them only with the intention of passing them on in exchange‘
This point about marketability bears elaboration. One may have a Picasso at home, which will fetch quite a sum at a Sotheby’s auction during a boom, but a Picasso, like a poem by Friedrich Shiller, a work of Sanskrit, or a multi-decade old bottle of red wine can never be the most saleable good. As Menger put it, ‘Compare only the number of persons to whom bread and meat can be sold with the number to whom astronomical instruments can be sold‘. This leads us to another criticism of bitcoin: It can never be the most saleable good. The reasoning for this is quite simple, until the majority of the 7 billion or so people that inhabit this planet have either a smartphone or frequent access to the internet, a digital currency is out of the question. Gold, on the other hand, is easily recognizable, as opposed to silver that may be mistaken for other metals such as nickel. Moreover, it melts at a relatively low temperature and is a relatively soft metal, which provides superior amalgamation and explains partly why it historically won out to metals such as platinum. If one questions the role of gold in the present monetary system, one only has to walk down the street and see a ‘We Buy Gold’ sign. Moreover, central banks hold gold and lots of it, they do not hold cattle, wheat, soybeans, copper, silver, or bitcoins.
Menger also went on to write, ‘I am ready to admit that, under highly developed conditions of trade, money is regarded by many economizing men only as a token. But it is quite certain that this illusion would immediately be dispelled if the character of coins as quantities of industrial raw materials were lost‘*. This, of course, leads us to that pesky thing called the regression theorem. In an article entitled ‘Bitcoins, the regression theorem, and that curious but unthreatening empirical world‘ author Konrad S. Graf* attempts to reconcile the regression theorem with bitcoins. He states,
‘First, one element to consider for intangible objects such as bitcoins are various “inherent” direct-consumption values that may be primarily psychological or sociological in character. Consider, for example, the geek value hackers find in creating and attempting to crack encryption codes of any kind: “Dude, look at this code; I bet you can’t crack it,” may indeed be more highly valued to some people in some contexts than certain “real” economic objects or specific quantities of fiat money. Regardless of any potential future indirect-exchange value, one can imagine such persons expending hundreds of hours of effort in creating and breaking encryption codes, just because they like to. This may be true, separate from any degree of dependence on any particular expectations of future exchange values of code objects’
While it may very well be true that some early adopters valued bitcoins with what Menger described as imaginary value, the point of the most saleable good bears repeating. Gold is and has been seen as an object of beauty since the dawn of civilization. Thus, the argument that bitcoins are in accord with the regression theorem because a handful of people consume them as they would a Picasso is like saying paper money has value because John Law or Ben Bernanke really enjoy playing monopoly. In fact, we might as well say that Alchemy works, considering a significant amount of human history and energy was spent in attempting to find the philosopher’s stone. Some people may enjoy work just for the sake of working. Unfortunately, this is not a sufficient justification for slavery nor the labor theory of value.
So where does bitcoin stand when it comes to the Austrian framework of money? For this we have to turn to The Theory of Money and Creditby Ludwig von Mises. Mises never claimed that only gold or silver are money. On the contrary, he stated that ‘the market enables any commodity to be turned into money and money into any commodity‘. Furthermore, Mises went so far as to say that silver was no longer a monetary metal, which explains why the gold/silver price ratio has tilted significantly towards gold from the late 19th century onwards, in having written ‘If any kind of money is deprived of its monetary characteristics, then naturally it also loses the special value that depends on its use as a common medium of exchange, and only retains that value which depends upon its other employment. In the course of history this has always occurred when a good has been excluded from the constantly narrowing circle of common media of exchange. Generally speaking, we do not know much about this process, which to a large extent took place in times about which our information is scanty. But recent times have provided an outstanding example: the almost complete demonetization of silver. Silver, which previously was widely used as money, has been almost entirely expelled from this position, and there can be no doubt that at a time not very far off, perhaps even in a few years only, it will have played out its part as money altogether‘. He further went on to crystallize this point by classifying silver as fiduciary media, having written, ‘Of no greater relevance is the circumstance that the fiduciary media were in the one case predominantly bank notes and cheques and are in the other case predominantly silver coins. The silver rupee is in truth nothing but a metallic note, for the conversion of which its issuer, the State, is responsible‘. Those who rushed into silver in 2011 would have been well advised to have read the TMC, and so would bitcoiners.
Ludwig von Mises claimed that there were three main types of money: (1) commodity money, (2) fiat money, and (3) credit money. What is important when it comes to commodity money are the technological aspects. With fiat money, the important aspect is the stamp that (initially at least) represented a fixed weight of commodity money. Credit money, on the other hand, is a claim falling due in the future (IOU) used as a medium of exchange. We can safely assert that bitcoin is not a credit money. Nor is bitcoin a fiat money since there is not a sovereign proclaiming it to be a fixed amount of anything. So is bitcoin a commodity money? The answer is no.
Bitcoiners would have one believe that bitcoin is a digital manifestation of the gold standard, and thus should be considered a commodity money since it is technologically similar. The problem with this reasoning has already been touched upon: bitcoins can be hyperinflated in substance. In the real world, a Niklas Zennström cannot come along and create underground reserves ex nihilo of what in substance would be the equivalent of gold, except that it be blue and called jold. On the other hand, the amount of potential flavors of bitcoin on the cloud is theoretically restricted to the amount of aggregate geobytes available on the various smartphones, tablets, notebooks, and all other electronics capable of using peer-to-peer.
If bitcoins are not commodity, fiat, nor credit money, then what are they? Has Ludwig von Mises missed something? The answer, once again, is no. The aforementioned types of money are a narrow subset of the broad money scheme that Ludwig von Mises had formulated. There were, aside from the three types of money already mentioned, so-called money-substitutes. Within money-substitutes are two categories, (1) money-certificates, and (2) fiduciary media. Money-certificates are self-explanatory, examples of which include countless paper notes that promise to pay the bearer x amount of gold on demand. The relevant thing to bear in mind as far as this article is concerned is that bitcoins are not money-certificates.
Thus, we are left with only one remaining option: fiduciary media. Within fiduciary media, there are (1) uncovered bank deposits and notes, or (2) token money. The former stuff is what has periodically led to booms and busts as well as countless bank runs. However, bitcoins are definitely not uncovered bank deposits or notes. Thus, we have an answer before us: bitcoins are fiduciary media, or more specifically token money. From a monetary standpoint, as devised and formulated by Ludwig von Mises, they are on a par with the stuff you find at Chuck E. Cheese’s.
(click to enlarge)
With the imminent hyperinflation meme fading away and no longer holding much water, the new reason to hold bitcoins is the anonymity, nay, the freedom that it provides. Want to gamble online or buy something illegal? Bitcoins are the solution. It is a way of circumventing the Kremlin and uplifting free and voluntary trade, or so goes the story. Unfortunately for many of the misinformed, the reality is toto caelo. This article is too short and not intended to get into the details. Thus, it would be best to take it from bitcoin developer Jeff Garzik himself.
The fun starts at 3:20
The ironic part about this is that anyone and everyone who has participated in illegal activity using bitcoins, presumably because they thought it was anonymous, now has a permanent record of every single one of their transactions contained on the public ledger. Imagine if bitcoins existed 50 years ago. Chances are, none of the last three Presidents (including Barack Obama) would have ran for office.
The question left to be answered is whether or not bitcoin is once again taking the shape of a bubble. The answer is yes. There is present a reflexive pattern of people buying because prices are rising, and prices rising because people are buying. The myopic are extrapolating the price trend of the past three months, which they deem is normal, and in so doing they exacerbate it to the upside, thus attracting even greater fools. The inflection point will come when the continuity of bullish thought is broken, which could be anywhere between $49/bc to $69/bc. One thing is for sure, the amount of suckers left who are willing to jump on the moving and ever accelerating train is drawing thin, and so are their pockets.
When prices for any asset go parabolic, it does technical damage to a chart. It is sort of like someone deciding to go full speed in the middle of a marathon. Surely, one would look good for a few minutes. However, at a certain point one would inevitably collapse, with the possibilities of finishing the race being greatly diminished, let alone doing as well as they would have otherwise. Like Icarus, who had soared too high and melted the wax on his wings, parabolic moves always end in a crash. Ironically, the best thing that can happen for bitcoin naysayers is if bitcoin skyrockets to $100/bc within a week.
There is nothing anti-Austrian about acknowledging that there exists in the market place a lot of naïve, irrational, and misinformed players. During the dotcom bubble, for example, a maintenance and building company called Temco Services almost tripled in a matter of minutes in 1998. The reason is because by 1998 every other layperson was involved in the market. Thus, the level of competence significantly dropped. The ticker symbol for Temco is TMCO, which was fairly close to that of Ticketmaster Online, which was TMCS. Ticketmaster Online (then TMCS) just happened to trade publicly for the first time on the day that Temco Services (TMCO) tripled. Rising asset prices create euphoria, and euphoria significantly drops the IQ of the participants.
So why is it that people are attracted by rising prices and shy away from falling prices, when in fact the rational thing to do would be to buy low and sell high? The answer is that we are wired that way. As put by Jason Zweig, ‘Groundbreaking new research in neuroscience shows that our brains are designed to perceive trends even where they might not exist. After an event occurs just two or three times in a row, regions of the human brain called the anterior cingulate and nucleus accumbens automatically anticipate that it will happen again. If it does repeat, a natural chemical called dopamine is released, flooding your brain with a soft euphoria‘*. The process also works in reverse, which explains why most people are turned off by falling prices. A loss fires up the amygdala, which is the part of the brain that processes fear and anxiety. If one were to look at the Google Trends chart* of bitcoin and the USD price chart at mtgox* (formerly magic the gathering online exchange), the data is nearly identical with the google trend followingthe price. The bottom line is that people are attracted to bitcoin because the price is rising.
Another reason why bitcoin is so susceptible to becoming a bubble is because it is perceived as being something new. New Era thinking always attracts lots of attention. The tulip was introduced to Europe by way of Turkey in the middle of the sixteenth century. In fact, the word tulip came from the Turkish tulipan, which means turban. Aside from being something new to Amsterdam, a country which at the time possessed an abundance of newly discovered gold and silver from the New World, the tulip also had an intriguing element to it. The plain tulip may turn into a precious Semper Augustus, the most precious tulip of them all. The reason is that the various color schemes of tulips were caused by a virus that attacked the bulb. Likewise, the Mississippi bubble, which was perpetrated by John Law, promised vast richest to be had from the New World. The manias in railways, the radio, the internet, you name it, most of them involved something new or something perceived to be new.
» Bitcoins can be hyperinflated in substance
» Bitcoins can never be the most saleable good
» Bitcoins cannot account for the regression theorem
» Bitcoins are the equivalent of token money
» Bitcoins are the opposite of anonymous
» The USD price of a bitcoin has been rising in an unsustainable fashion, the only thing missing being a blow-off top
* The Starfish and the Spider was originally published in 2006
* Underline added by the present writer
* The Intelligent Investor by Benjamin Graham, Commentaries by Jason Zweig