CC Image Courtesy of Trader Tim
Note: I started writing this article on Apr 10. I had grand plans of going on record, saying that "Bitcoin will crash! I will guarantee it!". As it happens, just hours after, it started crashing. Sometimes, the world just moves too fast for me.
At the beginning of February 2013, a digitial currency called 'bitcoin' (will explain later) traded at $20 USD. A month later, it traded at just above $30 USD. On Wednesday Apr 10, it reached over $250 USD per bitcoin.
Those who "invested" in bitcoin early - mostly hacker types - have been crowing about how much money they've made with bitcoin. Hacker news, a very prestigious blog for tech entrepreneurs, even posted a poll asking how many people became millionaires with bitcoin. The financial media haven't been slacking in reporting on bitcoin either. Several news outlets regularly tracking movement in bitcoin prices, with articles such as these.
In this blog post, you'll learn exactly what bitcoin is, and why I personally am pretty sure it's doomed to fail.
What's a bitcoin?
Bitcoin is a "digital currency". It's meant to be a completely digital substitute for dollars in your pocket, so to speak. Bitcoin lives on computer servers and it's highly secure, protected because of cryptographic mumbo jumbo that'll make your head dizzy. That means you can't forge one.
Another important characteristic about bitcoins: you only have so much of them. Right now, there's only 11 million of them around. New bitcoins will show up slowly over time, eventually reaching 22 million bitcoins over a hundred years from now.
Lastly, there is no 'central bank' for bitcoins. The government doesn't regulate it either. It's the wild wild west of currencies. For more information, you can check out this link.
Why is it popular?
Many people really like that there's only so many bitcoins around. I once met a programmer who wanted to create a business around bitcoins. He basically preached me on the evils of central banks - how they interfere with the free market, punish savers by devaluing money, etc. Does that sound familiar? It's the same argument given for a return to the gold standard. (i.e. base our currencies in gold, so that $10 = 0.01 gold ounces, or whatever).
Gold, like bitcoin, can't be created. That means you won't get the kind of inflation you get with fiat (paper) currencies. With fiat currencies, $10 next year won't buy you the same amount of stuff that $10 can buy you today, because central banks introduce lots of new dollars, devaluing the $10 in your hand (i.e. inflation). In the point of view for those who want to go back to the gold standard, the government is basically punishing people who have savings while encouraging people to spend. I personally have objections to this line of thinking, but we'll leave that discussion for another day.
Bitcoin resonates very well with people who subscribe to this world view. They want bitcoin to replace fiat currency, so some of them started using bitcoin to buy and sell on the internet. It became gradually more popular as time went on - more people, more trades in bitcoin. Recently, perhaps with the help of the media who started reporting on it, bitcoin exploded in popularity.
Bitcoin's fundamental flaw
The explosion in popularity translated into a spike in bitcoin's price. It was economics 101. There came huge demand, but only a limited supply to meet them. That's why bit coin prices jumped from $30 barely over 2 months ago, to $250 just yesterday.
This is good for those who held bitcoin, but terrible for those who want bitcoin to become a currency. To be useful, a currency has to be stable. Suppose you're one of these merchants who started accepting payment in bitcoins. In fact, let's take the iPhone 5 example. At $250 per bitcoin, the iPhone would cost over $1,200. Who in their right mind would pay $500 more to buy the same thing? But let's suppose bitcoin crashed to $100. Suddenly, the merchant is now selling a $700 iPhone for $491 - an unplanned sale.
By virtue of the fact that you have a limited supply of bitcoins, you'll always have a highly volatile currency. With no new supplies, people can hoard bitcoins, driving up the price. Once prices go up, human psychology kicks in, and more people join in the buying frenzy. This creates a bubble. Once prices start to go down though, human psychology kicks in again, and more people join in the selling frezy. This makes a crash. In fact, that's the reason why central banks were created in the first place - to stabilize the price of money.
Back in the gold standard days, the prices of stuff fluctuated wildly year after year. By having a central bank print money when there's big demand for money, you keep the price of money low. By taking away money when there's low demand for money, you keep the price of money high. The result is a much stabler currency.
Where bitcoin will go
For the last few months, we've seen a big spike in bitcoin prices. We've had a crazy buying frenzy. People are feeling good about buying bitcoin. I'm willing to go on record for saying that bitcoin will crash. I'm pretty sure about it. It's human nature.
But here's what I don't know - I don't know when it will crash. Many a people tried to predict when bubbles will end, and most failed miserably. It could take months, even years. In the meanwhile, some people will become rich, and they will call me a fool. But inevitably, it will all end in tears for many.
Make sure you're not one of them.