Bitcoin: A currency whose time has not come

If anybody needed confirmation that Bitcoin is a bubble waiting to burst, consider this: It took seven years since it started trading for it to cross the $1000 threshold, which it did in January this year. Four months later, in May, the price surged through the $2000 level. By August, it broke the $4000 barrier and … well, you get the picture. It takes ever less time to go through each successive $1000 level. Just after 1am London time this morning, it broke the $10,000 threshold for the first time. Thirteen hours later, it reached an all-time high of $11,434 and less than six hours later it was way back down, at just above $9000.

If you draw a daily chart of Bitcoin moves, this is a trend which will not show up. But these are the sort of market movements that are hard to resist – everyone loves a good boom, and before too long it is a pretty safe bet that there will be a bust from which there is no coming back. Aside from the fact that any asset which rises at such a speed almost inevitably comes crashing down again, there are numerous ironies associated with Bitcoin which make it unsuitable to be the great alternative to central bank controlled cash that its proponents claim.

Consider the fact that its initial popularity was derived from those who believed the best form of protection against an imminent collapse in civilisation was to live in a remote cabin in the woods with plenty of tinned food and a well-stocked armoury. The theory ran that central bank cash would soon become worthless as societies collapsed and alternative forms of money would come into their own. There is just one snag. Bitcoin is an electronic token which exists only on a computer. In the event that civilisation were to collapse, who would be there to keep the lights on – or more pertinently, generate the electricity required to ensure that Bitcoin could continue to be traded?

To understand why all this is an issue, we need to go to the heart of what Bitcoin is. It was designed as a peer-to-peer electronic cash system to cut out the conventional banking system. In order to make this work, transactions between holders of Bitcoin are recorded on a digital ledger known as the blockchain. In a conventional banking system, the ledger is a record maintained by the banks. To bypass this step, a ledger technology was created in the form of an electronic file which records all transactions in sequence, so we can see how title to Bitcoin passes from one holder to the next. In the absence of a centralised record keeper, it is important to ensure that people are not cheating (i.e. claiming to own Bitcoin to which they are not entitled). This is done by timestamping each transaction and linking it to each previous timestamped transaction in the form of a chain. In this way, we can trace back all transactions – there are no secrets.

But transactions are only added to the chain after a complex proof-of-work algorithm has been solved. Due to the transparency of the system, falsifying the current transaction would require falsifying all previous transactions, and because the proof-of-work algorithm is computationally onerous, there is little incentive to cheat – it is simply too expensive in terms of time and transaction costs. So once you solve the cryptographic puzzle and all users agree the solution is valid, one iteration of the proof-of-work algorithm suffices to ensure the blockchain is valid. Bitcoin comes into the equation because those who maintain the blockchain, and do the complex calculations, are rewarded by payment of Bitcoin. An additional complication worth knowing is that the supply of Bitcoin is limited to 21 million, and almost 80% of all coins likely to come into existence have already been created. Moreover, miners get progressively lower rewards for each block they “mine.”

Having completed that diversion, it raises two issues. First, the electricity requirements to run the blockchain and mine Bitcoins are enormous. Because of their increasing scarcity, miners have to expend more energy to generate each additional Bitcoin – it is an energy-inefficient process. Currently, this activity consumes as much electricity as the Turkmenistan economy and estimates suggest that by 2020 it could consume as much as Denmark. Second, the real bonus of the system is that the blockchain is applicable to a wider range of activities than Bitcoin. The real reason why Bitcoin has surged this year is that investors have been bringing blockchain-related products to market via initial coin offerings. But the Ethereum network, which is an open-source, blockchain-based platform designed for a wider range of applications and in which the digital currency (Ether) is derived as a by-product of the verification process, has been one of the fastest growing currencies this year.

Policymakers have taken note of the recent bubble with the BoE’s Jon Cunliffe reassuring the public in a radio interview this morning that it is too small to hurt the wider economy. Indeed, the global market cap of all digital currencies currently stands at $283 billion – less than 0.5% of world GDP. But central bankers have taken note of digital currencies and have been thinking about central bank controlled cryptocurrencies for quite a while (I will deal with this another time). I do believe that there is a future for digital currencies – it’s just that I don’t believe Bitcoin is the vehicle to take them forward.

The Bitcoin bubble in context

Over the course of recent months I have done a lot of work looking at Bitcoin and have watched its recent sharp ascent with a mixture of bemusement and concern. I do not intend here to go into a detailed description of how the currency operates and refer the interested reader to the website Bitcoin.org  for an overview. Instead I want to focus on the sharp surge in the price of Bitcoin which has seen its value against the dollar increase by a factor of almost six since the start of 2017.

The puzzling question is why its value should have risen so sharply this year – after all, it has been around for seven years and we have already been through one boom and bust episode. In 2013 Bitcoin’s value against the dollar surged by a factor of 83, only for it to fall back by 85% over the next 14 months. What is rather more of a concern today is that the market value of all Bitcoin in circulation stands at $99 billion versus $9 billion in late-2013, and one of the questions which has been posed to me in recent days is whether an implosion of the Bitcoin bubble represents a threat to financial stability in a way which it did not in 2013.

As to the first of these questions, I believe that the rally in Bitcoin this year represents a different sort of bubble to that of four years ago. In 2013 there was genuine interest in Bitcoin as an alternative currency. Much of this optimism was misplaced, however, as the disadvantages of digital cryptocurrencies became evident. For example, the huge variability in the price of Bitcoin means that it does not represent a stable store of value. Together with security issues – the collapse of the Mt. Gox Bitcoin exchange in 2014 being a case in point – investors began to rethink their Bitcoin strategy.

But the currency is underpinned by the blockchain – a distributed ledger which potentially has a huge range of applications outside the realms of the currency world. One of the fastest growing digital currencies this year is Ether which is created as a by-product of the Ethereum network – a blockchain technology with wider applications than that used for Bitcoin. But as investors have jumped on the blockchain bandwagon so they have forced up the value of the digital currencies which these systems churn out.

In many ways, the digital currency revolution is reminiscent of the dot-com bubble of the late 1990s: There are many new and interesting applications of the blockchain technology but they have yet to be fully realised. Accordingly, investors are paying for their potential rather than their realised value, and because it is almost impossible to put a price on potential value, they are overpaying. It is thus hard to avoid the conclusion that current Bitcoin valuations represent a bubble which is set to burst at some point. As a historical guide, I have compared data for the 14 months prior to the Bitcoin peak versus the late-1990s Nasdaq rally and the Tulipmania bubble of 1636-37. As is clear from the chart, the surge in Bitcoin outstrips the surge in equity valuations in 1999-2000 but would appear not to match up to events in the Netherlands almost 400 years ago. But given the poor quality of the data for tulip prices in the 1630s and the fact that we may not be comparing like with like (different types of tulip bulb sold for different prices), we should be careful in making comparisons. But the fact that the Bitcoin boom far outstrips the Nasdaq rally of the late-1990s demonstrates that this is a boom to be taken seriously.

On its own, the bursting of the Bitcoin bubble should not in theory impact most investors. Indeed, the market cap of all digital currencies represents only around 0.3% of global GDP. Moreover, China is increasingly the dominant player in the Bitcoin market, accounting for the vast majority of coins created. It is thus likely that much of the Bitcoin wealth is held by domestic Chinese investors who will bear the brunt of any price collapse (for a fascinating overview of the impact of the digital currency in the Middle Kingdom, this article from Quartz is worth a read).

However, there are residual concerns that a collapse in Bitcoin could be a canary in the coalmine for a more widespread asset price correction, following years of easy money which has pumped up equities and real estate prices. My guess is that this is unlikely and that the spillover effects will be limited, precisely because of the narrow base upon which Bitcoin ownership rests. But as IMF Managing Director Christine Lagard once said, “I'm of those who believe that excesses in all matters are not a good idea … whether it's excess in the financial market, whether it's excess of inequality, it has to be watched, it has to be measured, and it has to be anticipated in terms of consequences.” We should thus not be complacent if the Bitcoin bubble bursts. It might have a deeper meaning than we can currently ascertain.

Interest rates: Absolute zero

The Kansas City Fed’s Jackson Hole Symposium is closely scrutinised by market watchers for any indications of changes in the Fed’s policy stance, and sure enough, most of the headlines over the weekend focused on Janet Yellen’s comment that “the case for an increase in the federal funds rate has strengthened”. But this is to overlook a lot of other interesting material which comes out during the course of the two day session. This year’s symposium was entitled “Designing Resilient Monetary Policy Frameworks for the Future” and if there was any takeaway, it is that central bankers believe they still have sufficient ammunition to provide cover for the economic recovery. It was also evident that central bankers are aware of the impact of low interest rates on the structure of the global monetary system, and that we are not going back to a pre-2007 world anytime soon. 

Marvin Goodfriend’s paper was interesting and makes the point that we should ignore the zero bound constraint on interest rates altogether, primarily because “the effectiveness of evermore quantitative monetary stimulus is questionable.” He argues that one way to facilitate an end to the lower bound constraint would be to abolish paper money and replace it with electronic money. This is not a new idea, having been kicked around since the 1930s and gaining currency (if you’ll pardon the pun) in the wake of the financial crisis. Indeed, Goodfriend’s policy prescriptions echo those made by Andy Haldane a year ago. In brief, this policy relies on central banks making it unattractive to hold cash, thus raising the incentive to hold it in an electronic account overseen by the central bank. The downside, of course, is that this reduces the control which individuals have over their own cash balances: you no longer have the choice of the bank or the mattress – it’s the central bank or nothing, which may persuade many to shift into assets such as property or gold, thus creating bubbles elsewhere.

A bigger objection to removing the lower bound on interest rates is that it has a massive distortionary impact on expectations. Will investors be willing to fund projects if the rate of return is zero or negative? Will we be prepared to continue handing over 30-40% of our earnings in tax (more in continental Europe) when we simultaneously have to invest to provide a fund for our retirement? How does the banking sector cope in a world of increasingly negative rates? Will we eventually reach a situation where customers are charged for depositing funds (actually, yes, with corporate clients in some countries already facing this problem)? For all these reasons and more, it should be evident that a prolonged period of zero or negative interest rates may lead to consequences which we cannot yet foresee and could cause major long-term economic disruption. It is one thing to try the policy on a temporary basis but when it becomes the norm, something is wrong.


Whilst I agree with Goodfriend’s point that QE is at the limit, the notion that we should abolish the lower bound should be treated as an interesting thought experiment and nothing more. The idea that central banks can continue to operate an ever looser monetary policy, but still fail to achieve their economic objectives, should act as an indication that there are deeper seated economic problems which require alternative solutions. Indeed, former Fed governor Kroszner argues that “many central banks are being asked to do things they simply can’t do. Central banks can try to fight deflation. Central banks can’t simply create growth.” Indeed, the ECB has made the point since its inception in 1999 that it cannot create the conditions for a sustainable pickup in growth on its own. Governments need to play their part with structural policies designed to raise the economy’s speed limit.

A bigger problem is that in the wake of the financial crisis, many European economies have been trying to accelerate with the brakes on. In other words, they have operated a very loose monetary policy and a tight fiscal stance. This reflects a misunderstanding about the nature of the shock which hit in 2008. Whilst this may have been understandable in the immediate wake of the crisis, we have had long enough to review the evidence to realise that the current policy mix is not delivering. It is clearly not creating stable jobs in sufficient quantities to allow economies to generate escape velocity, and as a result lots of people are taking out their frustration by voting for populist politicians. This is not the whole story: it certainly does not explain the rise of Donald Trump, but it is part of a wider narrative. We have already seen in the UK how this has panned out, but it is still not too late for other European countries to learn from this mistake. Failure to do so will have major adverse consequences for the euro zone in the years to come.