The Problem with Bitcoin (Asset Bubbles)

This week we talk about Bitcoin and Asset Bubbles!

VIDEO SUMMARY

Before we get started, I just want to say, if you are thinking of making any kind of investment, please go talk with a finance professional first. No matter what town you live, there will be an accountant or a finance person who you can sit down with and have a conversation face to face. They can help you avoid making silly mistakes with your hard earned money.

But you did not come here for a lecture, you came to talk about Bitcoin. Now this is going to be controversial, because I am not particularly a fan of Bitcoin, and there is a lot of people out there right now who are very passionate about Bitcoin. People have made a lot of money in Bitcoin, and there is a lot of emotion surrounding it right now, for a very good reason. Over the last year, the value of Bitcoin has increased more than 1000%. There are a lot of people trying to figure out “What is going on with Bitcoin?” Some of this will be my opinion, and there are people out there with a different opinion. What I wanted to do was have a thoughtful conversation about the potential problem with what is going on with Bitcoin.

Let’s start by talking about how currencies work. There are countries all around the world, and each country has its own currency. Currencies are just like anything else, where their value is driven by supply and demand. But when we talk about currencies, supply and demand is being driven by underlying economic transactions. When people analyze currencies, they spend a lot of time studying economic activity and how money is flowing around the economy, because that drives supply and demand. For example, we can look at the US dollar, and we would try to understand the economic transactions driving supply and demand for the US dollar around the world. And then we can compare that against other currencies, like the Euro for Europe or the Yen for Japan or the British Pound. The point is that the actual people drive the value of currency through transactions in different places around the world.

Then Bitcoin comes along. Bitcoin is a cryptocurrency. The defining factor of Bitcoin is that Bitcoin is not associated with any government. This is one of the reasons people like Bitcoin so much. When you look at all the other national currencies, governments actively manage their own currencies. Bitcoin avoids all of that and is not subject to any government intervention. But this quality is also Bitcoin’s greatest weakness. The point of money is that eventually you want to spend it. The reason everyone works so hard to accumulate money is that one day they will want to use that money to buy something. In the case of a normal currency, you will be able be able to point to a specific location on a map, and you know that if you go to that location there will be people trading in a particular currency. That is how normal currencies work. There is a physical location somewhere where people are using that currency. If you have a bunch of US dollars, you know you can go to the United States and spend your dollars. There will be stores that accept US dollars, you can buy food in the restaurants with US dollars. There are a lot of businesses out there right now accepting Bitcoin, but the scary thing is, they do not have to. You cannot point to a location on a map with a community of people doing transactions in Bitcoin, because Bitcoin by design is not associated with any government.

I would argue that Bitcoin is not actually a currency. It functions a lot more like a commodity. Commodities are raw materials that you can buy and sell on a market. We are talking about things like Oil, Gold, Diamonds, Soybeans, etc. Rather than buy Bitcoins, you can transfer your money into gold and accomplish the same thing of not dealing with any government. You can just use gold to make your transactions. The main reason people do not use commodities as currencies is because they are so volatile, and you want a currency to be stable. You need a stable currency to have a healthy economy. Think about it. If you have money in your bank account, you want to know the value of your money will be stable tomorrow, and the next day, and so on. Commodity prices are always going up and down because of supply and demand. For instance, if you have a bad year for soybean crops, the price for soybeans is going to fluctuate. So you do not want to use soybeans as a currency. We see this same volatility in Bitcoin. But I do not want to take this comparison too far, because there is a big difference between Bitcoin and these commodities. Commodities are physically used in manufacturing. People use gold in manufacturing. People use diamonds in manufacturing. So even if market prices crashed in commodities, you would be able to find someone somewhere who has a demand for that good for their manufacturing plant. You would still be able to find buyers for commodities. You cannot say the same thing about Bitcoin. The underlying value of Bitcoin is that there are economic transactions occurring in Bitcoin, but as we talked about, people do not have to continue using Bitcoin because no government supports it.

To understand the problem, let us talk through the doomsday scenario with Bitcoin. Bitcoin is volatile. Someone holding Bitcoins might start to feel uncomfortable. So they will say, “I do not like the value of my money going all over the place. Let me move my money into a currency that I know will be stable, and that I know there will be someplace I can go to spend it.” This person then could transfer all their money out of Bitcoin into US dollars or Euros or some other standard currency. If enough people do this, the Bitcoin market will crash. If Bitcoins drop 20% in value, people are going to start to get nervous, and that is when everyone is going to run for the hills. You have to realize that in markets where no one wants to buy, the value can drop to zero. You can lose everything. And we discussed that no one has to use Bitcoin when there are other currencies out there. If this scenario happens, it does not matter how many Bitcoins you own, no one is going to pay you any money for them.

We call this type of activity an asset bubble. Normal markets are priced based on value. So you buy an investment because you think someone will see value in that asset to buy it from you. For example, you might purchase equipment because you know someone who needs it who will pay a certain price. Asset bubbles happen when the price of the asset rises above the underlying value. We call this speculation. Speculation happens when people are trading investments solely on price rather than the underlying value. This occurs when a lot of people enter a market, and supply and demand drives the prices up. The problem with speculation is that you buy an asset solely based on the idea, that someone else will buy it from you at a higher price. The risk is that one day, a buyer may not show up, and you are stuck with an asset where you paid more money than the asset’s actual value. Let us say you have one investor who buys an asset. They sell it to another investor for more money. That second investor finds a third investor who is willing to pay more money for the asset. But what happens if that third investor suddenly finds no buyers out there. That is what happens when asset bubbles burst.

Let us conclude by talking about the problem with Bitcoin. The underlying value of economic transactions do not support the current market price of Bitcoin. If that is the case, that means there is speculation in the market creating an asset bubble. That creates risk.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.