Tim Lee: Why bitcoin is a bubble

 As I just posted, Felix Salmon says “bitcoin is a bubble…”. Tim Lee writes “Why bitcoin is a bubble“, guest-posted at Megan McArdle:

My friend Tim Lee says that critics of Bitcoin need to do a better job of explaining why bitcoins–the virtual currency that has been soaring to impressive heights–are in a bubble.  Tim writes:

When people dismiss Bitcoins because they can’t think of how they’d use it, they’re missing the fact that Bitcoin is a platform, not a product in its own right. When ordinary users started buying computers, it wasn’t because they thought it would be cool to own a computer. They did it because they wanted to do spreadsheets or word processing or email. Similarly, ordinary users aren’t going to start using Bitcoins just because it’s a cool technology. If normal users start using Bitcoin, it will be because they’re interested in gambling, or cheap international money transfers, or some other applications that hasn’t been invented yet. And Bitcoin’s intermediary-free architecture means that many more people can try their hand at building the platform’s killer app.

I haven’t written about bitcoin before, but here’s my stab at why it’s fair to say that bitcoins are frothy: eventually, the novelty will wear off, the state will get involved, and the costs will be found to outweigh the advantages.

The problem isn’t that I can’t imagine how I’d used bitcoins.  I can imagine exactly how I’d use them: to evade government surveillance of my financial transactions.  This potential use seems to have tickled the imaginations of many, many bitcoin fanciers. The problem is, the government also has an imagination. 

The reason I think that bitcoins will ultimately go away is that I think they will, like other virtual currencies before them, ultimately prove to be too illiquid.  A dollar is one of the world’s most liquid assets: it can be turned into virtually anything I want, at least if I put enough of them together.  

But bitcoins are not so liquid.  Mostly, to buy things, I need to trade them for dollars or another currency.  And that is the fatal weakness of bitcoins: at some point, to compete with dollars, it needs to enter the real economy.  And if bitcoins become a good way to avoid government surveillance of your financial transactions, then governments will find a way to choke off those entry points so that bitcoins become very illiquid indeed.  (…) 

Some of those ‘technologies’ are pretty low tech. Bitcoins are essentially electronic bearer bonds.  Readers of 1930s-era thrillers will remember that these often figured heavily in the plot: bonds which paid out to whoever happened to be physically holding the bond.  These were very useful for refugees, tax dodgers, and criminals, and anyone else who wanted to keep the government’s eyes off their finances.

But the usefulness of bearer bonds became a problem.  If your bearer bond was destroyed, you had no recourse. They also turned out to be very useful to steal, since the original owner had no way to prove their property rights.  And indeed, one source alleges that about 10% of bitcoins have been stolen at some point.

Even worse, governments found a way to shut down the issuance.  In fact, this proved surprisingly easy: the US government simply announced that interest payments on bearer bonds would no longer be tax deductible.  And voila, no one wanted to issue bearer bonds any more.

 (…) In other words, I think that governments can make it so difficult to translate your bitcoins into the real economy that most people simply won’t bother.  And the more successful that bitcoins are–the better they become established as an alternate currency–the more likely it is that rich-world governments will swoop in and make it prohibitively difficult to use bitcoins to procure real-world goods in developed countries.  At that point you’ve essentially got a novelty currency like greenstamps, which can be exchanged for only a limited supply of goods, and maybe some developing-world travel.

Given that, bitcoins seem overvalued to me.  People are betting on bitcoins as an actual substitute for money, not a novelty currency.  And while I wish the bettors luck, I think they’re facing some pretty long odds.

More Tim Lee at Megan McArdle.

On the bitcoin-as-platform concept, my friend Charles writes “Bitcoin is really a template for a whole family of shared distributed ledger systems that can potentially solve all kinds of problems without any central authority being involved.” Personally I think Charles has the best perspective on the future utility of this machinery. The “Killer App” of bitcoin may not involve bitcoin as medium of exchange.

Scott Sumner: When bitcoin crashes . . .

Scott Sumner captioned his somewhat technical “no bubble” argument “When bitcoin crashes . . .”

. . . .I predict people will say it was a bubble, even though it wasn’t. The term ‘bubble’ can mean many things, but the sine qua non of definitions includes “rejection of the EMH.” But the EMH says that bitcoin is very likely to crash. Why is this so, and why don’t people know this?

1. We know that market volatility is serially correlated. Markets that have been highly volatile are likely to remain highly volatile.

2. Bitcoin prices are super volatile.

3. The EMH predicts that expected returns are near zero. Combined with high volatility, this mean the EMH predicts that bitcoin will exhibit large price increases and large price decreases at various times in the future.

More…

Felix Salmon on “The Bitcoin Bubble and the Future of Currency” a primer on the crypto-currency

Each time the value of a bitcoin hits a new high or a new milestone, there’s more press coverage of the phenomenon, drawing new people in, and sending the value of bitcoins even higher. Indeed, if you chart the value of bitcoins against the number of times that they’re being talked about on Twitter, you’ll see a very strong correlation. And because of the Cyprus connection, mainstream publications have a handy real-world news hook, now, with which to explain the bitcoin phenomenon.

This is actually a serious problem, if you’re trying to put together a currency, rather than a vehicle for financial speculation. If the currency of a country ever fluctuated as much as bitcoins did, it would never be taken seriously as a medium of exchange: how are you meant to do business in a place where an item costing one unit of currency is worth $10 one day and $20 the next? Currencies need a modicum of stability; indeed, one of the main selling points of bitcoin was that it couldn’t be destabilized by government institutions. But that comes as scant comfort to people watching the value of a bitcoin behave like some kind of demented internet stock during the dot-com bubble.

And just like demented internet stocks, bitcoins have seen busts as well as bubbles: in the second half of 2011, for instance, the value of bitcoins retreated from their peak around $30 each to a low point closer to $3. (Today, they’re trading above $140.)

In reality, then, bitcoin doesn’t really behave like a currency at all. In terms of its market value, it looks much more like a highly-volatile commodity. That’s by design: bitcoins were created to be the most fungible commodity the world had ever seen – to the point at which they would effectively erase the distinction between a commodity and a currency.

But is that a good idea?

(…) 

 Good question. More in the longish essay by Felix Salmon at The Medium. 


The bitcoin demand crisis?

 

As I write there are about 11 million bitcoins minted. There will be about 21 million bit coins when the increasingly power-hungry crypto algorithm stops minting fresh coins. Is it money? What is driving the enormous surge in trading prices? At the moment the total market cap is less than Facebook paid for Instagram (which was a company of nine people at the time?)

For some bitcoin perspective, read Zachary M. Seward’s  Quartz series – where Zachary attempts to unravel the future of bitcoin. This is a good place to get some perspective on the crypto-currency: Example: 

(…) Last time I wrote about bitcoin’s surge, I cast doubt on the popular theory that it’s due to the crisis in Cyprus and asked for better ideas. (Here’s my email address.) The best explanations I received were the simplest: bitcoin is going through a “demand crisis,” as Quartz reader Rees Sloan put it. That’s as obvious as it sounds—increasing demand for the currency is pushing its value higher—but framing it as a crisis emphasizes some other truths: As bitcoin’s value rises, so does interest in it, which drives the price up even further, leading people who own bitcoins to expect even more gain, making them reluctant to sell, reducing the available supply of bitcoins, driving the price still higher, leading to more interest, which…

(…)

That’s great publicity if you’re a bitcoin speculator, riding this surge to $100 before dumping the currency on a very eager market. It’s less encouraging if you believe in the idea of bitcoin as a truly alternative currency, unencumbered by sovereign governments, a refuge from the turbulence of monetary unions and fiat money. If that’s the bet you’re making on bitcoin, brace yourself: Just today, the value of a single bitcoin swung between $75.00 and $95.70.

Market forces tend to ruin good ideas.

 Full disclosure – we have no position in bitcoin And AFAIK there is no way to short bitcoin. If there was…

Scott Sumner: interest rates and monetary policy (Mishkin forgotten, again)

Reacting to some confusion in the comments, Scott Sumner wrote Further comments on interest rates and monetary policy

People are still confused about my views on monetary policy and interest rates.  First of all, no one should assume that they understand what I’ve said in the past on these issues.  This stuff is very nuanced, very counterintuitive, and I’m not a very talented writer.  So let’s try to first see what is actually true, and then think about what I’ve said:

1.  Interest rates are not a reliable indicator of monetary policy.  I’ve said that 100 times.

2.  NGDP growth is a reliable indicator of monetary policy.  I’ve said that 100 times.

{snip lots of important details}

To summarize:

1.  Over long periods of time long term bond yields do tend to track GDP growth (and levels) pretty well.  So I’m likely to have made some generalizations in that area equating low rates and tight money.  Japan still has tight money! They have low expected NGDP growth.  And they still have low rates.

2.  As far as the immediate market reaction to monetary announcements, I’ve always argued that it is highly unpredictable, but that there are certain principles that seem useful.  An announcement likely to dramatically change the future path of policy is more likely to lead to a ‘perverse’ reaction in bond yields, than would a one-time injection of money.  I wish I could say more, but I’m often just as confused as you are.

{snip lots more important discussion]

As you might expect there is much discussion following Scott’s post – where prof. Sumner commented as follows – this is the point of my post (excerpted)

(…) I’ve often said (and so did Arnold Kling) that much of my thesis is nothing but the NK dogma we’ve been teaching our grad students for 20 years (before 2008):

1. Zero fiscal multiplier.

2. Monetary policy drives NGDP

3. Low rates don ‘t mean easy money.

4. Highly expansionary monetary policy is likely to raise long term rates.

5. Fed is never out of ammo, even when rates are zero.

So why did I start blogging? BECAUSE ALMOST THE ENTIRE ECONOMICS PROFESSION SUDDENLY SEEMED TO FORGET WHAT WAS IN MISHKIN’S TEXTBOOK IN EARLY 2009. That’s why I got into blogging. But yes, nothing new here. There are other aspects of MM that are genuinely new, but not the fact that easy money can raise rates.

(…) 

Fed NGDP targeting would greatly increase global financial stability

Lars Christensen compares NGDPLT to ‘Adaptive’ policy - these excerpts will hopefully motivate you to read the complete Christensen essay: 

(…) Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

(…) under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity.(…) 

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

 Read the whole thing – I have filed for reference.

Cleveland Fed Estimates of Inflation Expectations

This is from the Cleveland Fed Inflation Expectations Estimator, updated through Dec 1, 2012. One of the primary goals of the Fed’s new rule-based QE3 is to reduce real interest rates by increasing inflation expectations. Is it working?

The markets obviously do not agree with the inflation hawks that warn of runaway inflation any day now due to all that “money printing”. Look at the following time series yield curve:

The Most Important Ben Bernanke Speech That No One Heard

Robert Holmes:

(…) But what the Fed chairman hinted at during the conference, overshadowed by the day’s earnings releases and gloomy news from Europe, bears more attention than it received, especially from the protestors.

“With respect to monetary policy, the basic principles of flexible inflation targeting — the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency — seem destined to survive,” Bernanke said in his speech.

Though his comments appear innocuous, some investors and economists are wondering whether he was suggesting that the Fed, which has primarily targeted inflation for monetary policy, would instead target nominal gross domestic product, or NGDP. Bill Gross, who manages the world’s biggest bond fund at Pimco, tweeted that “Bernanke’s emphasis on ‘communications’ is likely code for ‘targeting’ nominal GDP or unemployment.”

(…) 

We can only hope. Read the whole thing.

Dear Ben, Please surprise us with a policy regime that never again surprises us

Scott Sumner concludes a wry post on the EMH vs macroeconomics (e.g., “does the Fed have free will?”) with this:

1.  The expected part of monetary policy has no impact on financial markets.  It can still impact goods and labor markets, depending on when the policy became expected, and the duration of wage and price stickiness.

2.  Because the expected part of monetary policy cannot move markets, any systematic monetary policy should not involve Fed ‘surprises’ moving asset prices.  If they do, then the policy regime is non-optimal.

3.  If policy is already non-optimal, and expected to remain non-optimal, then markets may be pleasantly surprised if an obscure blogger is able to make the world’s major central banks see the light and ‘target the forecast.’  That’s a good surprise, but can only occur once—during the transition from a bad to a good policy regime.  After than, no more surprises.  Please.”

You will benefit from reading the entire post.

Bank of England governor Carney talking up NGDP targeting

The Washington Post has another example of the growing momentum behind nominal GDP targeting — the Bank of England! 

(…) But the idea may get a hearing over in Britain. Mark Carney, the new Bank of England governor imported from Canada, has been talking up NGDP targeting of late:

Addressing the Chartered Financial Analyst Society in Toronto, Mr Carney said that in major slumps: “To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. …

He added: “If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP level target could in many respects be more powerful than employing thresholds under flexible inflation targeting.”