By Debanjan Chatterjee
Since the year 2010, the price of Bitcoin has jumped 66,00,000%. That means, investing Rs 10,000 in 2010, would have bestowed you with Rs 66 crores today. In 2017 alone, the price of Bitcoin has jumped by more than 170%. A leap of such an astronomical margin is unimaginable for any financial asset and has led to frenzied buying.
Many believe that, akin to the dot-com bust, this trend has all the symptoms of a bubble. Others claim that a short run price correction will not detract the underlying value of the asset, as there is an emerging consensus about the potential of blockchain technology in general, and Bitcoin, in particular.
The greatest invention since the Internet
Bitcoin is a crypto-currency or digital currency. It was invented by an unknown programmer with the pseudonym Satoshi Nakamoto and was released as an open-source software in 2009. Bitcoin is not the only crypto-currency, albeit it is the most popular one. It has often been dubbed as the ‘greatest invention since the Internet’.
Bitcoin uses computer algorithms with very advanced encryption techniques to regulate the creation and verify transfer of funds. Transactions are executed on a peer-to-peer basis, thereby eliminating the need for a Central Bank. All transactions are recorded in a public distributed ledger called the blockchain, thus making them very easy to track.
There is a popular opinion that the advent of digital currency provides a new path for nations to emerge out of a recession. Pundits often claim that switching to Bitcoin can stem defaults and control potential damage from a ‘Grexit’ by switching to Bitcoin. Such a move would help to avoid uncertainty caused by any steadily weakening, post-Euro, sovereign currency. Some also argue that digital currencies can help unbanked poor by including them in the mainstream economy.
Not a smooth road
The ongoing Bitcoin mania has encouraged mushrooming of several privately funded exchanges which provide the opportunity to trade in Bitcoin derivatives. Analogous to events leading up to the 2008 crisis, these exchanges allow leveraging up to 100 times the price of Bitcoin. It is quite easy to imagine the shock waves that would ripple through the economy, in the case of a price crash. In addition, quite a few Ponzi schemes related to Initial Coin Offerings of digital currency have come to surface. These have the potential to wipe out huge amounts of investor wealth.
It is also important to keep in mind that Bitcoin is a digital asset, making the currency base vulnerable to hacking. In 2013, Mt. Gox (erstwhile largest Bitcoin exchange) was hacked and bitcoins worth more than $450 million were lost, forcing the company to declare bankruptcy. Unlike the case of banks, there is no insurance on such thefts of digital currency.
It might not even take profit-hungry traders or hackers to initiate the next recession. In May 2017, the Canadian exchange QuadrigaCX lost $14 million worth of digital currency due to a technical issue while upgrading its software. Additionally, confidence in the currency might get eroded every time there is a sharp price adjustment. Without a Central Bank, the economy is left to fend for itself as any monetary policy is impossible to execute.
Drawing an analogy to gold, many experts predict an appreciating value for Bitcoins. This continuous deflation is a big risk for producers of goods/services. Deflation would incite a drop in spending (and investment) as consumers (and investors) would postpone consumption in the hope of better bargains. Again, without a central monetary authority, no intervention can be designed to curb such a drop in economic activity.
The dark side of increasing acceptability
The game theoretical concept of ‘Braess Paradox’ predicts that a brand new road connecting your home and office might actually increase your commutation time, as all commuters would desire to take advantage of the new road, thus causing massive traffic jams. It is feared that something similar could happen with Bitcoin transactions. Of late, the rise in Bitcoin traffic has directly translated to an increase in confirmation time of transactions. This might imply an ever-increasing rise in transaction costs as Bitcoins increasingly get accepted as global currency, and is definitely not good news for economic agents. Development of better infrastructure to scale up Bitcoin logistics might trigger crowding behaviour similar to the one predicted by Game theory.
A lesson in prudence
On a concluding note, one might wonder whether the traditional economic wisdom of our times is sufficient to model scenarios emerging out of a paradigm shift in collective consciousness. Economist Frank Hahn In his 1991 paper, The Next Hundred Years, predicts that the discipline of Economics itself will evolve over time as pure economic theorising, based on axiomatic assumptions which will give way to simulations.
All said and done, it still might be prudent, to be cautious of animal spirits and analyse bread crumbs etching out the path ahead.
Featured Image Credits: Flickr