As I write this, the price of a single bitcoin stands are approximately $11,100 yesterday, up some 2000% in the last 6 months suggesting it is a financial bubble. Or maybe it’s not: just a very risky investment suited for inclusion in a regularly balanced portfolio. These are two competing views of bitcoin, and there are two ways to distinguish between them. One is on the basis of technical analysis — does this fast rise look like a bubble (Yes!), and the other is to accept that bitcoin has a fundamental value, one I’ll calculate that below. In either case, the price rise is so fast that it is very difficult to conclude that the rise is not majorly driven by speculation: the belief that someone else will pay more later. The history of many bubbles suggests that all bubbles burst sooner or later, and that everyone holding the item loses when it does. The only winners are the last few who get out just before the burst. The speculator thinks that’s going to be him, while the investor uses rebalancing to get some of benefit and fun, without having to know exactly when to get out.
That bitcoin is a bubble may be seen by comparing the price three years ago. At that point it was $380 and dropping. A year later, it was $360 and rising. One can compare the price rise of the past 2-3 years with that for some famous bubbles and see that bitcoin has risen 30 times approximately, an increase that is on a path to beat them all except, perhaps, the tulip bubble of 1622.
That its price looks like a bubble is not to deny that bitcoin has a fundamental value. Bitcoin is nearly un-counterfeit-able, and its ownership is nearly untraceable. These are interesting properties that make bitcoin valuable mostly for illegal activity. To calculate the fundamental value of a bitcoin, it is only necessary to know the total value of bitcoin business transactions and the “speed of money.” As a first guess, lets say that all the transactions are illegal and add up to the equivalent of the GDP of Michigan, $400 billion/year. The value of a single bitcoin would be this number divided by the number of bitcoin in circulation, 12,000,000, and by the “speed of money,” the number of business transactions per year per coin. I’ll take this to be 3 per year. It turns out there are 5 bitcoin transactions total per year per coin, but 2/5 of that, I’ll assume, are investment transactions. Based on this, a single bitcoin should be worth about $11,100, exactly its current valuation. The speed number, 3, includes those bitcoins that are held as investments and never traded, and those actively being used in smuggling, drug-deals, etc.
If you assume that the bitcoin trade will grow to $600 billion year in a year or so, the price rise of a single coin will surpass that of Dutch tulip bulbs on fundamentals alone. If you assume it will reach $1,600 billion/year, the GDP of Texas in the semi-near future, before the Feds jump in, the value of a coin could grow to $44,000 or more. There are several problems for bitcoin owners who are betting on this. One is that the Feds are unlikely to tolerate so large an unregulated, illegal economy. Another is that bitcoin are not likely to go legal. It is very hard (near impossible) to connect a bitcoin to its owner. This is great for someone trying to deal in drugs or trying hide profits from the IRS (or his spouse), but a legal merchant will want the protection of courts of law. For this, he or she needs to demonstrate ownership of the item being traded, and that is not available with bitcoin. The lack of good legitimate business suggests to me that the FBI will likely sweep in sooner or later.
Yet another problem is the existence of other cryptocurrencies: Litecoin (LTC), Ethereum (ETH), and Zcash (ZEC) as examples. The existence of these coins increase the divisor I used when calculating bitcoin value above. And even with bitcoins, the total number is not capped at 12,000,000. There are another 12,000,000 coins to be found — or mined, as it were, and these are likely to move faster (assume an average velocity of 4). By my calculations, with 24,000,000 bitcoin and a total use of $1,600 billion/year, the fundamental value of each coin is only $16,000. This is not much higher than its current price. Let the buyer beware.
For an amusing, though not helpful read into the price: here are Bill Gates, Warren Buffet, Charlie Munger, and Noam Chomsky discussing Bitcoin.
Robert Buxbaum, December 3, 2017.