How do you know if someone owns bitcoin? Don't worry, they'll tell you. It's an old gag, and those who own bitcoin are laughing all the way to the digital wallet. Measured in Australian dollars, the price of bitcoin has increased an eye-watering 145-fold in just five years and recently passed $78,000. Bitcoin has created up to 100,000 new millionaires, 8000 of whom have more than $10 million in their accounts.
The million-dollar question now is: what happens next? While the technology behind bitcoin is beautifully complex, the economics of its meteoric price rise is beautifully straightforward, at least at the theoretical level. Because the supply of bitcoin is fixed (only twenty-one million bitcoins will ever be created), its price is driven solely by demand. This demand appears to be coming from three main groups - institutional investors, true believers, and speculators - for very different reasons.
Institutional investors are the biggest force behind the price rise. These hedge funds and other large-scale players are buying the cryptocurrency to diversify their portfolios and because many of them fear a big increase in inflation might be around the corner. Massive increases in spending by governments and big increases in the money supply by central banks have left some investors nervous about an inflationary-backlash, making bitcoin and other fixed supply assets (including gold) an attractive hedge.
The true believers are the people who believe deeply in bitcoin and its ability to solve the world's problems. For them, bitcoin will hobble corrupt governments, empower the disenfranchised, promote financial inclusion among the billions of "unbanked" people, help reduce global poverty and become a new global currency and reserve asset.
Much less interesting are the third group of people driving bitcoin's price: old-fashioned speculators. When it comes to the technology and promise of bitcoin, these people don't know and don't care; they're just here for the rising price (or, for those trying to short-sell bitcoin, an anticipated price fall).
Who's been right so far? The institutional investors and speculators, if they've managed to "hold" their nerves (in crypto-slang), have done well. The experience of the true believers is more mixed. While their bitcoins have certainly gone up in price, it isn't for the reason they hoped. The price of bitcoin has increased 144 times faster than its use in transactions over the last five years. Its limited use in transactions and extreme volatility disqualify it from being a currency. Although the true believers have made money, it's hard to claim to be a savvy investor when you made it accidentally.
But all is not lost. Many of the true believers have revised their theory, arguing either the goal was always to become a digital gold or that becoming a digital gold was always just a stepping stone along the way to world domination.
So what happens next? The biggest short-term risk is a change in sentiment among the institutional investors who have been driving the price thus far. Given their fear of inflation produced big demand for bitcoin, the bottom could fall out of the market just as quickly if that inflation fails to materialise (as it spectacularly did after the global financial crisis).
Of course, when it comes to the true believers, a crash in the price of bitcoin is about as mysterious as a blocked toilet is to a plumber: they have seen it many times before. For those who are in it for the long-haul, at least three scenarios stand out.
The first scenario is one where the trend becomes the norm. Under this scenario, bitcoin solidifies itself as a new digital gold. Over time its price stabilises and it is held as an asset in the same way investors hold gold. Dreams of bitcoin solving the world's problems fade into the background as it becomes nothing more than yet another financial asset on the balance sheets of rich people.
The second scenario is that bitcoin evolves into a currency, either replacing the currencies of individual economies or even, perhaps, becoming a common currencies for the world as a whole. Even if this scenario were plausible, it's a terrible idea that would almost certainly be blocked by regulators.
A fundamental lesson we were meant to have learned from the Great Depression was that the supply of a country's currency should not be fixed. The reasoning is straightforward. When consumers become scared about the future - during a pandemic, for example - they start hoarding money and stop spending. Because my spending is your income and your spending is my income, this triggers a recession. The result is a dangerous deflationary spiral, with a lack of demand leading to falling prices and cuts in investment leading to a depression.
Central banks exist is to stop this kind of thing happening by increasing the supply of money to satisfy the desire to hoard cash while ensuring the economy doesn't collapse into a deflationary death spiral. Because bitcoin has a fixed supply, it's a terrible choice for a currency.
And it gets worse. Should policy-makers adopt the same currency as other countries (as would be the case if bitcoin were a global currency), they would lose the ability to adjust their exchange rate in the face of economic shocks. When the Greek economy was plunged into recession just over a decade ago, its exchange rate couldn't fall - and therefore support its recovery by making Greek exports cheaper - because its currency (the euro) was shared with other much bigger economies that weren't in a crisis. The result was a painfully long recovery.
Even if it was a good idea, bitcoin is unlikely to replace a country's currency given that taxes will still need to be paid in local currency (a privilege governments don't tend to give up), and regulators could easily make it illegal for businesses to accept payment in bitcoin, something which would send the price of bitcoin crashing.
The third scenario is that bitcoin doesn't replace any currencies but rather runs in parallel. In this case, financial stability could be put at risk. Because many economies, particularly developing and emerging economies, have suffered crises because they are too open to international capital flows, they have acted to restrict those movements. If bitcoin, as a parallel currency, is an opportunity to bypass these capital controls then it will likely be banned quite quickly. Economies with fixed exchange rates would also need to ban bitcoin since, as in the 1990s, investors could use foreign exchange transactions to bring the system down.
All this means bitcoin's future depends on what people decide to use it for. The path of least resistance is one where bitcoin becomes a new digital gold, or perhaps a parallel international currency that can be used by some people in some countries for some transactions. Aspirations beyond this, however, will likely find regulators and macroeconomic logic standing in the way. Shooting for the moon is possible; Mars is a stretch.
- Adam Triggs is director of research at the Asian Bureau of Economic Research at ANU, a non-resident fellow at the Brookings Institution, and a regular contributor to Inside Story.