What's All the Fuss About?

Michael - Thursday

With markets crashing around us, and the Senate once more rushing to try to keep the US government open, money is center stage. Interest in real dollars has overshadowed interest in virtual bitcoins, but there is a story there too. From just under $1,000 a 'coin' a year ago, last year it reached a high of near $20,000 before collapsing back to around $8,000 today. Still good money if you bought at $1,000; not so great if you bought at $20,000.

So what is all the fuss about? Why would you take $8,000 of your money and lay it out for…well, nothing?

The proponents say this is the next big technological disruptor. What are dollars anyway? Just pieces of paper. Once they were backed by gold, but then who determined what gold was worth? The market. And that’s what determines the value of bitcoins today. What’s the difference?

Actually, bitcoins are backed by something. They are backed by work—admittedly work by computers, but they are using power. A lot of power. In an article a few weeks ago in the New York Times, Morgan Stanley estimated that the energy required to generate one blockchain (more of that later) was about the same as an American family used in two years. That's a lot of work. The total power required to run the network of computers engaged with bitcoin is estimated to be about the same as the energy requirement of a medium-size country.

Every ten minutes or so the network hands out around $100,000 worth (at current price) of new bitcoins, rewarding the solvers of the complex and changeable algorithm.

It seems to have about as much point as going four kilometers underground in South Africa to dig out gold and then bury it in Fort Knox. But the point was made quite clear in the original paper of 2008 by the mysterious Satoshi Nakamoto. (No one has ever claimed responsibility for the paper, and the man identified as Satoshi strongly denied he was the author.) The point is to have a currency and transaction system completely independent of banks and governments, and that is exactly what bitcoin actually is. Every time a transaction takes place, a blockchain has to be built—generating more coins—which essentially sets in concrete that transaction against all other transactions so that it can’t be fraudulently reversed. If there weren’t so many legitimate players in the game, that would be possible. The fraudster could outgun the honest participants. The paper actually does a statistical analysis indicating the probability of the fraudster succeeding. As things stand now, it is vanishingly small. But it relies on all those computers working to build bitchains faster than an attacker can undo them. And, of course, they only do it for that ten minutely payout. (The idea of rewarding participants with bitcoin tokens is in the paper, but pretty much as an afterthought.)

So apart from the math being fun, is it really the huge breakthrough it’s made out to be? It depends who you ask. Nobel prize winning economist Paul Krugman writing in the NYT says not. A good test for a bubble about to burst is who is thinking of trying to get on board. When his barber asks about it (or my step daughter) the answer is definitely not. Krugman points out that if you had bought the bitcoins a year ago you’d be feeling pretty good right now, but so would a Dutchman who bought tulip bulbs in 1635 two years before the price collapsed forever. (You can read his article HERE.) Warren Buffet put it less elegantly, but more simply: “I never buy things I don’t understand.” Wise words.

All that said, the fact that something is a bubble doesn’t necessarily mean that it’s valueless. The internet technology bubble in 2000 led to totally outrageous prices for companies like Amazon and Apple. If only we could get those bargains today!

As for me, would I buy bitcoins? Certainly not now. This isn't an investment for widows, orphans, and writers.