Bitcoins II

Bitcoins are trading today at $90, six times what they were worth when I last wrote about them more than a year ago. That works out to a 180% annualized return. But a graph of price vs time is very volatile. That's because of the vast disparity between the cost to produce them and their future value discounted back to the present day (or not discounted as I explained before). There are a series of exponential increases followed by crashes.

If you take the attitude that Bitcoins are a fad and have no intrinsic value, then the spikes are classic asset bubbles. But if you assume Bitcoin is a legitimate currency, then the speculators driving up the price are the truly rational players. One day many papers will be written about this price graph.

Once the price reaches equilibrium with the dollar, the volatility will go down, and will approximate the situation under the gold standard. We may lament the reduced ability of the government to stabilize financial panics using monetary policy.

It seems likely that the Euro will be the first currency to be replaced by Bitcoin. This is party because of its fragility, partly because of boneheaded decisions such as confiscating Cypriot deposits, and partly because Europe will lead in development of Bitcoin transaction infrastructure due to its progressivist tendencies.

When people begin converting Euros to Bitcoin en masse, the Euro will experience hyperinflation, which will exacerbate these forces. The transition will probably begin almost as soon as the infrastructure is widely available. Bitcoins will then represent the same Money currently denominated in Euros. A Bitcoin will thus be worth approximately $500,000. I'm estimating conservatively using M2, but M3 is theoretically more accurate, since Bitcoin banks will continue to leverage loans against long term deposits.

When the Dollar converts, the value will increase to approximately $1,000,000 in today's Dollars. This may follow the Euro conversion quickly as there will certainly be a circus atmosphere surrounding the vast wealth generated by early adopters. On the other hand, it is possible the Dollar and/or Euro will survive as an alternative currency once equilibrium is reached.

Let's assume the value of the Dollar is wiped out by hyperinflation. Since US debt is denominated in Dollars, it will be wiped out too. The US government would be forced to start borrowing in Bitcoin. Since much of US wealth is dependent on the inertia of a global financial system based on Dollars, there is potential for a global economic depression and political and military upheaval. It is very hard to make solid predictions of this type, but if rogue states wish to destabilize the Pax Americana and become financial powers at the same time, they would do well to invest in Bitcoin.

There will be huge investments in mining. Bitcoins are mined by computation, essentially converting electricity to cash. The total energy cost of producing all that currency is hard to calculate without a good model of the price curve, but we can get a rough order of magnitude by assuming the amount spent mining is similar to the amount of currency produced. The result is roughly 6 months worth of the total global energy output. There will be quite a gold rush.