The case against ‘investing’ in bitcoins

Over at Vox.com, Tim B Lee, Vox’s resident explainer on bitcoins invested in bitcoins (again) and told us why. He makes the following points:

1. “Bitcoin is both a currency and a payment network.” I agree with this. There is lots of potential for bitcoin (and its ilk) to be a more efficient payments network and improve the ability of people to transact. There is also a good chance it will innovate in ways conventional payment networks haven’t.
2. Bitcoin will have great potential for international money transfers and also potentially for credit card networks both of which need competition.
3. “In the long run, the value of any currency is related to the volume of transactions conducted using it.” Lee points out that currently most bitcoins are just held by speculators but that if 1 and 2 occurs, they will be traded.
4. For investors, bitcoin is less liquid than other assets but in the future it will be easier to get them which will drive up their value.
5. Large scale investors have yet to get into the market and if they turn out to have been mistaken, they will.

So I agree with 1 and 2. But 3 is just wrong. Really wrong. To transact in a currency requires holding the currency. So the logic Lee is using is that, if a new person decideds 1 and 2 are compelling, they will sell US dollars and buy bitcoins so that they can transact in bitcoins. But remember why they are doing this. If it is just for, say, international money transfers, they are going to convert the bitcoins back into another currency. So there will be no new set of people holding bitcoins. For an asset to appreciate relative to other assets (in this case, for the ‘price’ of bitcoins to rise), there has to be more people wanting to hold bitcoins for long periods. But the case for transaction efficiency involves people wanting to hold bitcoins for very short time periods; if it all works well, a few seconds. Thus, one cannot expect the price of bitcoins to rise anywhere near any explosion in transactional usage for bitcoins. Moreover, that transactional demand will be driven by stability and, guess what, an appreciating currency ain’t stable. So there is a fundamental inconsistency in Lee’s expected path to riches and what will drive those riches.

Now this might be a little difference if people decide to transact purely in bitcoins. Then there will be more people, in equilibrium, wanting bitcoins rather than US dollars. So Lee might be thinking that his 5% (!) of retirement savings held in bitcoins will actually be valuable because it will be cheaper for him to buy things upon retirement in bitcoin rather than US dollars. That is possible but it wasn’t a reason he gave and I am not sure how many people believe that. For starters, better transactional efficiency should mean we shouldn’t care as much about what currency we actually hold, right?

Instead, what Lee actually makes a case for is to invest in intermediaries that will make bitcoins work as an efficient payment system — e.g., Coinbase. If you believe that bitcoin will take over as a transactionally efficient payment system, the most innovative intermediaries are surely where you would look to place your money.

In the end, Lee’s case hinges on 4 and 5 that there are frictions in financial markets and that there is opportunity getting in on the ground floor in bitcoin. Lee apparently had bitcoins at the outset but was forced to sell them too early for his job. I fear that he missed the boat himself.