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While we’re on the subject of bubbles, I’ll add a few comments on Bitcoin, just for fun. I’d write more, but my sides still hurt from laughing.

Objects like tulip bulbs and Bitcoin differ from securities in that they do not deliver a stream of cash flows to the holder. Instead, what objects like tulips and currencies provide is a little stream of services over time, for example, as a perennial thing of beauty or as a means of payment. What people sometimes forget is that it is not just scarcity that defines the value of an object, but the stream of useful “services” that it provides (for some reason, nobody wants to buy my unique, limited edition, digitally-signed porcupine seat covers). The price of the object, and the stream of services it provides, should be commensurate.

U.S. dollars, for example, have value primarily because they are tethered to the real economy by fiat (they legally must be accepted as a means of payment, as noted on the face of any dollar bill), and they represent the entire substrate of the banking system – nearly every payment that goes back and forth in the U.S. economy represents a transfer of base money. Base money (currency and bank reserves) provides billions of little “services” over time. With every transaction, reserves move electronically from bank to bank between one account holder and another. That combination of legal fiat and constant use as a substrate of the payments system is what gives money “value.” That value also means that the U.S. government essentially obtains revenue as “seigniorage” for producing the stuff. For those who imagine that governments are going to surrender that revenue in favor of using Bitcoin, I’ve got a non-fungible token to sell you.

As I’ve noted before, blockchain is a brilliant algorithm, and I expect that it will have a great number of uses for secure transactions and inventory management. Bitcoin, however, is a token generated by an energy-inefficient, replicable blockchain app. Ultimately, its value rests on the capacity to provide transactions services, yet without fiat to require its use, and with strikingly narrow bandwidth – one block of roughly 2000 transactions every 10 minutes – that I expect will prove to be a wildly limiting feature. That’s a problem in in a world where speculators now value the stock of bitcoin at one-fifth the value of the entire U.S. monetary base.

If you think about how money is valued, it’s clear that people accept it because they believe it will provide a claim on the future output of others. Of course, that expectation requires that future producers will also give away their output and accept the money, on the belief that yet other future producers will do the same. That expectation has to continue indefinitely. Like the question ‘What holds up Atlas when Atlas holds up the world?’ it’s not enough to answer that he’s standing on a turtle. It’s got to be turtles all the way down. The value of money has an enormous psychological component.”

– John P. Hussman, Ph.D., Turtles All the Way Down, February 2019

Of course, Bitcoin may have a certain user base as a vehicle for money laundering and black market transactions, but that’s an undesirable investment thesis. The vast majority of transactions are to exchange Bitcoin itself, though the New York Times did recently report that “pornography, patio furniture, and an at-home coronavirus test are among the odd assortment of goods and services that people are purchasing with the cryptocurrency.” So, basically, if your typical day consists of surfing porn on your patio while testing yourself for COVID, you’re gonna want to look into Bitcoin.

My largest concern is that people are actually forking over hard-earned savings in exchange for these tokens, which allows early “miners” to cash out. That’s essentially the defining feature of a Ponzi scheme. Like all speculative bubbles that rely on increases in price, rather than cash flows generated by the production of value-added goods and services, Bitcoin isn’t actually creating “wealth.” It’s only creating the opportunity for wealth transfer, primarily from those who will end up holding the bag.

Bitcoin has certain characteristics of base money in the sense that it’s exchanged on an electronic ledger, but by design, transactions are limited to an average of about 2000 per block, with one block successfully validated, on average, every 10 minutes. In order to validate a transaction block, CPU farms across the world grind out terahashes of random SHA256 validation attempts in order to discover a sufficiently small binary that matches the cryptographic hash of the block. All of this “mining” burns up about as much energy as it takes to run a modest-sized country. Validating a block of transactions produces a reward to the miner (and dilution of the coinbase) of 6.25 Bitcoin per block, which currently works out to nearly $200 per transaction. Yet the value of the median transaction in Bitcoin is only about $1000 in the first place.

There’s a rather primitive regression analysis floating around (tagged as “sophisticated” by some observers who apparently go numb at the word “logarithm”) that attempts to relate the log price of bitcoin to the log “stock/flow” ratio, as if it represents some mechanistic supply-demand relationship. Aside from the fact that the correlation between two diagonal lines is always about 0.9-something, I find that one can obtain a better fit just by regressing the log price of Bitcoin on the log ratio of block difficulty/block reward, which is basically a measure of how much energy one needs to waste in order to mine a new bitcoin. So the “value” of Bitcoin is partially linked to the backward-looking sunk cost of the energy wasted to mine these tokens. Still, I wouldn’t dream of using this sort of “model” to trade an object whose “value” is primarily in the heads of speculators. Use it if you like. If you happen make money on it, feel free send me a check, preferably in U.S. dollars.

Undoubtedly, this view of Bitcoin will be unpopular among those who associate holding Bitcoin with superpowers like laser eyes and diamond hands. “Not surprised Hussman doesn’t get Bitcoin. Few do.” M’kay. Look, there’s certainly a case to be made that a speculative mindset creates its own reality, and while it does, there’s an opportunity to obtain wealth transfers from frantic late-comers who can no longer tolerate missing out. Tulips gonna tulip. Not my gig, thanks.

In the short run, it will be said to be an attack, motivated by either deficient understanding or uncontrolled envy, of the wonderful process of enrichment. Those involved with the speculation are experiencing an increase in wealth – getting rich or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition. As long as they are in, they have a strong pecuniary commitment to belief in the unique personal intelligence that tells them there will be yet more. Accordingly, possession must be associated with some special genius. Speculation buys up, in a very practical way, the intelligence of those involved. Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets.

– John Kenneth Galbraith, A Brief History of Financial Euphoria