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What is behind the recent surge in the price of bitcoin?

What is behind the recent surge in the price of bitcoin?
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The latest iteration of a sustained surge in bitcoin price has seen the cryptocurrency rise by more than 300 percent during the past year. This is the third major cycle of price spikes involving bitcoin since 2013 — the previous two “bubbles” ended with a sharp fall of over 80 percent. Unlike a stock or a bond, it is hard to determine the fundamental value of bitcoin. Its value is entirely dependent on what people think it is worth. Some boosters have claimed that bitcoin could be worth as much as $400,000 while others foresee a spectacular price collapse.

Bitcoin came into existence in 2009 and its first-mover advantage has enabled it to achieve widespread recognition and notoriety. Bitcoin and other cryptocurrencies have essentially created a new form of payment system that is based on blockchain technology, which utilizes a distributed public ledger system that is validated by a decentralized user network and whose integrity is derived from the usage of sophisticated cryptographic algorithms.  

At present, bitcoin fails to fully meet the requirements to be considered a traditional form of money. Money serves three basic functions in a modern economy: It is a medium of exchange, it acts as a store of value and it is used as a unit of account. Despite recent support from PayPal, Square and other platforms, cryptocurrencies like bitcoin remain a niche payment method. Given the limited opportunities for using bitcoin to undertake normal day-to-day transactions, it is hard to consider the cryptocurrency as a viable or practical medium of exchange.

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Additionally, the extraordinary volatility in the price of bitcoin makes it a poor unit of account. A common unit of account simplifies measurement of relative prices and facilitates the efficient exchange of goods and services. Wild fluctuations in the price of bitcoin (as highlighted by the now legendary story of Laszlo Hanyecz), make it infeasible for denoting relative price levels. In fact, stablecoins exhibit more future potential to act as a medium of exchange and unit of account than first-generation cryptocurrencies such as bitcoin.

At present, it is bitcoin’s role as a store of value that has generated considerable interest and much debate. Bitcoin has no intrinsic value of its own — a feature that it shares with modern fiat currencies. However, unlike fiat currencies (whose supply, in theory, is unlimited), a major part of bitcoin’s appeal lies in the fact that its supply is constrained (by design, only 21 million bitcoins are expected to ever be mined). Critics, however, note that there is nothing preventing the creation of any number of new cryptocurrencies based on the same underlying blockchain technology.

Techno-libertarians, some of the earliest adopters, are attracted to bitcoin as it is highly decentralized and utilizes a blockchain-based distributed public ledger system to record transactions. This contrasts with fiat money (such as the U.S. dollar), which is not only issued by a government-controlled authority but also requires trusted intermediaries (like banks) to maintain private account ledgers to record holdings and transactions of each participant.

Recently, bitcoin has attracted the attention of asset managers and large financial institutions. Rich investors are adding bitcoin to their portfolios as some of the stigma attached to cryptocurrencies fade. There are emerging signs that bitcoin has attained mainstream status as an alternative asset class. Rising demand and limited availability of bitcoins has contributed to the price surge.

Despite favorable recent developments, it is still extremely hard to fathom the extraordinary valuations attached to bitcoin. As an asset that is neither tangible nor productive, bitcoin poses a bit of a puzzle. It is true that in an era of massive central bank balance sheet expansion and exploding public debt levels there is a slight but serious risk that fiat currencies may experience a sharp decline in value. It is, however, hard to discern the underlying logic behind the switch among not just cryptocurrency evangelists but also mainstream institutional investors toward bitcoin and away from gold as an inflation hedge.

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While the price of gold was up almost 25 percent in 2020, bitcoin rose by around 300 percent during the same period. Gold is tangible, durable, relatively rare, possess intrinsic value (it is, after all, a precious metal used in jewelry and electronics), and has a long track record (going back several millennia) as a stable store of value. Yet, an intangible and unproductive asset that has barely existed for a dozen years is suddenly considered to be a safer and better hedge against inflation than gold.

If it is not primarily an inflation hedge story, then what explains the sudden and irresistible attraction toward bitcoin? One possibility might be that we are in the midst of what Nobel Laureate Robert Shiller refers to as a contagious narrative — sometimes the myths and stories that investors use to convince themselves and others can be more important than fundamentals.

It is always tricky to ascertain the existence of an asset bubble when it is continuing to inflate. Prematurely calling the top is a frequent error made by market prognosticators. However, the pace of the recent runup in the price of bitcoin (after reaching the $20,000 price mark for the first time on Dec. 15, 2020, bitcoin surged to $30,000 mark in just 17 days) should give serious investors some cause for concern. Growing popularity might also subject cryptocurrencies to increased regulatory scrutiny in the not too distant future.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.