Higher Rock Education - Economics Blog

Tuesday, February 06, 2018
Investors of bitcoin are not the faint of heart. Their wild ride took them from a low of $739.55 to a high of $19,870.62 in 2017. (Yahoo Finance) During the ride the value experienced swings greater than 5% in a single day on 240 occasions. (That is the equivalent of the Dow Jones Industrial Average moving approximately 1,000 points in a day.) What caused the huge changes in value? Supply and demand, of course! The demand for bitcoin has been a tug of war between speculators and investors who believe the blockchain technology and the use of bitcoin as a currency is the wave of the future, and prominent economists and investors who believe bitcoin is the next investment bubble.

Bitcoin is a digital currency that has an electronic payment system. So is bitcoin a fad, or is it here to stay? What is it good for? Money…well, is bitcoin really money? Some, myself included, would argue it is not money, yet. The Wall Street Journal posted a terrific video illustrating several problems using bitcoin as currency. In it, the WSJ’s Thomas Di Fonzo uses bitcoin in several New York establishments. He pays $76 for a $10 pizza for lunch, and then waits until that evening before his order has been processed and prepared. Currency has three functions: store of value, medium of exchange, and measure of value. This blog takes a closer look at each of these functions as they relate to bitcoin.

A medium of exchange can be anything that is widely accepted as payment for a good or service. Most societies use their currency, but stones, salt, gold, and tobacco have been used as a medium of exchange. How about bitcoin? Bitcoin is becoming more widely accepted as a payment. The number of transactions using bitcoin has grown from less than 10,000 per day in 2011 to over 300,000 a day in 2017. (See Blockchain for a daily report on transactions.) Bitcoin is being accepted by many reputable establishments including Overstockcom, Microsoft, Reddit, Expedia, and Braintree. (For a more comprehensive list visit: Bitcoin Accepted Here.) But, in the beginning of 2018 most retailers do not accept bitcoin.

How do you respond when you are paying for a good or service using a credit card and the card reader is slow…real slow…perhaps it takes two minutes to process your payment? I confess, I get impatient and either forget the purchase or pull out cash. I do not think I would be willing to wait 10 minutes (or several hours as in the case of Di Fonzo’s pizza) for my bitcoin transaction to be approved. Blockchain reported that it took 2,214 minutes to process a transaction on February 4, 2018 at 1:00. (Blockchain Average Confirmation Time) Now assume there are fees associated with the transaction. For me, bitcoin is not the medium of exchange I would choose, and let’s face it I am not alone. Visa processes approximately 150 million transactions a day, or 500 times more than bitcoin. Most transactions are processed in less than 30 seconds.

Money or currency must be a store of value. Store of value means that the currency must retain its value. In our example above, there are two possible reasons why the pizza price was so high. Assume you are the owner of the pizza restaurant. You set your prices every day first thing in the morning. This morning a bitcoin was worth $10,000, so you set your $10 pizza price at 0.001 bitcoin. Later that day the price of bitcoin fell 25 percent, so the .001 bitcoin you accepted is now worth $7.50! You lost $2.50 because you accepted bitcoin. How could you protect yourself as a business owner? You could add to the bitcoin price to reduce your risk. (By the way, it is not inconceivable that the price would drop 25% in a day. The price fluctuated more than 25% 10 times in 2017.)

Another possible explanation for the high price of Mr. Di Fonzo’s pizza is the value of bitcoin had appreciated since it was priced. Again, assume one bitcoin was selling at $10,000 when you, as the restaurant owner set your price at 0.001 bitcoin, which would be a price of $10. The value of bitcoin jumps to $12,500. The pizza now costs $12.50. That’s great for you, but your customers probably won’t be very happy. Each of these examples illustrate how bitcoin fails to retain its store of value.

Consumers also need to measure the value of one item versus another item. Because money is expressed in units of a currency, money acts as a measure of value that enables people to compare the value of different goods and services. Bitcoin can be used; however, its volatility makes the job much more difficult. The comparison would need to be made at a specific moment. Imagine you are making some improvements to your home and accept bids from two individuals. On a Monday you receive a bid of 1 bitcoin, and on Wednesday you receive another bid for 1.25 bitcoins. With a stable currency the comparison is easily made. But what if the value is volatile. You phone the Monday vendor and tell him that he has the job, only to learn that because the value of bitcoin has decreased 50 percent he needs to increase his price to 1.5 bitcoins. You tell him sorry, but you are going to accept another bid. After hanging up the phone, you call Wednesday’s vendor to tell her that she has the job but learn her price has increased to 1.6 bitcoins! It is difficult to compare values when the value of the underlying currency is unstable. It is likely the vendors would quote a price in dollars or another currency that is more stable.

It should be safe to hold cash, but with bitcoin, holding currency carries a large risk. Bitcoin does not meet the tests of currency because its volatile value complicates transactions and detracts from its acceptance. The most common choice among vendors is not to accept bitcoin because sellers do not feel comfortable that the currency will maintain its value. Accepting bitcoin as payment is really speculating in its appreciation and most business owners have chosen not to take the risk. A more stable bitcoin would improve its store of value, make it an easier measure of value, and help it act as a medium of exchange by increasing its acceptance. Only time will tell whether the value of bitcoin is stable enough to become more widely accepted as a currency and not as a speculative investment.

So, what has caused all the excitement? Investors! Read What’s in a Bitcoin to learn more about the supply and demand for bitcoin and the excitement over the blockchain technology.

© 2018 Higher Rock Education and Learning, Inc. All rights reserved. No portion of this site may be copied or distributed by any means, including electronic distribution without the express written consent of Higher Rock Education and Learning, Inc.