Bitcoin Just Hit The Big Time -- Here's What Everyone Ridiculing It Doesn't Understand

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The electronic currency Bitcoin just got a big vote of confidence from one of the world’s most successful venture capital investors.

Fred Wilson of Union Square Ventures just invested in a startup called “Coinbase,” which facilitates Bitcoin transactions.

This investment doesn’t mean that Bitcoin is guaranteed to become a mainstream currency, but it’s a small step in that direction.

So it’s time folks who just instinctively ridicule Bitcoin took a moment to understand it.

Bitcoin is an electronic currency–a new form of money.

It’s also, possibly, the next great asset bubble. (Or investment, depending on how the story ends. Or both, depending on when you get in and get out.)

Bitcoins are strings of numbers that can be electronically owned by and transferred among individuals and organisations. For now, the currency is primarily used for payments by fringe retailers or illegal transactions, but it is being accepted more and more widely (Coinbase was created to help that process). And organisations that exchange Bitcoins for standard currency are now being approved to operate as banks.

The premise and promise of Bitcoin–the part that appeals to folks who don’t happen to be gold bugs, conspiracy theorists, or cryptography geeks (obviously they all love it)–is that the current plan is for only a finite number of Bitcoins to be created. This is in direct contrast to standard government-issued currencies, which governments can always print more of. If the supply of Bitcoins remains finite, this should theoretically eliminate inflation, which is one of the biggest drawbacks of paper money.

Why is inflation a problem for paper money?

Because it destroys the value of paper money over time.

Even a low rate of inflation can wallop the value of normal currencies over several decades. A dollar in 1900, for example, is only worth about $0.04 in today’s currency.

So Bitcoin is conceptually very interesting, especially since it is not issued by a government agency. (Here’s a great presentation on what Bitcoin is and why some people are so excited about it.)

What has suddenly grabbed the public’s attention about Bitcoin, however, is the recent explosion in the value of the currency.

Because the number of Bitcoins is limited, their value increases rapidly when more people want them. And when the value of something increases rapidly, even more people want them. So the initial price increases fuel future price increases which fuel more future price increases..

Of course, this dynamic has fuelled the inflation of every asset bubble in history. So it behooves people to analyse the sustainability of such price increases carefully.

When Bitcoin was launched in 2010, the currency initially had very little value. Quickly, however, the price of each “coin” soared above $25, making the initial Bitcoin believers rich. Then prices collapsed, with coins trading down to $5 again. And then Bitcoin prices began a slow and steady rise that has suddenly gone parabolic.

At the beginning of March, Bitcoins could be exchanged for about $35.

Then, over the course of 6 weeks, the value of Bitcoins soared above $250. Then they crashed again, dropping all the way to the $50s. Now they’re changing hands at about $115.

Bitcoin Prices

This explosive price increase has many intelligent people crying “bubble!”

And these intelligent people may well be right.

But if there’s one lesson that gets repeated again and again in bubbles, it’s that prices can rise much higher and bubbles can last much longer than most observers think.

(Internet stocks, for example, were first described as a “bubble” in 1995, a full five years before the peak. And the amount of money made in those next five years made everyone who was sceptical early on look and feel like a fool. House prices, meanwhile, were described as a “bubble” as early as 2002 and 2003. And it wasn’t until 2007, many years later, that house prices finally peaked.)

Driving prices in all bubbles, of course, is the possibility that the price action might not actually be a bubble. And that applies to Bitcoin, too.

If Bitcoins become an accepted currency everywhere in the world, if governments don’t intervene and make Bitcoin transactions illegal, and if the supply of Bitcoins remains finite (if the systems aren’t hacked or the anonymous creators don’t get greedy and decide to create many more), then Bitcoin prices could go much, much higher.

After all, how much would you pay for a currency that could be used everywhere in the world and would never demolish your savings by losing value to inflation?

You might pay a lot for that currency.

And, as with any asset, it would be hard if not impossible to determine how much value was “too much”–because determining the value of any asset or means of exchange is always a subjective exercise.

At the same time, though, there are many big risks that could bring the Bitcoin frenzy to a quick and brutal end.

Governments, for example, might decide that Bitcoin undermines the value of their own legal currencies–and ban it.

In the U.S., only Congress has the power to print money, and Congress might well decide that Bitcoin is money (which, it is).

Or, Bitcoin’s technology could be hacked, allowing Bitcoins to be stolen from their owners.

Or someone could make counterfeit Bitcoins.

Or someone could create a better Bitcoin–a new electronic currency that makes Bitcoin useless and irrelevant (Lots of folks are working on these currencies.)

Or Bitcoin could never really gain mass-market acceptance.

In short, there are lots of reasons why Bitcoin might not be the wonderful “store of value” that Bitcoin fanatics and investors say it is–and, instead, might just become the next tulip bulb or dotcom stock bubble.

On the other hand…

Bitcoin might fulfil its promise.

And/or Bitcoin might make some speculators fantastic amounts of money in the hours, days, months, or years before its value crashes.

So you can understand why not just monetary theorists and technology folks and speculators are excited about it.

And that’s why one very smart and successful investor, Fred Wilson, just invested in the Bitcoin ecosystem.

SEE ALSO: Here Are 6 Reasons Why Bitcoin Prices Could Crash

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