Investing in Bitcoin is perfectly rational

This virtual currency is like a Ponzi scheme, but the technology behind it will transform money

You know it’s time to sell, according to Wall Street folklore, when the shoeshine boy starts giving you share tips. Stock markets may not have reached such a feverish state quite yet. But Bitcoin, the virtual currency, very obviously has.

Attending a lunch party the other day with non financial types, the apparent magic money tree of Bitcoin was one of the chief subjects of conversation. Seemingly everyone had some part of the action. “I’ve just made $500 in two days,” said one, “and I’m buying more.” The godson of a colleague, meanwhile, sold recently at an £18,000 profit, enough to pay for his first year at uni.

Few of those caught up in this latest financial mania have any more than the foggiest of notions what Bitcoin really is, or how it works, but that doesn’t make their behaviour irrational or stupid. In his pioneering book on crowd psychology, Extraordinary Popular Delusions and the Madness of Crowds, the Scottish journalist Charles Mackay chronicled three separate financial manias – the South Sea Bubble of 1711-20, the Mississippi Company bubble of 1719-20, and the Dutch tulip mania of the early 17th century. I’m not sure Bitcoin exactly mirrors any of these historical precedents; it’s actually much more like a giant Ponzi scheme, or chain letter, than a classic financial speculation. Indeed, at more than three times the size of Bernie Madoff, it’s very probably already the biggest such racket in history.

The thing all manias have in common, however, is that they are based on the “greater fool” theory, the belief that the price of a commodity is determined not by its intrinsic value – which in Bitcoin’s case is zero – but by the expectations of market participants. It is therefore perfectly rational to buy at what seems a ridiculously high price if you think there will always be an even “greater fool” willing to pay more.

Virtually everyone who buys Bitcoin does so using this principle. They are not naive idiots; they are taking a calculated gamble. Obviously, you don’t want to be there when the music stops, but the global nature of Bitcoin, with hundreds of thousands of new accounts being opened by the day, means the supply of fools is almost boundless.

At this stage, moreover, the phenomenon is not generally regarded as “systemically significant”. If the price collapses, it is very unlikely to cause wider economic damage, except perhaps as the spark for a more broadly based asset sell-off.

This might change as Bitcoin goes mainstream; the Chicago Mercantile Exchange plans to start trading Bitcoin futures by the end of the year, a key step in opening up the market to institutional investors. Yet for the moment it’s not big enough in itself to cause extensive damage.

What’s more, there’s very little evidence of “leverage” in Bitcoin trading; things only get really dangerous when investors start borrowing to buy. Bitcoin is also far too volatile – yesterday, it was down more than 10 per cent at one point – to act as a credible alternative means of exchange. As such, it is not really a currency at all, but no more than a mechanism by which wealth is transferred from the many (the new fools) to the few (the older ones).

But nor can it be lightly dismissed as just another passing fad. Bitcoin is very much part of one of the great defining characteristics of our age – loss of trust in established institutions, or in this case, fiat currencies. Cryptocurrencies such as Bitcoin are what Mervyn King, former governor of the Bank of England, has called “digital gold”; they appeal to those who distrust governments and banks to manage the supply of money soundly.

The financial crisis taught us that banks are not to be trusted to keep our money safe; subsequent money printing by central banks has further undermined faith in its intrinsic value, distorting capital allocation and driving an indiscriminate surge in asset prices, including, ironically, Bitcoin.

So intrigued is the Bank of England by the Bitcoin phenomenon that as part of its “One Bank Research Agenda” it has commissioned an in-depth study on the practicalities and consequences of launching its own e-money system, in competition to Bitcoin but using the same “blockchain”, distributed ledger technology.

Already, it might be said, we are well on the way to purely digital money. For many of us, cash is fast becoming redundant.

The advent of central bank digital currencies would be a further leap into the future, potentially rendering the traditional bank account obsolete, and making money free transactions – essentially barter – perfectly possible. This might in turn upend the established role played by commercial banks in money creation and the provision of credit.

In any case, technology is likely to prove just as disruptive of conventional money systems as it is of everything else, perhaps more so. Bitcoin is the outrider; we know not where it might lead us.