Monday, 20 June 2022

Why the value of Bitcoin is falling: an explainer

When I was young, before I even knew what economics was, I would stare at the pink front page of the Financial Times, wondering why anyone would be interested in the merger of two companies that no one has ever heard of.*

But sometimes, there is some financial news that I think people are genuinely interested in, they just have no idea what is going on. And because most of what is written about finance is for those in the know, it will forever remain a mystery to them.

There are a lot of things in life that are near impossible to enjoy unless you have some background understanding. It is why most lay people think cricket is dull or ballet boring. What makes matters worse is that when asking fans of a particular niche how to get into it, they usually say that you will just pick it up. I was once told by a poetry buff friend to just read poetry and I will pick it up. I read it, didn't get it, and put it down.  

It takes quite a lot of willpower to get through the early phases of a hobby, so I think any way you can make this learning curve less steep is great. This is why I started writing this blog, to help people understand economics. And who knows, some of you may even go on to to read an article... in the Financial Times.

*

The value of Bitcoin is going down. The reason it is going down, is because of inflation. To understand why this is interesting we need to look at what usually happens with two other types of investments when inflation happens: stocks and gold.

Inflation is the average rise in prices. So if inflation was 100%, a pint that was previously £5 would now cost £10. If you had £10 in your pocket, it would only buy 1 pint rather than 2.

In order to control increasing inflation, central banks will raise interest rates that ultimately determine the interest rate you get from your bank. You can read a brief explainer on the theory behind this here, but the upshot is that raising interest rates make saving more attractive.

If you looked at the interest rate you could get on your savings account over the last few years, whether it is an ISA or bond, you would be lucky to get anywhere near 1%. This meant that most people would try and look for higher returns elsewhere. In order to get higher investment returns, you usually need to invest in something more risky, like the stock market. 

If you put your saving into a bond, they are pretty much risk free - a safe asset. Usually you just have to give the bank your money for a set amount of time (1 or 2 years, say) and you are guaranteed a return. A share in a company, however, is a risky asset. It may give you much higher returns but it's not for certain. The fact that returns to safe assets have been so poor over the years is one reason why the stock market has been so high. 

So when inflation happens, people move their assets away from risky assets like the stocks into safe assets like saving bonds. This is why the stock market isn't doing so well now.

Another thing that happens with inflation is that gold increases with value. Traditionally, gold has been viewed as a "hedge" against inflation. A "hedge" is just something that protects yourself against a financial loss. This is because with inflation, the purchasing power of currency goes down (you can only buy 1 pint instead of 2). Gold is a precious metal and has a value of its own so won't necessarily lose value due to inflation. Why it has a particular value is difficult to get your head round but the easiest (and best?) answer is that gold is shiny and people like it. 

So what does all this have to do with Bitcoin? Well Bitcoin was invented to be an alternative currency to regular old pounds and dollars. Fan of Bitcoin's say that you cannot completely trust government controlled "fiat" currencies: governments can simply print money out of thin air (unlike crypto) and you will just get inflation. I don't buy this argument, but it is an argument nonetheless.

So given that cryptocurrency is an alternative currency, you would expect Bitcoin to be a hedge against inflation. So you would expect more people to invest in Bitcoin when inflation happens. But this has not been the case. In fact, the opposite has happened. 

This is because many investors think Bitcoin resembles a risky asset (like a stock) rather than a safe asset (like gold). This also suggests that part of the dramatic rise in Bitcoin was due to the fact that returns on savings bonds have been so poor. Even if there was a a 1 in 1000 chance of Bitcoin becoming a global currency, it might be worth a punt as the returns could be huge! But this becomes a less attractive bet when the return on safe assets, such as savings bonds, are rising.

This may or may not be particularly good news for crypto fans. It suggests that most investors are not massively convinced by the overall claims of it being an alternative currency. However, part of of what makes a good currency is stability - you are less likely to spend your Bitcoin if you believe that it will be worth twice as much tomorrow! Perhaps this crash brings a period of stability that makes it more usable as a currency. So the crash might be bad news if you invest in crypto but good news if you believe in the overall project of it being an alternative currency. 

  
*I love reading the FT now, but I still think mergers are extremely boring.

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