Earlier this year, the price of the electronic currency Bitcoin exploded upwards, making its early advocates rich and smug and leaving everyone else shouting “bubble!”

Then, the price of Bitcoin crashed, making everyone who had cried “bubble” feeling smart and smug.

And then, a few weeks ago, the price of Bitcoin started exploding again.

And, so, once again, Bitcoin believers are crowing, and everyone else is mumbling about “bubbles.”

So, who’s right?

Most likely, everyone.

Why?

Because Bitcoin is the perfect asset bubble.

There is absolutely no way to value Bitcoin, which means there is nothing constraining its price other than supply and demand. As long someone new can be convinced to buy Bitcoin, its price can keep rising. Bitcoin prices could literally go to 1,000 or 10,000 or 100,000 or 1 million per coin, and there would be no way to prove that these prices were ridiculous.

What’s more, even if Bitcoin is a bubble, prices could keep rising for years.

As everyone who has ever been involved with asset bubbles can attest, they usually have a few defining characteristics:

They usually have some basis in logic or theory (as Bitcoin does)

They can last much longer and inflate much more than most people think (the current Bitcoin price rise might be only the beginning)

They can make early adherents absolute fortunes

They can go through many “mini-bubbles” on their way to becoming a massive bubble — with each new high exceeding the old high and each new low higher than the old low

They can burst relatively suddenly, without any particular warning, and their collapse can wipe out almost all of the many years of gains.

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 plan is for only a finite number of Bitcoins to be created. This is in 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.

(Although inflation has remained low in recent years, it ravages the value of paper money over time. A dollar in 1900 is only worth about $US0.04 in today’s currency.)

So Bitcoin is conceptually 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…at least for a while.

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 $US25, making the initial Bitcoin believers rich. Then prices collapsed, with coins trading down to $US5 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 $US35.

Then they blasted up to about $US250.

Then they collapsed to about $US100 again.

And now they’ve soared through $US300.

Importantly, this behaviour is exactly like the price behaviour of prior bubbles.

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 the rolling booms and busts of the 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 or Bitcoin isn’t superseded by some new currency like Ripple, then Bitcoin prices could go 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 it.

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 Bitcoin could never gain mass-market acceptance.

Or some other Bitcoin could replace Bitcoin, just as new toy fads eventually replaced Beanie Babies. (After all, it wasn’t long ago that many of today’s Bitcoin fanatics were going on about how you had to own gold.)

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

But in the meantime, Bitcoin believers are coining it.

SEE ALSO: Bitcoin Is A Joke

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