Is Bitcoin Defying a Principle of Microeconomics?
Update: This article has been changed to add three charts that were left out during the editing process. In 2015, Bitcoin performed exceptionally well both as a currency and as a commodity. Interestingly, the cryptocurrency Bitcoin, which is also classified as a commodity, has even defied the well-held microeconomics principle that preaches that: “Commodities typically […]
Update: This article has been changed to add three charts that were left out during the editing process.
In 2015, Bitcoin performed exceptionally well both as a currency and as a commodity. Interestingly, the cryptocurrency Bitcoin, which is also classified as a commodity, has even defied the well-held microeconomics principle that preaches that: “Commodities typically follow an inverse relationship with the value of the dollar. When the dollar strengthens against other major currencies, the prices of commodities typically drop. When the value of the dollar weakens against other major currencies, the prices of commodities generally move higher,” says Commodities Expert Chuck Kowalski. But, surprisingly, at the end of 2015, Bitcoin’s value increased and was heralded as the world’s best-performing currency.
Also Read: 2015 Proves Bitcoin Is Here to Stay
USD vs. Commodities vs. Bitcoin
In 2015, the price of Bitcoin increased about 37 percent against the U.S. dollar. Simultaneously, “The value of the US dollar rose throughout 2015 posting gains in the 10 percent to 12 percent range against currency indexes,” according to Dr. John M. Mason.
These two facts seem to indicate a direct relationship between Bitcoin, which is classified as a commodity, and the U.S. dollar. This direct relationship is surprising because it indicates a possible departure from the microeconomic principle that calls for an inverse relationship between the strength of U.S. dollar and the value of commodities.
But is Bitcoin a commodity? Authorities think so. Granted, Bitcoin is not a typical commodity, but it was nonetheless officially classified as a commodity by the U.S. Commodity Futures Trading Commission (CFTC) in September 2015. Earlier, in March 2014, the Internal Revenue Service (IRS) had ruled that Bitcoin should be considered as property for federal tax purposes.
Certainly, there is a difference between economics behavior and law. Just because Bitcoin has been legally mandated as a commodity, it does not mean that the market will treat it as such. However, even if Bitcoin were acting as a currency rather than a commodity, it is remarkable that Bitcoin’s value still went up, while the value of most currencies went down.
Why does the dollar’s value have such an impact on commodity prices? There are numerous reasons. “The main one is that commodities are priced in dollars. When the value of the dollar drops, it will take more dollars to buy commodities,” affirms Chuck Kowalski.
Commodities have historically followed an inverse relationship with the value of the dollar. This principle was amply demonstrated once again in 2015. The dollar was the strongest in 11 years. Since June 2015, the U.S. dollar surged 24 percent, while most commodities plunged, as described in Bloomberg’s article titled “Dollar Strength Fuels Commodities’ Worst Year Since 2008: Chart.”
Let’s look specifically at base metals’ prices. Their prices fell in 2015. In describing the world economic outlook the IMF points out:
“In an environment of declining commodity prices, reduced capital flows to emerging markets and pressure on their currencies, and increasing financial market volatility, downside risks to the outlook have risen, particularly for emerging market and developing economies.”
Market Realist blames the strong dollar as one of the main factors behind the fall of base metals, in the week finishing November 20. The graph below shows the negative relationship between the London Metal Exchange (LME) 3M Copper versus the U.S. dollar.
Bitcoin & Gold
Gold is another case in point. “Gold is considered a safe-haven asset as throughout history it has been viewed as a store of value.” Bitcoin also has the capacity to store value. Gold is particularly interesting because Bitcoin has been referred to as the new gold, or digital gold.
Some observers, like Martin Tillier, wonder whether Bitcoin is already replacing gold as the new Safe Heaven.
Deloitte’s paper titled Bitcoin the New Gold Rush, mentions similarities between gold and Bitcoin in terms of financial instruments. Specifically, regarding hedging and investment services, the paper indicates, “Bitcoin, like other assets such as gold, can create demand for peripheral products. Institutions are already starting to offer financial instruments, including insurance and derivatives, to help hedge clients’ risks. They may also create new investment offerings focused on Bitcoin, such as index funds and exchange-traded funds.”
The inverse relationship between the dollar and gold is more complex and less predictable than the relationship between the dollar and other commodities. The rule of thumb is that the value of the dollar is inversely correlated to the value of other currencies. A decrease in the dollar value increases the value of other currencies. As a result, the demand for commodities, including gold, increases. This, in turn, drives commodity prices up. At the same time, when the U.S. dollar value starts to fall, investors shift to other sources of investment to store value. And gold is one of these options.
Market Realist published the chart below showing the relationship between the gold price and the U.S. dollar index.
Fortunately, in 2015, Bitcoin did not follow the steps of gold’s path. Bitcoin’s value went up while gold’s value versus the U.S. dollar fell nearly 10 percent. So, Bitcoin’s behavior in relationship to the dollar, and commodities, including gold, showed remarkable resilience. Indeed, in 2015, Bitcoin proved once again to be really sturdy both as a currency or a commodity.
What are your thoughts on how Bitcoin’s value will fare in 2016? Let us know in the comments below!
Images courtesy of Pixabay.