Bitcoin Bubble

Posted on Posted in News, Research

Jeffrey Chen

The biggest investment craze of 2017 has been: Bitcoin. Hype surrounding the cryptocurrency has been unavoidable, reinforced by mainstream media, and accompanied by an increase in predictions of bitcoin’s imminent collapse.

Bitcoin has been proclaimed dead many times. In 2013, ‘Bitcoin is dead’ articles took off as price reached $100; experts declared it a “scam,” a “joke,” and “doomed to fail.” In 2017, Bitcoin died at least 100 times, up 350% from 28 deaths last year, according to news aggregator Bitcoin Obituaries.

It seems that every day someone compares bitcoin price with the Dutch tulip mania of 1637. The market currently shares some features of an investment bubble, most notably the speculative behavior by private investors that is driving price growth. Psychological and behavioral factors, however, do not support claims that bitcoin “has no fundamental value.” We find that facile comparisons to tulips lack depth and put readers at risk of losing the forest for the trees.

What, then, is the valuation of Bitcoin? No one really knows, but we think readers might benefit from a more rational discussion of the current situation. In this article, we look at past investment bubbles to put the current hype in historical context. In a subsequent article, we will discuss the potential value of cryptocurrency from an economic perspective. At the very least, we hope readers will take away some talking points when friends, relatives, and strangers inevitably want to talk about ‘the bitcoin bubble’.

A Brief History of Bubbles

In an economic sense, ‘bubbles’ are best defined as:

“where investors buy an asset not for its fundamental value, but because they plan to resell, at a higher price, to the next investor”

“a state of booming economic activity that often ends in a sudden collapse”

Famous bubbles in history include the Dutch tulip mania of the 1600s, the South Sea Company bubble of 1711-1720, and the dot-com bubble in 1999.

  • Tulip Mania

In the winter of 1636-37, trading of tulip futures in the Netherlands brought rampant speculation. The price of rare tulip bulbs, especially those infected with a virus that produced colorful patterns, inflated to the equivalent of a nice house. Though tulips themselves had little utility, they became valued as status symbols– luxury goods–in a highly unequal society. Futures contracts provided a convenient way to speculate with little equity.

Much of this growth was driven by greed or the fear of missing out. In the Dutch tulip mania, speculators were buying tulips not because they wanted to use them, but in the hope that they could sell them at an even higher price. When prices fell a large number of defaults propagated throughout Dutch society. Experts agree that the spectacular collapse of the bubble had little impact on the overall economy, but it damaged trust in financial markets. Bitcoin bears invariably compare its parabolic price increase to that of tulips, and argue that when the price starts going down, so many people will lose money that it will similarly destroy trust in Bitcoin as a currency.

  • The South Sea Bubble

The South Sea Bubble was a speculative bubble involving the South Sea Company, a British trading company that was created to offload England’s war debt in exchange for a monopoly in trade with Spain’s colonies in South America. Investors, seeing potential profits from trade with South American colonies rich in commodities, bid up the price to incredible heights. However, the company’s profitability was mediocre at best, and insiders began selling off shares at the peak; when share prices imploded investors who had bought on credit were promptly bankrupted. Banks and goldsmiths who had made loans were unable to collect, and went bankrupt themselves.

At the height of the South Sea Bubble, numerous joint-stock companies raised capital for business ventures that were outrageous and often fraudulent. The most infamous proposal: “For carrying on an undertaking of great advantage; but nobody to know what it is.” Basically, people were investing in something they knew nothing about, yet somehow hoped would make them rich. The most famous investor to get caught out in the South Sea Bubble was Sir Isaac Newton.

Some observers argue that the South Sea Bubble is a better analogy for Bitcoin, because “the bubble is not just about bitcoin.”In fact, there is a whole cryptocurrency market, with various altcoins offering investment opportunities premised on claims to represent the future of blockchain technology. Some of the more dubious ICOs are reminiscent of fraudulent joint-stock companies. Other, quality projects, may be around for centuries. It is very possible that the market will climb higher, crash, and then settle back at lower levels.

  • The Dot-Com Bubble

The dot-com bubble, or Internet bubble, was a period of excessive speculation that occurred around 1997- 2001. During this time many Internet-based companies were founded, and many later failed. The Internet was heralded as the “next big thing” and as usage rapidly increased dot-com companies were operating at a net loss to harness network effects and build market share as fast as possible. At the height of the boom, it was possible for a dot-com company to raise a huge amount of money via an initial public offering even though it had never made a profit.Another phenomenon of the dot-com bubble was an unprecedented amount of personal investing. The NASDAQ peaked in March 2000 before dropping 80% over the next 2.5 years.

Comparisons between the dot-com bubble and Bitcoin today are more instructive than tulips or the South Sea Company. There are many similarities, not least the irrational exuberance of many private investors who fear missing out and are willing to invest, at any valuation, in unproven business models, overlooking traditional metrics like price-earnings ratio in favor of confidence on technological advancements. In the dot-com bubble’s ensuing crash, much of the invested capital was lost, but also much of it was invested in the infrastructure and capabilities that paved the way for an industry that has changed all our lives.

Is Bitcoin a Bubble?

It is hard to deny that, as with previous speculative asset-price bubbles, similar dynamics are driving bitcoin price right now. “This is absolutely a straightforward grassroots bubble, driven by speculation and greed,” says Bitcoin scholar Andreas Antonopoulos in a recent interview.According to Antonopoulos, who points out that 2017’s bull run is actually the sixth bubble in bitcoin, the more interesting and relevant questions are when the bubble will pop, and how violently.

After the bubble pops, what then? This is where simple comparisons fall short. The real tulip mania looked nothing like Bitcoin.The South Sea Bubble, unlike the decentralized ledger technology that underpins bitcoin, was based on a government-sponsored trade monopoly that proved unprofitable and unsustainable.

Due the fundamental differences between the nature of cryptocurrencies and NASDAQ-listed stocks and securities, it is dangerous to compare the $250 billion market capitalization of bitcoin with the Dot-com bubble, which peaked at about $3 trillion.Bitcoin is smaller by an order of magnitude, with unexplored potential. Moreover, the collapse of the dot-com bubble did not equate to the collapse of the internet: a number of companies survived, consolidated market share, and went on to become successful.

Summary

The run-up in bitcoin price, especially during the latter half of 2017, exhibits many of the same features as historical asset-price bubbles, especially regarding purely speculative behavior such as greed and fear of missing out.

Yet, most commentators simply stop there, with the tacit assumption that “bitcoin has no fundamental value.” This is where they may prove to be wrong.

In the future, Bitcoin and blockchain might revolutionize the financial industry, force us to reexamine our assumptions about governance, and change the way people around the world communicate value. Such an outcome is not inevitable, but given the possibility, it would be wise not to ignore. We will examine this potential more in another article. For now, investors should proceed with caution.


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