Bubbles and Bitcoin

Every time the price of bitcoin rises sharply there is a lot of talk about whether or not it is “in a bubble.” Naysayers and true believers alike squawk that they’re right and everyone else is wrong. Bitcoin is either going “to the Moon!” or into the gutter. One side grumbles about speculators and the other seems blithely ignorant their influence. The same stock phrases are shot back and forth and nobody ends up understanding the situation any better. There seems to be lots of talk about bubbles but very little understanding of what actually comprises a speculative mania, so I hope you find my contribution helpful.

The Nature of Bubbles

Anyone interested in the subject of “bubble” economics should pick up Douglas E. French’s book Early Speculative Bubbles & Increases in the Money Supply. What we can learn from French’s research is that speculative bubbles are first and foremost monetary phenomena. The infamous case of tulip mania, for example, had its origins in a Dutch policy where the government would subsidize the transformation of any gold into the national currency. Combined with pirating operations and burgeoning foreign trade, gold rushed into the Dutch economy literally by the boatload. The book covers a number of other cases, but to make a long story short, rapid expansions in the money supply can instigate speculative manias, depending on what catches investors’ fancy during that time.

Bitcoin’s price has been on a sharply upward trajectory again, but as others have written before, new technologies don’t have linear adoption curves. Since bitcoin’s price is inextricably tied to its level of adoption, movements in price like this should be expected if the technology is indeed gaining traction.

A price graph alone isn’t enough to predict a bubble, and a bubble isn’t merely a rapid rise and fall of price. Bubbles are a specific kind of phenomenon and they include a few characteristics I haven’t yet seen in the bitcoin market. According to Antonin Murphy, the sequence of events in a bubble looks something like this:

  1. An exogenous shock, like the start or end of a war, a technological or natural resource discovery, or a precipitous drop in interest rates suddenly creates new opportunities for profit, and a boom begins.
  2. The boom is nurtured by an expansion of the money supply, or the velocity of circulation increases.
  3. As demand increases so do prices, and with higher prices come more profit opportunities. Multiplier and accelerator effects interact and a “euphoric state” begins. Overtrading may also happen.
  4. Overtrading might take the form of pure speculation: the buying of assets for capital gain as opposed to income return from the asset. It may also take the form of buying on margin or installment purchases.
  5. Newcomers anticipating easy money become numerous. The insiders start to recognize the risk and start selling.
  6. A “financial distress” period sets in when the newcomers realize that if there is a big sell-off, prices will collapse. The race to exit hastens.
  7. Revulsion for the asset develops as banks start calling in loans and selling collateral.
  8. Finally, panic sets in as the market collapses. Some may start looking to government for a bailout.

We’ve seen big price swings, but if we use the above as a rubric I wouldn’t say we’ve seen any “bubble” activity. Perhaps the exogenous shock might be the Federal Reserve’s “QE infinity” program, FinCEN’s announcement in the US, China’s announcement of non-regulation, or the invention of bitcoin itself. It is, after all, an unprecedented new technology. As for a growing money supply, the world’s central banks are doing that all the time. But that money hasn’t been going into bitcoin yet. From the evidence before us, bitcoin’s price explosions can be more easily attributed to the volatility of a small market gaining interest. In April we saw an 80% drop in the price, from $260 down to the neighborhood of $50, yet here we are at a multiple of that previous high. In a bubble, the crash occurs because everyone discovers that the high price was completely, idiotically, unrealistic. Once it pops there’s little reason to get back in for years. It is much more plausible that that particular case was just temporarily overzealous new money.

In the end, everyone who got in still believes bitcoin has a future. I have yet to hear someone say “I got burned and I’m never using bitcoin again!” Anyone who tries it discovers how empowering it is to have a cash-like asset that can be teleported across the globe at a moment’s notice, without the risks posed by credit cards or the limits imposed by the legacy banking system. The euphoric period of a bubble produces prices that are outlandishly beyond a logical valuation of the asset. But what’s the logical valuation of a bitcoin? It totally depends on what kind of future you anticipate for the technology. If it merely ends up being half of one percent of worldwide e-commerce, that’s still going to mean far and away more demand than we see today. If entrepreneurs and technologists can build the infrastructure that bitcoin needs for widespread adoption, and the world agrees that it wants bitcoin, a price of $800 per coin will seem like a bargain. Maybe that won’t happen. Either way, the price will respond accordingly.

Anecdotally, there don’t seem to be very many people taking enormous, deluded risks on bitcoin, which is the sort of thing you would see in a bubble. There certainly hasn’t been enough of that to call it “widespread.” It is still a difficult currency to get into, difficult to handle, and for most people who hear about it, the very concept is still confusing and arcane. It can take days or weeks to get fiat funds into a bitcoin exchange. You can’t buy bitcoin futures, buy them on margin, or anything else that speculators use other than making straight purchases. The financial ecosystem of bitcoin just isn’t developed enough to facilitate a real bubble.

Even if we did see a bubble, the cat is out of the bag. We now know that a distributed, headless payment network is possible, and there are just too many benefits to give up on the idea. If bitcoin turns out to be a failed implementation, then the crytpography hackers who have been working on it will either adapt it or come up with something better. Now that cryptocurrency is here, it’s not going away. The only question is: what role will it play in the future? With the rapid changes that took a geeky invention like email from university laboratories to your grandmother’s kitchen, I don’t think it’s unreasonable to suspect bitcoin can have a similar trajectory.

“Bubble” is Not an Epitaph

People will cry “bubble” as if it’s a knock against bitcoin or a sentence of doom. But the bubbles of history always had more to do with inflationary monetary policy than they did with any of the asset’s flaws. The Dutch tulips didn’t do anything wrong. Stocks in the 1920s didn’t do anything wrong. In 2007 the houses didn’t do anything wrong. We still have tulips, stocks and real estate today. The problem instead was bad monetary policy, which bamboozled entire industries into producing too much of the wrong thing.

We may yet see that happen with bitcoin, but it will only happen once the institutions closer to the central banking money spigots get involved. Unusually high growth in the money supply has always been the lifeblood of speculative bubbles. If and when it does happen, all it means is that some self-deluding gamblers are probably going to lose money. But the technology will still be there, with better and better infrastructure all the time.

But here’s my prediction: if there are ever assets priced primarily in bitcoin, you will not see speculative bubbles in them the way we’ve seen bubbles happen on Wall Street. Why? Because big artificial boosts in the money supply are just not possible with bitcoin. Under the current Dollar regime, the Fed can pin interest rates to the floor, and this easy money can breed bubbles. Bitcoin doesn’t do that.

Try not to Think About Price so Much

It’s fun to see your balance in fiat grow by leaps and bounds overnight, but bitcoin is about something much more important. Bitcoin is about bringing some wonderful traits money used to have into the 21st century. Once upon a time the value of the currency was determined by the marketplace, not centrally managed by a government. Once upon a time the growth of the money supply happened at a predictable rate not set by a central planner. Instead, it happened commensurate with the time and effort spent making more of the currency and the uses it could be put to. Once upon a time, the money itself was not an instrument governments could use to impose shadow taxes on its people.

Bitcoin is about bringing those features back, in a form ready for the demands of a technologically sophisticated world. The price can zip up and down and do loop-de-loops every day for all I care, as long as the right features and infrastructure can keep developing and adoption grows.