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Almost 170 years before the invention of Bitcoin, journalist Charles Mackay underlined how whole communities can "fix their minds on an object and go crazy in its pursuit". Millions of people, he wrote, "become simultaneously struck by delirium and haunt him, until their attention is captured by a new madness more captivating than the first".
His book Extraordinary Popular Delusions and the Madness of Crowds, published in 1841, identifies a series of speculative bubbles, in which people buy and sell items at ever-higher prices, until suddenly they do not. The most well-known example citing is the tulip mania that gripped the Netherlands in the early seventeenth century. Tulip bulbs have risen in value to sell up to 25,000 florins each (close to $ 45,000 in today's money) before their price collapses.
The Bitcoin bubble overcomes this and all the other cases identified by Mackay. It is perhaps the most extreme bubble since the late nineteenth century. In four years its price has risen by almost 2,800%, reaching a peak of US $ 19,783 in December 2017. Since then it has decreased by 80%. A month ago it was trading at over $ 6,000; it has now fallen to US $ 3,500.
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This is however a fantastic gain for anyone who bought Bitcoin before May 2017, when it was worth less than US $ 2,000, or before May 2016, when it was worth less than $ 500.
But will it simply continue to fall? What makes Bitcoin something good?
To begin to answer this question, we need to understand what creates the values that drive price bubbles, and therefore what precipitates prices.
The graph above shows the size of the Bitcoin bubble compared to the price movement of Japanese property and the dot-com bubble from four years before the peak up to four years later.
When the values of resources diverge
We generally think of bubbles in financial assets such as stocks or bonds, but they can also occur with physical assets (such as properties) or raw materials (such as tulip bulbs).
A bubble begins when the price that people are willing to pay for something deviates significantly from its "intrinsic value".
The intrinsic value of an asset is theoretical, based on its "fundamental" value. The fundamental value includes: the ability to generate cash flows (for example, interest or rental income); scarcity or rarity (for example, gold or diamonds); and the potential use (for example, silver and platinum are used in both jewelry and industrial operations).
A home can have a fundamental value due to the scarcity of land, its use as a house or its ability to generate rental income. A tulip (or Bitcoin) does not have any of these things; even the presumed scarcity does not exist if we consider all the alternative flowers (or cryptocurrencies) available.
Jan Brueghel the Younger / Wikimedia Commons, CC BY
Prerequisites for the price bubble
A bubble tends to appear after a long period of economic growth, when investors get used to the price, an ever-increasing asset and credit is easily accessible.
To these conditions must be added something more so that a bubble is formed. This is generally a major upheaval or innovation, like the development of new technology. Think of the railways in the nineteenth century, electricity in the early twentieth century and the Internet at the end of the twentieth century.
Initially, most investors tend to be cautious and "rational" for a new technology. For example, early investments in railways have benefited from limited competition and have focused only on profitable routes. It was gradual and successful commercial.
This creates greater growth and profitability, leading to positive feedback (from increased investment, higher dividend payments and increased consumer spending), which further increases confidence.
If the conditions allow it, it develops in a period in which the economic historian Charles Kindleberger described as "euphoric": investors are fixated on the ability to make a profit by selling the good to a "bigger madman" at a price even more high.
Jeon Heon-Kyun / EPA
That is, they are attracted not to "fundamental" reasons – the benefits from potential cash flows such as dividends or rental income – but from "speculative" motivations – the pursuit of short-term capital gains.
Higher prices attract more speculators, pushing prices even higher. The uncertainty about the importance of the new technology makes it possible to rationalize the extreme evaluations, although the justifications seem weaker with the price increase.
The virtuous cycle of continuously rising prices continues, often fueled by credit, until there is an event that leads to a pause in price increases. Kindleberger suggests that this may be a change in government policy or an unexplained failure of a company.
When asset prices cease to rise, investors who have borrowed to finance their purchases realize that the cost of paying interest on their debt will not be offset by the capital gain to be realized by holding back the asset. So they cut their losses and start selling the good. Once the price starts to fall, more investors decide to sell.
The Bitcoin bubble
The observers of the cryptocurrency market will find this story familiar. Bitcoin emerged following one of the longest economic expansions in history, with easily accessible credit and global interest rates at the lowest levels in 5,000 years of civilization.
The price hike has attracted speculators in the Bitcoin market, aided by intense media attention. There are cases of individuals paying for Bitcoin using credit cards or mortgaging their homes again. The motivation for higher prices has become more fantastic, with claims that the price could rise to $ 100,000, despite the more sober warnings.
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Possible triggers of a break in Bitcoin's price increase included concerns about increased government regulation of crypto-assets and the possible introduction of central bank digital currencies, as well as on large asset theft and collapse. exchanges that have haunted the brief history of Bitcoin.
Walking down
In liquid markets such as shares (where it is inexpensive to buy and sell goods in large quantities) the price drop can be high. In illiquid markets, where assets can not easily be sold for cash, the fall can be brutal. Examples include mortgage-backed securities (MBS) and secured debt obligations (CDOs) that led to the global financial crisis.
Bitcoin is particularly illiquid. This is due to the fact that a large number of different Bitcoin exchanges compete; often considerable transaction costs and constraints on the ability of the Blockchain to record transactions.
Liu Xingzhe / Chinafile / EPA
Later
The consequences of an explosive bubble can be brutal. The collapse of the stock market of 1929 was a prelude to the Great Depression of the years & # 39; The collapse of Japanese asset values after 1989 announced a decade of low growth and deflation. The dot-com collapse of 2000-01 has destroyed $ 8 trillion in wealth.
The impact of an accident depends on the size, ownership and importance of the asset involved. The effect of the tulip crash was limited because the speculation on the tulips involved a relatively small number of people. But the sharp decline in property values in 2007 led to the worst financial crisis since the Great Depression.
Bitcoin is more like tulips. The entire market valuation was around $ 300 billion at the peak. To put this in context, US equity and real estate markets are currently valued at over $ 30 trillion each (the equivalent Australian markets are valued at $ 2 billion and $ 6.9 trillion respectively). Relatively few investors own the majority – it is estimated that 97% of all Bitcoins are owned by only 4% of users. This suggests that the effects on the broader economy of the Bitcoin crash should be contained.
Estimation of the intrinsic value of Bitcoin
The true value of cryptocurrencies is widely debated. Bitcoin entrepreneurs suggest that a much higher price is justified. Others, like Eugene Fama (a Nobel Prize winner) and Warren Buffett, believe it is almost useless. The Bank of International Settlements described it as "a combination of a bubble, a Ponzi scheme and an environmental disaster".
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What is the real value of a bitcoin?
Getting a realistic estimate of the intrinsic value of Bitcoin is difficult because it is not a resource that generates a periodic cash flow, such as interest or rental income.
For such a resource, value ultimately depends on what others are willing to pay for it. This often refers to scarcity.
This does not provide a positive story for Bitcoin. Although the total number of Bitcoins is limited, there are many competing, virtually indistinguishable cryptocurrencies (such as Ehtereum and Ripple).
Bitcoin also does not meet the criteria of a currency. Its price movements are too volatile to be a unit of account. The transaction capacity of the Blockchain is too limited to be a means of exchange. Nor does it seem to be a good value reserve.
Since it does not produce income, has a limited value of scarcity and few people are willing to use Bitcoin as currency, it is also possible that Bitcoin has no intrinsic value.
