The Bitcoin Bubble

The price of Bitcoin has reached and passed $11,000, from $800 just one year ago (Figure 1). The Economist’s Buttonwood’s notebook thinks that while the stock market has been trading at high valuations for some time, there is nothing like the excitement about shares that there was during the dotcom bubble of 1999-2000. That excitement has shifted to the world of cryptocurrencies like Bitcoin and Ethereum. There are three strands to their appeal: the limited nature of supply; fears about the long-term value of fiat currencies in an era of quantitative easing; and the allure of anonymity. These three factors explain why there is some demand for Bitcoin – but not the recent surge. A possible explanation is the belief that blockchain, the technology  that underlines Bitcoin, will be used across the finance industry. But you can create blockchains without having anything to do with Bitcoin; the success of the two aren't inextricably linked. A much more plausible reason for the demand for Bitcoin is that the price is going up rapidly.

Figure 1

Source: The Economist

Bloomberg has a piece on what could pop the bitcoin bubble. First, divides among developers as to how to proceed with upgrades to bitcoin’s network have led to "forks," in which different versions of the currency are spun off from the original. Excessive fragmentation could prove a bug for bitcoin, just as it did for the US financial system during the free banking era. Second, the spectre of a complete crackdown on cryptocurrencies remains an ever-present tail risk, in light of bitcoin’s chequered history as the means to purchase illicit materials, a vehicle for capital flight, and a victim of theft. Third, the asset could fall into the hands of hackers – as happened in 2011. But a $31 million hack of alternative currency ‘tether’ earlier this month was only a speed bump for bitcoin. Fourth, the introduction of futures could lead more investors to enter into positions that put downwards pressure on prices. Fifth, the failure of major cryptocurrency exchanges to handle traffic on the day bitcoin breached $10,000 throws into sharp focus the scalability problems that cryptocurrencies face as speculative vehicles. Lastly, it’s been a puzzle to explain why bitcoin has gone parabolic. Why would we expect the way down to be any different?

Economists have been weighing in on the debate, sometimes proposing extreme solutions. Robert Shiller in an interview with Quartz argues that bitcoin is currently the best example of irrational exuberance or speculative bubbles, made especially powerful by the idea that governments can’t stop it or regulate it, which fits in with the angst of this time in history. Joseph Stiglitz said in a recent interview with Bloomberg that bitcoin is “successful only because of its potential for circumvention, lack of oversight” and that it “ought to be outlawed” because “it doesn’t serve any socially useful function”.

Jean Tirole writes in the FT that there are many reasons to be cautious about bitcoin; investors must be protected and regulated banks, insurance companies and pension funds should be prevented from building exposures to these instruments. Tirole argues that bitcoin is a pure bubble, an asset without intrinsic value – thus unsustainable if trust vanishes. Bitcoin’s social value is also elusive: unlike traditional issuance, it does not produce seigniorage but mining pools compete to obtain bitcoins by investing in computing power and spending on electricity. Bitcoin may be a libertarian dream, but it is a real headache for anyone who views public policy as a necessary complement to market economies. It is still too often used for tax evasion or money laundering, and it presents problems in terms of the ability of central banks to run countercyclical policies. Technological advances can improve the efficiency of financial transactions, but should not lead us to abstract from economic fundamentals.

Kenneth Rogoff’s “best guess” is that in the long run the technology will thrive, but that the price of bitcoin will collapse. What happens from here will depend a lot on how governments react and on how successfully bitcoin’s numerous “alt-coin” competitors can penetrate the market. In principle, it is easy to clone or improve on bitcoin’s technology, but not to duplicate bitcoin’s established lead in credibility and the large ecosystem of applications that have built up around it. For now, the regulatory environment remains a free-for-all, but if bitcoin were to be stripped of its near-anonymity, it would be hard to justify its current price. Perhaps bitcoin speculators are betting that there will always be a consortium of rogue states allowing anonymous bitcoin usage, or even state actors such as North Korea that will exploit it. It is also hard to see what would stop central banks from creating their own digital currencies and using regulation to tilt the playing field until they win. The long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates.

Tyler Cowen used to think Bitcoin was a bubble, but no longer holds this view. He argues we should think of Bitcoin as competing for some of the asset space held by gold and also to some extent art. Gold, too, in its hedging functions is a “bubble”, though not a bubble. It is hard to ship, but has some extra value because it is perceived as a focal asset and one that does not covary positively in a simple way with the market portfolio. The same is true of Bitcoin, yet that kind of focality-based “bubbliness” can persist for centuries. Gold has become less of a hedge, partly because inflation has been low and partly because China and India dominated the gold market more than a few decades ago. So new and better hedges are needed. And Bitcoin is a strong competitor in this regard.

John Cochrane thinks that what's going on with Bitcoin seems like a perfectly "normal" phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand – no annual reports on how much the Russian mafia wants to move offshore next week – that's plausible too.

Izabella Kaminska has a long piece in FT Alphaville explaining why Bitcoin futures and a shoddy market structure pose problems. She also writes in the FT that true investing is not the same as gambling, and in the face of the cryptocurrency fad, regulators need to underscore this distinction. For decades, regulators across the world have wrestled with the question of how best to mitigate the negative effects of gambling. For the longest time, licensed gambling zones confined to specific geographic areas seemed the optimal solution. The internet has changed all that. Geographic constraints have become meaningless, while innovation – such as the invention of cryptocurrency – has started to compromise the efficacy of bans. Even if cryptocurrency trading were to be banned, the chances are that as long as some jurisdictions continued permitting it, digitally-enabled backdoor channels would be created to keep servicing clientele in restricted areas. That leaves only one option for regulators today. Gambling activities must be stigmatised rather than promoted.