On October 19, Edward Chancellor debuted as the first guest writer of this blog. His most recent commentary on the Bitcoin phenomenon, originally appearing on Breakingviews, is a timely expose on modern bubbles:
Bubbles aren’t just about the madness of crowds, nor are they simply manifestations of excess liquidity and leverage—even though both of these factors are present in the extraordinary rise of bitcoin over recent months. Every spectacular bubble involves a premonition of the future. The trouble is that they turn out to be deeply flawed premonitions. In this respect, the current excitement about crypto-currencies has much in common with great historic speculative manias.
The head of New Zealand’s central bank, Grant Spencer, is correct to say that bitcoin resembles a “classic” bubble. First, there’s the telltale super-exponential price explosion. The South Sea Company stock soared 10-fold in 1720. Today’s red-hot cryptocurrency is up more than twice that amount over the last twelve months. Bubble assets also exhibit tremendous volatility during their so-called ‘blow off’ stage. Bitcoin’s recent price oscillations suggest as much.
Great bubbles attract speculators from far and wide. At the high point of France’s Mississippi Bubble, also of 1720, up to half a million foreigners are said to have flocked to Paris. In the internet age, bitcoin leaves John Law’s scheme far behind. Coinbase, which provides bitcoin wallets, now boasts some 12 million accounts – a threefold increase in a year. While the Mississippi fraud minted the first paper “millionaires,” bitcoin appears to be producing digital billionaires – including reportedly the Winklevoss twins of Facebook notoriety.
Every great bubble produces great anecdotes. Charles Mackay’s account of the early bubbles in “Extraordinary Popular Delusions and the Madness of Crowds” is stuffed with such urban myths. CNBC recently reported that a young Dutch family had sold its house, cars, and other possessions, and moved to a campsite. The father intended to feed his children with the profits from trading crypto-currencies. The computer programmer who used bitcoins to buy pizzas back in May 2010 shelled out more than $150 million at current prices for his lunch.
George Soros argues that a “super-bubble” only forms after it has survived a severe test, imbuing speculators with a sense of invincibility. Bitcoin has weathered a number of such trials. After peaking at close to $1,000 in late 2013, it shed more than 75 percent of its value over the following 18 months, before starting its more recent, epic ascent. Bitcoin has also survived a number of outright scandals, including grand larceny at the Mount Gox exchange when billions of dollars worth of bitcoins (at current value, anyway) vanished into the ether.
All great bubbles occur during periods of easy money when interest rates are low or falling and liquidity is super-abundant. The Dutch tulip mania, for instance, appeared in the mid-1630s at a time of massive capital inflows, falling interest rates, and massive money printing by Amsterdam’s Wisselbank, Europe’s first central bank. Sound familiar? At the beginning of 2017, the world’s largest central banks were expanding their balance sheets like never before. Some $11 trillion worth of bonds worldwide currently offer negative yields. The American stock market is more expensive than at any time save for the dot-com peak in early 2000. This leaves savers with an uncomfortable dilemma: speculate or starve.
The supreme object of speculation is one which generates no yield and is therefore impossible to value. Think of those tulip bulbs, or gold in the late 1970s, or contemporary art in recent years. Bitcoin, which produces no income, has a restricted new supply, and whose ownership is concentrated in relatively few hands (some 95 percent of outstanding coins are held in just 4 percent of accounts), providing a very small free float, is the most perfect speculative asset ever devised. Throw in some leverage, open a futures market, and there’s no limit to bitcoin’s potential upside.
The word speculator derives from the Latin word for a ‘lookout.’ The financial variety looks out into the future and backs this vision with money. Great bubbles are often uncannily accurate premonitions of the future. The seventeenth-century mania for tulips anticipated the development of the country’s flower industry, now one of Holland’s largest exports. Britain’s railway mania of the 1840s reflected an enthusiasm for the commercial and cultural potential of this new transportation technology. Likewise, speculators in the dotcom bubble foresaw how the internet would profoundly change our lives.
Law’s Mississippi Bubble appears most relevant to what is going on today in crypto-currencies. Law believed that money needn’t be backed by any commodity. He established a bank, the Banque Générale, which issued a paper currency and demonetized gold. Law used the newly issued bank notes to support the share price of his Mississippi Company and reduce the rate of interest – in other words, he provided the world’s first quantitative easing experiment.
Law’s vision was prescient. We now live in his world of paper credit and central bank money. However, it was also deeply flawed. Law tried to achieve, in the space of a few years, what would eventually take two and a half centuries to accomplish. Only in 1971was the link between currencies and gold finally severed with the collapse of the Bretton Woods currency accord. Confidence in what Law called his “system” soon collapsed and the Mississippi’s share price fell by 90 percent. Law, who in his heyday boasted of being the world’s richest man, died in penury in Venice. Speculators in tulip bulbs and in all the other great manias have also learned that in investment to be early is to be wrong.
This brings us back to crypto-currencies. They aim to cure today’s monetary problems—a lack of confidence in paper credit and central bank money—with a new technology, the “distributed ledger” or blockchain. Bitcoin believers call this revolutionary—it will “change the world.” Perhaps they will be proved correct – in the very long run.
But if that time comes, bitcoin won’t be a contender. Its technology is simply too inefficient. Transactions on the network are too expensive, massively energy intensive and can take days to settle. Reports suggest the verification process has become centralized in the hands of an unregulated cartel of Chinese ‘miners.’ Amazon won’t take payment in bitcoin. The U.S. government won’t accept bitcoin for the payment of taxes. Bitcoin for practical purposes is going nowhere, except in the markets where it’s been heading vertically upwards.
Super-parabolic price movements often contain their own premonition, namely that the end is nigh for the mania. When the tulip boom ended, the price of Gouda bulbs fell from 60 guilders to 10 cents, a price decline of 99.9 percent. Given that bitcoin has soared higher than humble tulips and has even less intrinsic value, a decline of similar magnitude is not out of the question.