Bitcoin just another block in the long chain of economic bubbles

19 June 2018 Authored by Consulting.ca

Asset bubbles have been bursting since the Golden Age of the Netherlands in the 1600s, and as recently as the Bitcoin crash of this year. In a report from consultancy Capco, the firm examines asset price crashes in history to find common themes and help explain what happened to Bitcoin.

Created by ‘Satoshi Nakamoto’ – an as yet unknown person or group of people – Bitcoin was the first cryptocurrency created, as well as the first commercial use of blockchain. Blockchain is a sort of ‘digital ledger’ distributed across a network, wherein data has no central location and cannot be copied.

Created in 2008, the cryptocurrency reached its peak in December of 2017, with each bitcoin being worth US$17,900. The bubble, however, burst soon afterward, with Bitcoin declining to a value of US$6,200 by February of 2018. Bitcoin is currently worth US$6,428.

Cryptocurrency advocates are trumpeting that bitcoin will rebound this year, reaching beyond US$20,000 due to increasing rates of global adoption. Critics like Bill Gates and former PayPal CEO Bill Harris are more sceptical. Gates said that he would short the stock if there was an easy way to do it, while Harris called bitcoin the ‘greatest scam in history,’ claiming it has no intrinsic value.Cryptocurrency price increases, 2017In 2017, Bitcoin prices increased 1,318%, with other cryptocurrencies typically seeing 10x price increases. Starting at about $800 at the beginning of 2017, bitcoin reached close to $18,000 per unit – driven up to a frothy peak by irrational investor excitement and their ‘fear of missing out.’ Cryptocurrency Ripple, on the other hand, increased in value by a spectacular 36,018%.

Many analysts argue that the cryptocurrency bubble is one of the biggest asset bubbles in history. Bitcoin’s 65% slump from its peak price coincided with a major slump in the majority of other cryptocurrency prices. In a recent report from management consultancy Capco, the firm compares the cryptocurrency bubble to other historical asset bubbles to highlight common attributes and identify cogent insights.

According to Capco’s report, asset bubbles are commonly driven by irrational investor behaviour, fraud, and the inability of investors to accurately peg the value of the underlying asset. In the case of huge technological advances – like the 1840s Railway Bubble and the Dotcom Bubble, and indeed Bitcoin – investors went hog-wild over little-understood innovations that promise to ‘change the world.’ Likewise, the innovation of new financial derivatives products helped overheat the US housing market and caused the financial crisis of 2008.

With the Dotcom Bubble, by 2004, less than half of the tech companies that were around ten years earlier remained. The bubble burst because it became obvious that companies weren’t making any money; many were simply adding ‘.com’ to their names and seeing their stock rise as a result. Many IPOs made dishonest profitability claims, while investors exhibited a strong ‘fear of missing out.’Historical Asset BubblesIn the 1840s British Railway Bubble, investors were caught up in railway mania and the allure of the revolutionary tech advancement, while also being seduced by promotional deals making dishonest claims. After a decade, the bubble burst in 1846, tanking railways stocks and bankrupting the majority of railway firms.

The 2008 sub-prime mortgage crisis was driven by innovative credit derivatives that allowed risky sub-prime borrowers to get mortgages, further heating up the real estate market in the US. House prices nearly doubled between 2002-2006, and it all came crashing down in 2008, leading to the largest recession since the Great Depression. As with Bitcoin, investors found it difficult to value the underlying asset – the derivatives products.

Other Big Bubbles

One of the most famous, and possibly the first example of an asset bubble, is that of ‘Tulip Mania’ in 1600s Netherlands. Tulip bulb prices shot up 20-fold and then collapsed 100% within a year when futures on tulip bulbs were introduced. The Dutch economy was unaffected by the crash in prices, which would also likely be the case if Bitcoin were to collapse completely – with the effect likely being equivalent to about a 1% fall in the stock market.

The Japanese stock market and real estate bubble collapsed in the early 1990s after overheated growth in the 1980s. At one point, the Palace grounds in Tokyo had a greater value than all the real estate in California. This sort of inflated measurement had no bearing on the underlying value of the asset, driven instead by irrational confidence that prices would continue to go up. Americans were worried in the 1980s that Japan would overtake them as the dominant economy, on the back of decades of spectacular economic growth and high-tech industrialization. Instead, the bubble burst and Japan went through its lost decade of stagnation and deflation (‘stagflation’).

Common traits

According to Capco’s report, bubbles often include a number of common traits. In the case of new technology, bubbles are driven by irrational investor behaviour as they try to get in on the latest thing which promises to ‘change the world.’ However, despite investors throwing huge amount of money at the breaking innovation, mass tech innovation generally takes many years to mature. With the Dotcom Bubble, it took 15 years to achieve mass internet adoption after the crash.

With tech bubbles, price tends to jump much higher than the underlying value, which is difficult to measure. In the case of the financial crisis of 2008, the underlying asset was hart-to-valuate delinquent mortgage, while in the case of Bitcoin the underlying asset is blockchain technology.

Investors also tend to get worked up new technology they don’t necessarily understand, buying into the perceived future benefits of largely unproven technology. Irrationality and a herd mentality are clearly a factor in this.

The report also relates that fraudulent activity and dishonest are nearly always a part of bubbles. The Dotcom Bubble involved IPO fraud and dishonest claims of profitability, while the 1840s Railway Bubble involved dishonest promotional claims. Now, in relation to the cryptocurrency bubble, research suggests that 80% of Initial Coin Offerings (ICOs) may be scams.

Finally, many crashes follow soon after the introduction of futures contracts. The price of tulips crashed after the creation of a futures market for bulbs, while the Bitcoin price saw its decline after the CME and CBOE futures exchanges introduced Bitcoin futures.

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