It looks like bitcoin is taking investors through all of the stages of a classic bubble: euphoria, denial, fear, and desperation. When bitcoin fell under $7,000 and the market capitalization of the whole sector halved, the funeral preparations by nay-sayers were already underway.
The fact that bitcoin has already survived five such bubbles doesn’t seem to deter them.
Bubble Dynamics
Prior to the 20th century, bubbles were few and far between. The Dutch tulip mania in the 1630s, the British South Sea Bubble of the 1710s, and the French Mississippi Bubble of the 1710s are the most commonly cited examples of early bubbles.In recent times, the term “bubble” has been applied to collapses of several financial asset classes, including the 1930s stock market crash, the 1980s Japanese real estate market deflation, the 1990s Asian financial market collapse, the late ‘90s dot-com bubble, and the 2000s housing crisis.
Increasingly treating bitcoin as a synonym for tulip mania, financial leaders are questioning the cryptocurrency’s long-term sustainability. The CEO of JPMorgan Chase, Jamie Dimon, called bitcoin a fraud when it reached $4,000 in September last year.
Recently, Krugman claimed that bitcoin is a larger bubble than the 2008 housing crisis. And according to mainstream pundits, the 70,000 percent increase in bitcoin’s value over the past five years is unwarranted.
Bitcoin as Money
Bitcoin’s original purpose was to be a medium of exchange independent of government. However, critics claim that a new monetary system cannot be created out of thin air by a few cryptographers in Japan or wherever they originally came from.There are two main arguments: First, bitcoin does not have any use case outside of being a medium of exchange, and second, bitcoin is not a tangible commodity.
The proponents of the first argument claim that fiat currencies like the U.S. dollar and the euro have value because the government backs them and because you can pay your taxes in them. Similarly, gold has value because it can be used in industrial applications. Following this logic, bitcoin has no value because it cannot be used to pay taxes in most jurisdictions and it has no physical applications.
The second argument stems from Austrian economics and Ludwig von Mises’s regression theorem. This theorem states that the purchasing power of fiat today can be traced back to the purchasing power of fiat yesterday, which can eventually be traced back to when fiat was convertible to gold and other commodities.
The theory holds that the purchasing power of money can be regressed to a time when money was not used as money but as a commodity. Gold’s original purchasing power was established on the free market through the forces of supply and demand because gold could be directly used as jewelry.
Is It Electronic Cash?
But bitcoin’s original purpose was to be an electronic cash system. Critics claim that bitcoin is too volatile to be a store of value or a unit of account, and therefore, bitcoin is a bubble.According to this statistic, bitcoin is a significantly riskier asset than gold or the S&P 500. Bitcoin has a 30 percent correction every quarter, while the S&P 500 has had 12 corrections of 30 percent or higher since its inception in 1929.
The main point is that bitcoin’s volatility makes it poor money, and if it is poor money, then why does it have value?
In 2017, more than 470 new cryptocurrencies were launched. According to this argument, the supply for cryptocurrencies is larger than the demand. And since the demand is finite, and the supply is theoretically infinite, the bubble will eventually collapse and investors will lose billions.
Bitcoin has only been around since 2009, and the technology has evolved from being a free and fast payment system to an expensive and slow payment system. Critics of bitcoin claim that if it does not implode because of other factors, bitcoin will be replaced by a cryptocurrency with superior technological features. Specifically, bitcoin will be replaced by a cryptocurrency that does not require billions of dollars in electricity and mining hardware per year.
Independence
But low-interest policy and demand for a secure way to save are fueling part of bitcoin’s rise in price. If central banks stop debasing the purchasing power of fiat currencies and people can return to the good old days of saving cash in their bank accounts, a large portion of bitcoin’s appeal will vanish.In contrast, bitcoin’s price will go much higher if fiat currencies continue to be a poor vehicle for saving. The No. 1 reason bitcoin may not be a bubble stems from bitcoin’s technological qualities that make it a superior way of saving value. The upward price trend and speculation around bitcoin stems from bitcoin’s potential to be a global and permissionless system of managing wealth that cannot be confiscated.
This is why the five arguments analysts use when calling bitcoin a bubble can be countered: First, it is true that bitcoin’s price fluctuates heavily; however, this does not mean that bitcoin is not a good investment. To avoid buying at all-time highs, several investors invest a small amount of money in cryptocurrencies every month to gain exposure at an average price. This strategy is commonly referred to as cost averaging. Highly volatile assets have the advantage, in that a small position of a portfolio has a reasonable impact on the overall performance. If this is sized correctly, investors may be able to handle the volatility much better.
Each individual values bitcoin for a different reason. If we consider the market price of bitcoin to be a surrogate of information concerning the individual preferences of consumers in society, then the cost of $10,000 per bitcoin means that a lot of people around the world value bitcoin even though it is not a physical commodity. And even Mises’s regression theorem kicks in, as bitcoin was valued by geeks and programmers as a permissionless payment system before it had any dollar value attached to it.
The third argument, that bitcoin is the most volatile asset class, also is not evidence that investors should avoid bitcoin. Many investors specifically target volatile asset classes with active trading strategies.
Fourth, any analyst or economist who says the supply of cryptocurrencies is infinite does not fully understand the technology. Creating cryptocurrencies by copying and pasting code is free and can be used to increase the supply of cryptocurrencies. However, creating a new cryptocurrency does not mean it will have a network of users. Creating a network of users requires resources that are scarce, such as capital and labor. Although the supply of cryptocurrencies is technically unlimited, the supply of functioning global cryptocurrency networks is limited.
The final point regarding bitcoin being replaced by a better technology is probably the strongest argument against bitcoin.
However, there are a few solutions for bitcoin’s scaling problem in the works, and until this day, bitcoin remains the most decentralized and independent network—a true competitive advantage.
