Despite the protest of Bitcoin investors, Bitcoin appears to be experiencing a classic asset bubble. On December 18th, the digital currency lost almost 50% of its value overnight when China’s largest Bitcoin exchange announced it would no longer accept new deposits. Bitcoin’s price plummeted from $1,100+ in late November to $558 by the 18th. The China development was not unpredictable – China’s central bank had announced earlier this December that Bitcoins were not legally protected and could not be used by financial institutions because they have no intrinsic value.
Comparing Bitcoin to other historical asset bubbles gives an idea of how inflated Bitcoin’s price is. From January 2013 to April 2013, the price of Bitcoin increased 1,789% in three months. For comparison, according to the Case-Schiller Housing Index, home prices in the 2000’s housing bubble increased about 90% in six years.
With the housing crisis, there were at least plausible arguments about why a bubble in construction seemed unlikely. Homes do have great intrinsic value. A nationwide property bubble seemed like a long shot considering the variegated and localized nature of the real estate market. These rationales were, of course, wrong. But at least they existed. Bitcoin as a system so lacks any intrinsic value that economist John Quiggin has called it “perhaps the finest example of a pure bubble.” Even in the infamous Dutch tulipomania there was a smidgeon of intrinsic value – the lowly tulip bulb.
Beyond demonstrating that Bitcoin is in a bubble, the December 18 episode also disproves Bitcoin’s conceptual validity. Economist Hyman Minsky isolated five broad phases that generally present themselves in all asset bubbles, and Bitcoin has predictably shown at least three: displacement, boom, and euphoria. The first, “displacement,” occurs when “investors get enamored by a new paradigm.” The new paradigm for Bitcoin, according to a famous position paper by its creator “Satoshi Nakamoto” (a pseudonym) was “decentralization” and “crypto proof.” By mathematic proofs, Bitcoin might avert the traditional ravages of central banking: “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.” According to Nakamoto, this new paradigm of mathematical proofs securing a currency could prevent the “bubbles” of central banks he so distrusted.
But if Bitcoin’s value is not supposed to be contingent on the acts of these ‘corrupt’ central bankers, the experiment has clearly failed. China’s central bank, by announcing the Bitcoin freeze, began the process of pricking the euphoria bubble, resulting in a 50% price decline. While some investors have ridden up through the first three phases of displacement, boom, and euphoria, others have surely lost their savings riding the roller coaster. The China incident has demonstrated that Bitcoin has elements of a pyramid scheme whose success depends on continuously attracting new investors to boost price. Rather than the purportedly ‘crypto-secure’ and new asset class, Bitcoin’s price fluctuations have devolved into classic speculation.
Whether it is now a good investment is another question. The bubble could theoretically reinflate and deflate several more times, each time minting new princes and paupers. But this does not mean Bitcoin, based on its supposed mathematics, is qualitatively different than any other bet like gold or stocks, and its supporters should stop masquerading it as such.
December 18 should also serve as a clarion call to libertarians pumping money into Bitcoin. A third party currency claiming to be independent of government inflation and corruption is rightly attractive to those suspicious of traditional banking authorities. But Bitcoin is not free from the constraints of economic law. Libertarians like other investors should feel free to ride the Bitcoin roller coaster like any other bubble and get while the getting’s good. Binge too long, though, and it could get messy.
[Image Credit: http://media.salon.com/2013/04/bitcoins2.jpg]
