If Bitcoin Is A Bubble…

Organizational Theorist Frederic Laloux’s Five Kinds of Human Organizations

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Bitcoin’s Equity Bubble and The Macroeconomy

As of this writing, bitcoin has a market cap of around $280 billion.  While that’s substantial, it’s relatively small compared to the biggest corporations, which are valued north of $500 billion each. It also pales in comparison to the $75-trillion global economy. If bitcoin’s price collapsed to zero tomorrow, economic impact would be negligible.  But what would happen if bitcoin rises another 1,000%, as it has thus far in 2017? If it achieves a $3 trillion market cap and then suffers a price collapse of, say, 80-90%, as it has twice thus far in its short history, what impact will it have on the economy then? Still probably fairly minimal. U.S. equities alone are valued at $25 trillion. If U.S. equities fall 10% and wipe out $3 trillion in value, that alone would not likely cause a recession.

Let’s pursue a truly extreme and hypothetical case to illustrate our point. What if the currency rises to $1,000,000 per bitcoin? It may sound farfetched but it wouldn’t be too surprising given what has already happened to bitcoin prices (Figure 2). That would give it a market cap of around $20 trillion, depending upon how many bitcoins exist by then. If it then collapsed, it could have a negative impact upon the finances of more recent buyers, many of whom might not be financially well off and many of whom would have purchased near the top. If one assumes a -5% wealth effect for drops in asset prices – a dubious but common assumption—then if bitcoin one day lost $20 trillion in market cap, it could shave $1 trillion of consumer spending globally. That would be enough to slow the global growth rate by over 1%.  Moreover, a crypto meltdown could also one day hit investment in computer hardware like during the collapse of technology stocks between 2000 and 2002 which led to a sharp decline in business investment and tripped the U.S. economy into a recession in 2001. A combined wealth and investment effect might drive the global economy into a recession and trigger a backlash against cryptocurrencies if they rally enough in the meantime to have such an impact. Obviously, this is an extreme hypothetical. For the moment, however, we’re not the point where this is a serious concern. And, as Aristotle once commented, ‘probable impossibilities are to be preferred to improbable possibilities.’

Investors who are buying bitcoin are presumably hoping to find someone else to sell the currency to at a higher price. That said, there is more to bitcoin economically than just the theory of the greater fool. As more people bid up the price, the difficulty of solving bitcoin’s cryptographic algorithms increases. This in turn is driving up investment in more powerful and faster computing technology of both a traditional integrated circuit and non-traditional variety. Indeed, solving cryptographic problems may be one of the first tests facing quantum computers.

The problem is that investors in bitcoin and its peers are mainly out to make profits and not to finance or subsidize the development of distributed ledgers nor more powerful computers. As such, if the price of crypto assets collapsed, investors may be sorely disappointed just as many were when the first generation of internet stocks collapsed between 2000 and 2002, driving the Nasdaq 100 index down over 80%.

One possible result of the current run up in cryptocurrencies and their possible collapse is that central banks may one day decide to issue their own distributed ledger currencies. Former Fed Chairman Alan Greenspan once compared making monetary policy to driving a car guided only by a cracked rearview mirror. Even now, important policy decisions must be based upon imperfectly estimated economic numbers that are weeks or months old by the time they become available. In 2017, economic policy making is still a vestige of the 20th century.

Blockchain technology has the potential to one day allow policy makers to issue their own cryptocurrencies that will give them real time information on inflation, nominal and real GDP. It won’t allow them to peer through the front windshield into the future but at least they can look into the rearview mirror with much greater clarity and see out the side windows of the monetary policy vehicle. This could allow them to create the amount of money and credit necessary to keep the economy growing at a smooth pace more easily than they do today. Switching off of the gold standard vastly reduced economic volatility and improved per capita economic growth (Figures 3 and 4).  Moving to blockchain-enhanced fiat currencies could further reduce economic volatility and, ironically, enable further leveraging of the already highly indebted global economy as people find ways to use capital more efficiently. More broadly, crypto-inspired investments could bring about new technologies that we cannot yet imagine.

Whether bitcoin “equity” investors are rewarded for bringing about such “improvements” is another matter. A few investors in the early days of the internet during the 1990s came away enormously wealthy. Many others lost money. The current cryptocurrency boom could end in a similar fashion.

Bitcoin Supply and Demand

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If Bitcoin Is a Bubble

The truth is that most of the assets that trade on exchanges have been in ‘bubbles’ at one time or another for reasons that have nothing to do with the existence of futures contracts. ‘Bubbles’ by the way are only visible in rear-view mirrors.

Silver experienced a bubble in 1980 when the Hunt brothers cornered the physical spot market. The price soared from $4 per ounce to around $50 and then collapsed. The futures market performed just fine during this period and fulfilled its function of allowing silver users to hedge risk from the price volatility.

The same can be said of subsequent bubbles, including those in the equity market in 1987 and the Nasdaq in 2000. As the housing bubble popped, beginning in 2007, the banking system suffered severe stress but futures markets functioned with neither interruptions nor bailouts. Daily margining helped to prevent the kinds of overleverage that plagued the banking sector.

Many commodity prices also experienced bubbles during the past decade and saw their prices collapse.  Crude oil fell from $147 per barrel in the summer of 2008 to as low as $36 per barrel by early 2009.  Natural gas prices dropped from $13 per MMBtu in 2007 to as low as $2 per MMBtu by early 2015 while exhibiting bitcoin-like volatility. Metals prices also collapsed between 2011 and 2016 after huge run-ups during the previous decade. In every case, futures markets functioned well.

GDP Growth Per Capita Improved Under the Fiat Currency Standard

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Does Bitcoin Have Inherent Value?

There are those who argue that bitcoin has no inherent value and is merely a speculative vehicle. With respect to inherent value, we largely agree. Bitcoin has no inherent value. Neither do the U.S., Australian, Canadian or New Zealand dollars, the euro, the yen, the pound, the Swiss Franc or any other government-issued currency. Yet large user networks trade in these currencies in great quantity every day and agree that they do have value in the present moment. Moreover, futures contracts have existed on these fiat currencies for four decades. If fiat currencies have no inherent worth then neither do government bonds. Both are forms of debt whose value derives from taxing authorities and whose value can be eroded by inflation.

Gold also has little inherent worth. It barely figures into industrial processes. Most gold is hidden away in vaults and that which is not is largely worn as jewelry – pretty but not economically functional, unless conspicuous consumption really does create value. A small amount of gold winds up in people’s teeth.  The fact that gold is prized is a function of both its scarcity and a large user network that accepts that it has value. Bitcoin is no different, only more recent. And, while it can’t be worn as bling-bling, it can be exchanged for hard currency, which is accepted in jewelry stores worldwide.

Only industrial metals, agricultural goods and energy products can be said to really have any inherent worth. Yet despite the critical importance of these goods, prices are not sky-high because supplies are, for the moment, abundant.