What is the bitcoin bubble?

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Despite bitcoin being a new currency/asset, in a short amount of time we continue to reach new euphoric highs in its price. Its short history seems to repeat itself, the price rises exponentially and crashes. Is bitcoin a bubble? Opinions are very split, we take a look at some of Bitcoin’s price history as well as what defines a bubble.

Definition of a bubble

The definition of a bubble is broad used liberally. A bubble may also be known as a speculative bubble, economic bubble, asset bubble, financial bubble or even Tulipmania. It is when trade in an asset strongly exceeds its asset’s intrinsic value. Paul Krugman, a recipient of the Nobel memorial prize in economics says “Bubbles can also be when asset prices are based on implausible or inconsistent views about the future”.

Funnily enough, despite the fact that money makes the world go round, there is no clear definition of an economic bubble. By the broad definition outlined above, bitcoin struggles to be defined as a bubble. However, the bitcoin price movements have shown some particular bubble behaviour.

Bitcoin bubble or par for the course?

We don’t need beat around the bush, the price of bitcoin since its inception has been called a bubble time and time again. Let’s take a look at the historic highs and lows since Bitcoin was deemed to have any value.

Data gathered from Bitstamp exchange BTC/USD
Data gathered from Bitstamp exchange BTC/USD

The extreme volatility of in the bitcoin price has had people shouting bubble from the rooftops, particularly the economy experts employed by large corporate banks. There are many arguments and reasons for bitcoins volatility but what are the characteristics of bubble behaviour? How can you define a bubble? Is bitcoin a bubble?

Classic bubble behaviour vs a real bubble

Bubbles have shared many things in common. Parabolic growth, extreme sell offs, not reaching a consolidation price above the previous high. Bubbles can often leave a trail of financial destruction. For example, the tulipmania bubble caused a lot of financial ruin, or the Japanese stock market crash that has yet to recover from it’s highs of 1990 . Not every asset or stock that shows any kind of bubble behaviour is necessarily a bubble though.

Bitcoin doesn’t tick all the boxes. Parabolic growth has been reached several times with bitcoin, as you see in the chart above, growth has been exponential. To date, there have been 13 instances where bitcoin has lost at least 30% of its value. With high frequency a lot of growth has quickly proceeded it. This is one of many classic characteristics of a bubble. To be satisfied with calling bitcoin a bubble then we need to question its consolidation prices that follow the “crashes”. Out of the 13 times that bitcoin has dropped in price by more than 30%, it has consolidated above the previous low 11 times. Just twice the market didn’t consolidate a price. On the first occasion, Mt.Gox which handled almost all trade volume, suffered severe DDOS attacks. The second occasion, the same exchange, announced that it was insolvent. The effects of both were devastating in the short term.

The argument of calling anything that doesn’t strongly fit into historic bubble’ characteristics is going to be subjective. The bitcoin community is mostly in favour of it not being a bubble, with bankers strongly in favour of it being a bubble. Economic experts independent of these tend to be split. Unless blatantly obvious, the definition of a bubble is subjective.

Examples of historic asset bubbles

We can’t write this article without mentioning tulips, so that will be our starting point.

Tulipmania (The Netherlands, 1637)

The first recorded economic bubble. Mania was correct alright, many terms have been derived from this period. It is deemed to be a speculative bubble since prices grew extremely fast- far from their intrinsic value. A tulip bulb has a certain value, but when a craftsman has to work 10 years to buy a single bulb, we can all agree that we’ve gone mad. The term “Madness of the crowd” was conned by this period. People truly believed during this period that the demand for tulip bulbs would last forever. The problem being, the purpose of a tulip bulb could only be extended to its beauty and not much else. Nevertheless, exchanges across multiple Dutch towns and cities traded the bulbs and people were easily tempted by the proverbial dangling carrot.

Japanese asset price bubble (Japan, 1986-1991)

The Japanese asset price bubble is a very classic more modern bubble. The ingredients that created the storm made it a textbook bubble. Multiple factors included:

  • A reduction in interest to fuel spending in the economy
  • Reluctantly increasing interest rates to counter asset inflation
  • Aggressive inheritance tax fueling speculative prices in the housing market

The result was a shift from savings to assets in a short amount of time. Central banks are in a position to adjust the interest rates in order to encourage people to spend or save. The Japanese are traditionally great savers but the low interest rates encouraged spending. Once the shift from saving to investing in assets and accruing debt incurred, the bank of Japan failed to act.

To date, Japan’s Nikkei 225 stock market hasn’t recovered to it’s 1989 peak. Despite recovering well in the past 5 years, it has struggled to consolidate since the bubble.

 

A classic case of parabolic growth followed by the burst of the bubble.
A classic case of parabolic growth followed by the burst of the bubble.

 

Housing can often be seen as a strong and safe asset due to its tangibility. House prices continued to rise during this period. Interest rates were low which consequently encouraged a lot of borrowing and spending. However, once this was curbed to slow down economic activity, people were forced to default on their loans and sometimes lose their properties. It is estimated that in 2010, 20% of homes in the USA were underwater. This means, the amount owed on a property was more than the house is worth. The effect was devastating and it was felt across every corner of the globe.

 

Conclusion

Bitcoin has had some rough cycles through its short history but defining it as a bubble would be subjective. Some rough times of volatility have had some critics calling it a bubble from the start. A bubble means more than just volatility and an asset needs to be showing multiple characteristics to be deemed a bubble. There have been some textbook bubbles in the past, but bitcoin isn’t one of them.

 

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