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Bitcoin and Bubbles

March 1, 2018

Bitcoin has been on a wild ride, rocketing from $1,000 to nearly $20,000 last year. 

Bitcoin has been on a wild ride, rocketing from $1,000 to nearly $20,000 last year.  A recent slide to $7,300 brought claims that Bitcoin was a bubble.  What exactly is a financial bubble, and does Bitcoin have a future?

Most commonly described as a cryptocurrency, Bitcoin joins together several innovations.  It is first and foremost an electronic payment system, not unlike credit cards or mobile banking, using its own currency instead of dollars.  Accounts and transactions are recorded on the Blockchain, contained on all the network computers worldwide.  Instead of Visa or a bank keeping accounts, the Blockchain ledger is kept by everyone.  Bitcoin owners use an electronic key to carry out transactions.

The Blockchain represents a major innovation itself, but that’s a topic for another day.  There are now dozens of other cryptocurrencies.  Ethereum and Litecoin appreciated by a factor of 100 in 2017.

What determines the value of Bitcoin?  The market, meaning everyone willing to buy or sell Bitcoin.  Why would anyone trade real money for electronic numbers?

One reason is for purchases, as mentioned.  Bitcoin costs merchants less than the three percent credit cards charge and presents less risk of fraud as buyers cannot readily dispute charges for items they purchased.  And cryptocurrencies provide millions of people access global markets for the first time.

Some people now use Bitcoin to hold wealth, like gold.  For hundreds of years, gold has preserved wealth through wars, inflation, and financial crises.  Should banks fail again like in the 1930s, many people believe gold will be safe.  Increasingly people feel similarly about Bitcoin.

But gold is real, whereas Bitcoin is computer code.  Couldn’t the operators create millions of Bitcoins with a few keystrokes, rendering those bought for thousands of dollars worthless?  No, because the Blockchain governs the creation of new Bitcoin and caps the number at 21 million.  Only a majority of users can modify the Blockchain, limiting the supply, as with gold.

A third reason to buy Bitcoin is to make a profit.  The value of Bitcoin depends on how much people will pay for it.  People will pay $10,000 Bitcoin if they think price will hit $20,000, and $20,000 if it is going to $30,000!  In 2017, many investors boarded the Bitcoin train.

When lots of investors buy an asset, the price will rise, making a boom a self-fulfilling prophecy.  Prices can rise astronomically, but not forever; eventually investors can’t afford even higher prices.  Shattering the expectation of rising prices can set off an equally rapid price collapse.  An asset price bubble is like a roller coaster.

Bubbles challenge economists like myself who think that markets work well.  Why?  We argue that market prices must guide businesses, investors, and consumers.  If so, rising home prices before 2006 indicated a demand for more investment.  But if rising prices were just a bubble, we built unneeded houses.  Las Vegas’s newly built, never occupied houses and townhomes were wasted investments.

Frequent bubbles render market price signals as noisy as a third-grade class at recess.  Some free market economists try to deny bubbles, but Nobel Prize winning economist Vernon Smith, one of the most thoughtful market economists, believes differently.  Professor Smith pioneered the use of experimental methods to test economic theories.  He found that bubbles commonly occurred in financial assets experiments; indeed, he had to basically rig an experiment to prevent them.  Pricing assets like stocks, gold, and now cryptocurrency involves projecting the future, and excessive optimism contributes to bubbles.

Do bubbles prevent markets from working?  Market economies emerged about three hundred years ago, and over this period, standards of living have increased dramatically.  Economic history clearly demonstrates that markets, even when occasionally beset by bubbles, produce prosperity.  Markets limit the waste from bubbles because investors can sit out during a perceived bubble if they choose, or invest to profit when the bubble bursts.

Is Bitcoin a bubble?  Perhaps, but cryptocurrencies offer significant potential.  Bitcoin is creating value in the economy, and either it or some successor currency is likely to have a future.

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Daniel Sutter is Affiliated Senior Scholar at the Mercatus Center and Professor of Economics at the Manuel H. Johnson Center for Political Economy at Troy University.