ABSTRACT
Is Bitcoin really "a bubble wrapped in techno-mysticism inside a cocoon of libertarian ideology"? as put in by Paul Krugman. Let's decode…
Investing as an activity goes way back, probably a bit longer than one would imagine, but so does its pay-off. While the concept of investing is ancient, investing as we know it today only started in the 16th Century in Europe in The Amsterdam Stock Exchange, which is often regarded as the predecessor of modern investing. However, the need for a bank grew with the prevalence of European trade and with the need to offer financiers a way to profit in this trade. Although the Amsterdam Stock Exchange paved the way for modern stock exchanges, it was also responsible for facilitating the first financial bubble in history.
The Dutch tulip bulb market bubble was indeed one of the most famous market crashes of all time. It occurred in Holland during the early to mid-1600s when speculation drove the value of tulip bulbs to extremes. At the height of the market, the rarest tulip bulbs traded for as much as six times the average person's annual salary.
In this research article, we move on to decode the intricacies of the Dutch tulip bulb market bubble (the first financial bubble in history) and its parallelism with Bitcoin.
Is Bitcoin really "a bubble wrapped in techno-mysticism inside a cocoon of libertarian ideology"? as put in by Paul Krugman. Let's decode…
INTRODUCTION
Investing as an activity goes way back, probably a bit longer than one would imagine, but so does its pay-off. While the concept of investing is ancient, investing as we know it today only started in the 16th Century in Europe in The Amsterdam Stock Exchange, which is often regarded as the predecessor of modern investing. However, the need for a bank grew with the prevalence of European trade and with the need to offer financiers a way to profit in this trade. Although the Amsterdam Stock Exchange paved the way for modern stock exchanges, it was also responsible for facilitating the first financial bubble in history. Before we move on to decode the intricacies of The Dutch tulip bulb market bubble (the first financial bubble in history) and its parallelism with Bitcoin, we need to understand what a Financial Bubble really is.
By definition, a bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value or a contraction, which is sometimes referred to as a "crash" or a "bubble burst."
THE INFAMOUS DUTCH TULIP MANIA
The Dutch tulip bulb market bubble was indeed one of the most famous market crashes of all time. It occurred in Holland during the early to mid-1600s when speculation drove the value of tulip bulbs to extremes. At the height of the market, the rarest tulip bulbs traded for as much as six times the average person's annual salary.
Here goes the beginning of the end.
Tulips first arrived in Western Europe from native Turkey in the late 1500s. Due to their then-novelty and exotic nature, they were purchased as a status symbol, initially, by the wealthy and later, to emulate the wealthy by the middle-class.
The Dutch learned that tulips could grow from seeds or buds that grew on the mother bulb. A bulb that grew from seed would take seven to 12 years before flowering, but a bulb itself could flower the very next year. "Broken bulbs" were a type of tulip with a striped, multicolored pattern rather than a single solid colour that evolved from a mosaic virus strain. This variation was a catalyst causing a growing demand for rare, "broken bulb" tulips which is ultimately what led to the high market price. This phase one is what economists describe as 'Displacement' in any financial bubble, where an event or innovation occurs that sharply changes expectations, typically grounded in reality and good intentions.
In 1634, Tulip Mania swept through Holland. As described by Charles Mackay, "The rage among the Dutch to possess tulip bulbs was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade." A single bulb could be worth as much as 4,000 or even 5,500 florins - which if estimated in today's money means that the best of tulips cost upwards of $750,000.
By 1636, the demand for the tulip trade was so large that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Haarlem, and other towns. This is phase two, often described as 'Expansion'- where the narrative takes hold and people begin bidding up asset prices.
It was now during this time that professional traders joined in, and everybody appeared to be making money simply by possessing some of these rare bulbs. Indeed, it seemed at the time that the price could only go up; that "the passion for tulips would last forever." People began buying tulips with leverage-using margined derivatives contracts to buy more than they could afford. This marked phase three- 'Euphoria' where everyone assumed they could get rich easily and very quickly. During this phase, risk is taken and Euphoria makes people think the good times will last forever.
But as quickly as it began, confidence was dashed. By the end of the year 1637, prices began to fall and never looked back. A large part of this rapid decline was driven by the fact that people had purchased bulbs on credit, hoping to repay their loans when they sold their bulbs for a profit. But once prices started their decline, holders were forced to liquidate - to sell their bulbs at any price and to declare bankruptcy as a consequence. This led to the fourth phase- 'Crisis'. This is the phase where the insiders begin selling, and panic buying quickly shifts to panic selling, leading to phase five- 'Contagion' which explains that just as prices overshoot to the upside from euphoria, they often overshoot to the downside once the contagion of bad news spreads, and people think things will never get better again.
CAUSES AND AFTERMATH
Learning about the first financial bubbles inevitably makes us think about some of the other devastating financial bubbles in history like - The South Sea Bubble of 1720, Japan's Asset Price Bubble of the 1980s, the Dotcom bubble, and the 2008 U.S. Housing Bubble are all classic examples of such economic bubbles. So, what actually causes such devastating financial bubbles? The answer lies in the following 3 points-
1. Low-Interest Rates
Low interest rates make it easy for people to get cheap credit. This allows them to spend more. The greater spending power, in turn, results in prices rising due to increased demand for goods.
2. Demand-Pull Inflation
The greater demand for an asset leads to a price increase for the asset. However, the price rise is seen as an indicator of future increases in price. This leads to the formation of a speculative bubble.
3. Supply Shortage
The reduced supply or the expectation of a reduction in the supply of an asset in the future leads to increased demand for the asset. Investors think that there are only a limited number of assets available in the market, and they rush to buy as much as possible.
Now, coming to the fact that what actually happens when an Asset Bubble bursts?
Sometimes the effect can be small, causing losses to only a few. At other times, it can trigger a stock market crash, and a general economic recession, or even depression. Much depends on how big it is—whether it involves a relatively small or specialized asset class. And, of course, how much investment money is involved. Another factor is, to what degree debt is involved in inflating the bubble. But, whatever the cause may be one cannot deny the fact that asset price bubbles in recent history shoulder blame for some of the most devastating recessions, the reverse is equally true: the largest and most high-profile economic crises in the U.S. have been preceded by them. While the correlation between asset bubbles and recessions is irrefutable, economists debate the strength of the cause-and-effect relationship.
PARALLELISM WITH BITCOIN: The Mother of All Bubbles
As mentioned previously, there have been pretty big financial bubbles in history, so what makes Bitcoin- the mother of all financial bubbles?
Essentially, because the situation around Bitcoin has shown almost all characteristics of a financial bubble. Bitcoin was launched in 2009, it took two years for it to reach the price of $1. In February 2011, 10 years later in 2021, at one point it was worth just under $45,000. Hence, it has grown a staggering 45,000 times in 10 years, a CAGR of 191.16%. Even now, when Bitcoin has become somewhat mainstream, at least as a term if not as an investment, it continues to be volatile, it doubled investor wealth in 2020 but it also halved in the span of 30 days from mid-April to mid-May. These fluctuations have started to have impacts on conventional markets such as the stock markets. Bitcoin reached a market cap of over one trillion USD in May of 2021, which is more than the combined market cap of Visa and JPMorgan combined. Due to its sheer size and the amount of money tied up in this cryptocurrency, when the bubble bursts and Bitcoin hits near-zero, it will definitely be the 'mother of all financial bubbles.
So, let’s come back to a more basic question now.
What is Bitcoin?
Simply put, it’s a cryptocurrency, i.e. a digital currency.
Bitcoin is a digital currency created in January 2009 following the housing market crash. It offers the promise of lower transaction fees than traditional online payment mechanisms and is operated by a decentralized authority, unlike government-issued currencies. There are no physical bitcoins, only balances kept on a public ledger that everyone has transparent access to, that – along with all Bitcoin transactions – is verified by a massive amount of computing power. Balances of Bitcoin tokens are kept using public and private "keys", which are long strings of numbers and letters linked through the mathematical encryption algorithm that was used to create them.
Aside from the astronomical rise in value that bitcoin has had, there are plenty of things that point to it being a quintessential financial bubble. For starters, Bitcoin has been characterized as a speculative bubble by eight winners of the Nobel Memorial Prize in Economic Sciences: Paul Krugman, Robert J. Shiller, Joseph Stiglitz, Richard Thaler, James Heckman, Thomas Sargent, Angus Deaton, and Oliver Hart.
The views of economists including those mentioned above, if put together paint a picture that clearly explains why Bitcoin is indeed a bubble.
For example-
In 2014, Robert J. Shiller stated that bitcoin "exhibited many of the characteristics of a speculative bubble" and in 2017, he reiterated that bitcoin was the best current example of a speculative bubble.
Richard Thaler also emphasizes the irrationality in the bitcoin market that has led to the bubble, demonstrating the irrationality with the example of firms that have added the word blockchain to their names which have then had large increases in their stock price. The extremely high volatility in bitcoin's price also is due to irrationality, according to Thaler.
While these economists have spoken about a lot of problems with respect to Bitcoin and cryptocurrency, the main arguments for classifying it as a speculative bubble put forward by these economists are:
1. A Lack of Intrinsic Value
While fiat currencies have been in use for as long as one can remember, they do not have any intrinsic value either, they are backed by faith in the government. They work as a store of value only because they can be used to trade almost anywhere and anytime. Moreover, fluctuations in these currencies are effectively monitored by the governments to prevent excess volatility and protect people from undue losses. Bitcoin completely fails in this department. Only 15,174 businesses accept Bitcoin, as of December 2020, out of an estimated 582 million entrepreneurs that exist worldwide. Since it is not an effective medium of exchange, it also fails as a real store of value since it lacks real utility. Also, its volatility is another reason why it is not a reliable store of value. Hence, it is not a real asset and has no intrinsic value.
2. Susceptibility to Market Manipulation
Bitcoin has been artificially driven by tweets from Tesla CEO- Elon Musk. At first, Musk was all aboard the Bitcoin train. He purchased $1.5 billion Bitcoin for Tesla's balance sheet in February and announced that the company would begin accepting Bitcoin for electric vehicle purchases a month later. Then, after 49 days, he tweeted that Tesla would no longer accept Bitcoin because of the adverse environmental impacts of mining it. He's since turned his attention to Dogecoin. The fact that tweets with little or no substance are creating and erasing hundreds of billions of dollars in crypto market value would seem to indicate that a bubble has been brewing for some time. There have been many other cases where eminent personalities have caused major fluctuations in the Bitcoin market which proves how fickle this market is.
3. Price Being Driven by Momentum and Attention from the Regular-Joe
Two factors which are behind the soaring price of Bitcoin are momentum and the attention that people pay to it. Momentum means that if bitcoin went up more than usual it will on average continue to go up. Similarly, if there are more, for example, Google searches on the word bitcoin, bitcoin prices tend to go up. Hence, a lot of the Bitcoin gains are due to hype.
Another thing that points to Bitcoin being a bubble is that there are no readily identifiable real-world correlations.
For example, we know that gold and the U.S. dollar have an inverse relationship to one another. When the dollar is declining in value, gold is very likely rising in value. This is a correlation that's been established over a long period of time.
Bitcoin, Ethereum, and Dogecoin don't have these correlations. Enthusiasts like to point out how crypto is a hedge against inflation, but they forget that Bitcoin has both risen and fallen when the money supply expanded rapidly or slowly. Crypto is driven by emotion and technical analysis, primarily because it has no real-world correlations.
CONCLUSION
Due to its monumental returns and growing popularity, a lot of altcoins have also come into existence, institutional investors are also getting in on the action. This is reminiscent of the Tulip Bubble crisis, what starts as a fad or trend for a small group of the population soon becomes a tool for sophisticated investors to make money. While this brings a spurt in prices with it, it also marks the beginning of the end for most financial bubbles. There is very little contrast in the way that the Tulip Mania played out 400 years ago and the current Bitcoin situation. Both started insignificantly, only to become public frenzies very soon. And in the pursuit to make an easy profit, the Tulip Bulbs broke, which points to what is inevitably coming for Bitcoin. The bubble will eventually burst. However, the blockchain technology that Bitcoin is based on has monumental potential and has already been put to use in the financial world in many places. Thus, with the right regulation and an environment-friendly approach, some sort of digital currency can be a part of the future.
