Blog Post

The Bitcoin Bubble

The price of bitcoin has just passed $11,000. A year ago it was worth less than $800. Economists and commentators are thus increasingly concerned that this may be a bubble waiting to burst. We review recent opinions on the topic.

By: Date: December 4, 2017 Topic: Finance & Financial Regulation

The price of Bitcoin has reached and passed $11,000, from $800 just one year ago (Figure 1). The Economist’s Buttonwood’s notebook thinks that while the stock market has been trading at high valuations for some time, there is nothing like the excitement about shares that there was during the dotcom bubble of 1999-2000. That excitement has shifted to the world of cryptocurrencies like Bitcoin and Ethereum. There are three strands to their appeal: the limited nature of supply; fears about the long-term value of fiat currencies in an era of quantitative easing; and the allure of anonymity. These three factors explain why there is some demand for Bitcoin – but not the recent surge. A possible explanation is the belief that blockchain, the technology  that underlines Bitcoin, will be used across the finance industry. But you can create blockchains without having anything to do with Bitcoin; the success of the two aren’t inextricably linked. A much more plausible reason for the demand for Bitcoin is that the price is going up rapidly.

Figure 1

Source: The Economist

Bloomberg has a piece on what could pop the bitcoin bubble. First, divides among developers as to how to proceed with upgrades to bitcoin’s network have led to “forks,” in which different versions of the currency are spun off from the original. Excessive fragmentation could prove a bug for bitcoin, just as it did for the US financial system during the free banking era. Second, the spectre of a complete crackdown on cryptocurrencies remains an ever-present tail risk, in light of bitcoin’s chequered history as the means to purchase illicit materials, a vehicle for capital flight, and a victim of theft. Third, the asset could fall into the hands of hackers – as happened in 2011. But a $31 million hack of alternative currency ‘tether’ earlier this month was only a speed bump for bitcoin. Fourth, the introduction of futures could lead more investors to enter into positions that put downwards pressure on prices. Fifth, the failure of major cryptocurrency exchanges to handle traffic on the day bitcoin breached $10,000 throws into sharp focus the scalability problems that cryptocurrencies face as speculative vehicles. Lastly, it’s been a puzzle to explain why bitcoin has gone parabolic. Why would we expect the way down to be any different?

Economists have been weighing in on the debate, sometimes proposing extreme solutions. Robert Shiller in an interview with Quartz argues that bitcoin is currently the best example of irrational exuberance or speculative bubbles, made especially powerful by the idea that governments can’t stop it or regulate it, which fits in with the angst of this time in history. Joseph Stiglitz said in a recent interview with Bloomberg that bitcoin is “successful only because of its potential for circumvention, lack of oversight” and that it “ought to be outlawed” because “it doesn’t serve any socially useful function”.

Jean Tirole writes in the FT that there are many reasons to be cautious about bitcoin; investors must be protected and regulated banks, insurance companies and pension funds should be prevented from building exposures to these instruments. Tirole argues that bitcoin is a pure bubble, an asset without intrinsic value – thus unsustainable if trust vanishes. Bitcoin’s social value is also elusive: unlike traditional issuance, it does not produce seigniorage but mining pools compete to obtain bitcoins by investing in computing power and spending on electricity. Bitcoin may be a libertarian dream, but it is a real headache for anyone who views public policy as a necessary complement to market economies. It is still too often used for tax evasion or money laundering, and it presents problems in terms of the ability of central banks to run countercyclical policies. Technological advances can improve the efficiency of financial transactions, but should not lead us to abstract from economic fundamentals.

Kenneth Rogoff’s “best guess” is that in the long run the technology will thrive, but that the price of bitcoin will collapse. What happens from here will depend a lot on how governments react and on how successfully bitcoin’s numerous “alt-coin” competitors can penetrate the market. In principle, it is easy to clone or improve on bitcoin’s technology, but not to duplicate bitcoin’s established lead in credibility and the large ecosystem of applications that have built up around it. For now, the regulatory environment remains a free-for-all, but if bitcoin were to be stripped of its near-anonymity, it would be hard to justify its current price. Perhaps bitcoin speculators are betting that there will always be a consortium of rogue states allowing anonymous bitcoin usage, or even state actors such as North Korea that will exploit it. It is also hard to see what would stop central banks from creating their own digital currencies and using regulation to tilt the playing field until they win. The long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates.

Tyler Cowen used to think Bitcoin was a bubble, but no longer holds this view. He argues we should think of Bitcoin as competing for some of the asset space held by gold and also to some extent art. Gold, too, in its hedging functions is a “bubble”, though not a bubble. It is hard to ship, but has some extra value because it is perceived as a focal asset and one that does not covary positively in a simple way with the market portfolio. The same is true of Bitcoin, yet that kind of focality-based “bubbliness” can persist for centuries. Gold has become less of a hedge, partly because inflation has been low and partly because China and India dominated the gold market more than a few decades ago. So new and better hedges are needed. And Bitcoin is a strong competitor in this regard.

John Cochrane thinks that what’s going on with Bitcoin seems like a perfectly “normal” phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand – no annual reports on how much the Russian mafia wants to move offshore next week – that’s plausible too.

Izabella Kaminska has a long piece in FT Alphaville explaining why Bitcoin futures and a shoddy market structure pose problems. She also writes in the FT that true investing is not the same as gambling, and in the face of the cryptocurrency fad, regulators need to underscore this distinction. For decades, regulators across the world have wrestled with the question of how best to mitigate the negative effects of gambling. For the longest time, licensed gambling zones confined to specific geographic areas seemed the optimal solution. The internet has changed all that. Geographic constraints have become meaningless, while innovation – such as the invention of cryptocurrency – has started to compromise the efficacy of bans. Even if cryptocurrency trading were to be banned, the chances are that as long as some jurisdictions continued permitting it, digitally-enabled backdoor channels would be created to keep servicing clientele in restricted areas. That leaves only one option for regulators today. Gambling activities must be stigmatised rather than promoted.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic

Blog Post

Ethics and artificial intelligence

Machine learning and artificial intelligence (AI) systems are rapidly being adopted across the economy and society. Early excitement about the benefits of these systems has begun to be tempered by concerns about the risks that they introduce.

By: Valerie Frissen, Gerhard Lakemeyer and Georgios Petropoulos Topic: Innovation & Competition Policy Date: December 21, 2018
Read article Download PDF More on this topic

Policy Contribution

The euro as an international currency

Is a more important international role for the euro worth pursuing? What measures would achieve this result, if it is worth pursuing?

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 18, 2018
Read article More on this topic More by this author

Blog Post

Brexit: Now for something completely different?

The life of Brexit. After a week of ECJ rulings, delayed votes, Theresa May’s errands across Europe and the vote of no confidence, we review the latest economists’ opinions to try to make sense of what has changed and what hasn’t.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: December 17, 2018
Read article More on this topic

Opinion

Can virtual currencies challenge the dominant position of sovereign currencies?

Marek Dabrowski and Lukasz Janikowski analyse why private money has historically failed in competition against sovereign currencies and what it means for modern virtual currencies, such as Bitcoin.

By: Marek Dabrowski and Łukasz Janikowski Topic: European Macroeconomics & Governance Date: December 15, 2018
Read about event More on this topic

Past Event

Past Event

Investment and intangible capital

This event featured a presentation of the EIB's 2018 Investment Report.

Speakers: Román Arjona, Maria Demertzis, Debora Revoltella and Mario Nava Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 14, 2018
Read article More by this author

Blog Post

Les gilets jaunes

For weeks, protesters wearing yellow motorist vests have taken to the streets of Paris to protest against the rising price of fuel. They have since taken on a wider role, and are seen as symbols of the growing popular discontent with President Macron. Silvia Merler reviews scholars’ opinions about this movement.

By: Silvia Merler Topic: Energy & Climate, European Macroeconomics & Governance Date: December 10, 2018
Read about event More on this topic

Past Event

Past Event

Civil society for the digital age

What is the place of civil society in the digital age as well as the role of technology in society?

Speakers: Eline Chivot, Orla Lynskey, Bertin Martens, Georgios Petropoulos, Thiébaut Weber and Glen Weyl Topic: Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 4, 2018
Read article More on this topic

Blog Post

The international role of the euro

The authors assess whether the euro area should pursue a greater international role for the euro, as outlined by European Commission president Jean-Claude Juncker, and how it might go about doing so.

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 3, 2018
Read article More by this author

Blog Post

Green central banking

A few weeks ago, Silvia Merler discussed the rise of “ethical investing”. A related question emerging from the discussion is whether central banks should also “go green”. Silvia reviews the latest developments and opinions on this topic.

By: Silvia Merler Topic: Energy & Climate, Finance & Financial Regulation Date: December 3, 2018
Read article More on this topic More by this author

Blog Post

Machine learning and economics

Machine learning (ML), together with artificial intelligence (AI), is a hot topic. Economists have been looking into machine learning applications not only to obtain better prediction, but also for policy targeting. We review some of the contributions.

By: Silvia Merler Topic: Innovation & Competition Policy Date: November 29, 2018
Read about event More on this topic

Past Event

Past Event

How to speed up sustainable finance?

Which steps are needed to really change current practices and speed up sustainable finance?

Speakers: Sophie Barbier, Molly Scott Cato, Cathrine de Coninck-Lopez, Alain Deckers, Edmund Lakin and Dirk Schoenmaker Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: November 28, 2018
Read article More on this topic More by this author

Blog Post

The Brexit withdrawal agreement

On November 14th the UK government cabinet approved the draft text of the withdrawal agreement, the deal reached between EU and UK negotiators. The decision was followed the next day by the resignations of several members of Parliament. We review the first reactions in the blogosphere.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 19, 2018
Load more posts