The Bitcoin Bubble Explained to a Couple of Four-Year Old Twins
IT WOULD BE NICE if people like Mike Novogratz and Yanis Varoufakis (and almost all journalists) knew the definition of a speculative bubble. Because bitcoin is not a bubble, so anyone who calls cryptocurrencies or bitcoin a bubble doesn’t know what a bubble is. Lou Kerner has described it as a Cambrian explosion, which, if you’re looking for a metaphor, is better. To make the concept clear, I’m going to explain it to these two girls, daughters of my Pillar project cofounder Tomer Sofinzon:
I’ll start by defining bubbles and then work toward what’s really going on — volatility.
What is a Bubble?
The definition of a bubble is …
Other people have other definitions, but we know this is the right one, because even the twins know that …
Most markets are actually ruthlessly efficient, making it impossible to know what will come next. But let’s look at some real bubbles. We all know that tulip prices skyrocketed in the early 17th century:
But did they?
No. It turns out that the claims of tulip bulbs trading hands at the prices seen in the image above for February 1637 are sketchy at best and almost certainly didn’t happen at all. The person who has studied Tulip mania most is Anne Goldgar, author of the book Tulipmania. She has summarized the false beliefs around this market and its brutal price efficiency in what is easily the most definitive blog post on the Tulip “bubble.” Please see that post, including my question in the comments, and her reply.
In the 17th century, many European empires spread across the globe, often financed by a new invention called the joint stock company. Most of these were incredibly profitable and consistently provided investors with excellent returns. But in the 18th century, the South Sea Company scam created the term “bubble,” and we can see why in the price of its stock:
Enron was clearly a bubble — there was no “there” there, management was lying, as was Bernie Madoff. So when they popped — nothing left.
Bubble Bursts vs Natural Death
Here’s the price of Long Term Capital Management in the nineties:
Was LTCM, the hedge fund that went bust, a bubble? Was Pets.com a bubble? Blockbuster? Lehman Brothers? They died and didn’t come back, so is a bubble anything that goes up and then craters?
No. LTCM was a bunch of famous Wall Street honchos and Nobel-Prize-winning economists who were overconfident, overlevered, overexposed, and screwed up. Others made the same trade with less leverage and good money management and survived. It wasn’t a scam, it was a high-risk maneuver that didn’t pay off, not all that different to what happened at MF Global. There are similar stories at Atari, Hummer, Circuit City, Kodak, Sears, and many others. Markets are tough, competitors are fierce, random stuff happens, overconfidence and mean reversion are correlated. What kills one group launches another. The creative destruction of progress moves markets forward, taking big companies down in its wake.
Bubble or Blip?
Now look at this one:
Is that a bubble? Sure looks like one. That’s the price of the Dow Jones Index from 1920 to 1933. Here’s how that story looks today using inflation-adjusted dollars:
Bubble … or blip? It’s true that a lot of value was destroyed in the 30s, but it was also a fantastic buying opportunity for the future. Let’s look at Amazon.com:
And now the big picture:
Bubble or blip?
What about the dot-com bubble? Here’s how we know it wasn’t a bubble: if you could go back in time and buy a broad basket of dot-com stocks right at the peak in early 2000, you would today have an excellent return. Some companies were overvalued and were wiped out. That’s normal. But look at the value of dot-com companies today —the worldwide web is so ubiquitous and has created so many trillions of dollars’ worth of value, you can’t even tell what a dot-com company is now!
Let’s look at housing prices:
Was that a bubble? Does it look like a bubble to you? Here’s the way to think of it:
If it’s a buying opportunity, it wasn’t a bubble.
The Infamous Bitcoin Bubble
Using that definition, let’s look at the historical price of bitcoin:
Can you see the bubble bursting? Look closer — the top price is $25. This chart is from 2010–2011. Let’s look again:
Does that shape look familiar? Look a bit closer — this chart tops out at $200 — it’s from 2011–2013. Can you see the previous “crash”? Let’s take another step:
The top of this chart is $1,100. Do you see the previous tops? See any buying opportunities? And now we see the price today:
I have presented these charts to make sure anyone who reads this doesn’t use the words bitcoin and bubble in the same sentence again. If bitcoin drops to $8,000, as Mike Novogratz predicts, will it be “game over,” or will it be a screaming buy? I encourage you to think about the thousands of hedge funds and institutions interested in buying bitcoin before you answer that. Given the evidence I’ve presented, isn’t it more likely that in two years we’ll see the same shape again, but with $100k or more on the vertical axis?
For technically inclined, this is what we call scale-invariance. The graph looks roughly the same at all scales. As Benoit Mandelbrot discovered in the Seventies, many phenomena, both natural and man-made, are scale invariant. There’s no guarantee that will continue, but there’s no particular force working against it. Of course, there are limits to growth, as Lex Solokin and I recently discussed. But the overall crypto-economy is just getting started. Ask anyone who has bitcoin if he/she is waiting for a greater fool to come along and buy them.
What we’re looking at, as Tyler Cowen, one of the few authors I know who has put it correctly, is volatility. When most people — especially journalists and TV pundits — use the word bubble, they almost always mean volatility. (The word “bubble,” even though it’s wrong, gets more readers and viewers, which is why I used it in the title of this essay.) The price will continue to fluctuate, and 10-20 percent changes in a day will continue. That doesn’t make it a bad store of value or investment.
I think Tyler should have used the term “demand function,” rather than “utility function.” I also think that in a few years Tyler will be right — the utility function is coming, and it may well be scale invariant to what we see today (at least for a while). Scott Sumner tells anyone who will listen that bitcoin can’t be a bubble if it pops so often. Today’s bubble usually turns out to be tomorrow’s blip. Felix Salmon, who called bitcoin a bubble years ago, must already wish he had bought a few. As Eliyezer Yudkowsky says, “If you’re so smart, why ain’t you rich?”
(If you don’t know what HODL means, now you do.)
True bubbles — where people pay extraordinary prices for nothing — are rare.
We can see there are two kinds of actual bubbles:
- Speculators betting on greater fools, usually using derivatives.
Everything else is volatility, some of it destructive. Bubbles are usually short lived. For a bubble to last for years is very, very unusual. Cryptocurrencies in general do not fit this description, though there are quite a few scam coins that do.
The Real Bubble
There is a bitcoin bubble now. It’s the bubble of people saying it’s a bubble, as we can see from a Google Trends search for the term “bitcoin bubble”:
I hope that bubble pops soon and never comes back. If bitcoin finally crashes, it won’t be the sound of a bubble popping, it’ll be something structural or competitive that dismantles it and replaces it with something else. The value of all cryptocurrencies will continue to rise, though with plenty of volatility for the foreseeable future. Tomer and I are working on creating a broadly diversified index of cryptocurrencies, for those who want less volatility.
A Final Test
Let’s look at one final graph:
This is the price of Ripple. It looks a lot like the price of bitcoin, ether, dash, and other cryptocurrencies. There’s nothing in this graph that tells you it’s a bubble or a rising volatile currency. And there are concerns about every currency. Ripple in particular is worth looking at more closely. Do they have a sustainable business model? Is the token well governed? Is it a good idea to hold long-term?
Bubble or blip? This will be an interesting chart to watch. Now do you understand, girls?
Oh well, I tried.
David Siegel is a serial entrepreneur from the United States living in London. He is the CEO of 20|30 and the Pillar project, both of which have newsletters you may wish to subscribe to. He is the author of The Token Handbook. His full bio is at dsiegel.com. Connect to him on LinkedIn.