“Bitcoin Caused the Financial Crisis” could be a headline we see a lot of in the next few years. More precise headlines may clarify that it was the bitcoin bubble or the bitcoin mania that caused the financial crisis, and they would be correct. The asset itself doesn’t cause the bubble and subsequent pop, rather it is the way people behave with respect to the asset that causes its rise and fall.
Let’s discuss how to value bitcoin, what evidence there is, if any, that bitcoin is experiencing a bubble, and how a financial crisis induced by bitcoin mania could take shape.
It’s very hard to value an asset such as bitcoin. It doesn’t produce earnings or income like a stock or bond, so there isn’t an earnings multiple or yield number that you can use to get an idea of whether you’re buying at a cheap or expensive price. You can look at historical pricing, but even then you don’t know if bitcoin is cheap or expensive, because on the one hand the rapid price rise looks like a bubble, but, on the other hand, the argument could be made that bitcoin is simply appreciating to its fair market value, and isn’t there yet.
Bitcoin is fundamentally worthless. You could say the same about fiat currency and you would be right, and you could say the same about gold and you would be mostly right, putting aside the metal’s uses in technology and jewelry.
However, fiat currency is by decree of the government, and the government legitimizes its use by requiring tax payments in that currency, in effect creating demand for that currency. And gold has been used as a store of value for thousands of years, and it is both physical and unique.
Bitcoin isn’t a currency because you can’t pay taxes with it. It’s just a digital asset that many people speculate will become increasingly used as a store of value, or to transact.
The problem with bitcoin is that it is no better or worse than another crypto already existing with similar properties, or to-be-created with similar properties. There are low barriers to entry for potential competitors.
A better coin can be created today, and this new coin may be the world’s preferred digital asset next year. And bitcoin will be worth pennies, or the new coin will be renamed bitcoin and the original bitcoin will be put aside.
Why shouldn’t that be the case? Because of the loyalty of bitcoin’s fan base? Because bitcoin has been around a while longer than the others? These questions are worth pondering.
If you put aside other cryptos and pretend bitcoin is the one that will survive as digital gold, there still is no way currently, until the price begins to stabilize, to value it. In the future, perhaps bitcoin will trade similarly to gold, and respond largely to fluctuations in interest rate expectations.
Some argue that you can value bitcoin by measuring the demand for bitcoin transactions and dividing that number by the amount of available bitcoin, which is currently a fixed number. There are formulae involved that help set a price based on the number of users.
However, the extremely volatile price movements cut against bitcoin’s use as an asset for transacting. How do you transact in something that fluctuates in price so wildly and so frequently? Also, the recent sharp increase in prices does not correspond to an increase in transactions, the volume of which has remained about the same.
The current trading price, which is over $7,500 today, is set entirely by speculators. This is fine, it is what it is, but there’s no rational way to get comfortable with a value for bitcoin. You could guess and do very well, but bitcoin could also implode and find its fair value at $10, or less.
New Buyers and Derivatives
We just had a huge influx of new buyers after the CME Group approved the launch of bitcoin futures by year’s end.
These folks opened up 100,000 Coinbase accounts in 24 hours, bringing the total CoinBase account number to over 12,000,000. (If you do use Coinbase, consider trading on the integrated GDAX platform to minimize your fees.) They are probably thinking that the launch of bitcoin futures trading means that bitcoin is gaining wider acceptance, that futures will allow new investors to enter the market, and that the formation of multiple ETFs that will hold these futures is coming soon, and so new investor and institutional money will flood the bitcoin market.
I think on these points they may well be right. Once futures and new ETFs launch, the price of bitcoin may skyrocket at an even more rapid rate. With this in mind, I am considering making a small upside bet myself, to participate in a continuation of the upward move. But if I do this, it will be keeping in mind that I may lose my entire investment, because bitcoin could just as plausibly go to zero as it could go to $100,000, with different probabilities for each of the foregoing, probably.
If sufficient folks are sucked into this market, and prices rise significantly enough to bring bitcoin’s market capitalization into the trillions of dollars, then we could have a large enough market that, when it crashes, could lead to a recession.
How could the popping of a multi-trillion dollar bitcoin bubble (if we get to that high of a market capitalization) lead to a recession? We’ll go into that in detail below.
Irrational Exuberance, Fanaticism, and Similarity to Other Bubbles
Bitcoin may be in a screaming bubble, or it could just be catching up to its real valuation. There’s no way to tell the difference except in hindsight.
That said, we seem to be witnessing a good deal of similarity to other bubbles in the irrational exuberance and fanaticism of some of bitcoin’s promoters.
I hear a lot of the following. What downside? It can only go up. Get in before you miss out. This is easy money. This is a paradigm shift. There’s no way to lose. Oh and YOLO FOMO while we’re at it.
It’s hard to discuss the downside or even the valuation of bitcoin with some of its proponents without being ridiculed. The comments I’ve seen in response to some well-reasoned arguments against bitcoin are hard to believe.
The comments consist almost exclusively of ad hominem attacks, most of which are too vulgar to repeat here. Many defenders of bitcoin refuse to discuss the downside in a reasoned or logical way.
The arrogant know-it-all-ism is at such high levels that it is hard to imagine bitcoin will keep going higher, but it likely will as there are plenty more participants to suck into the crypto market via the to-be-launched futures and ETFs.
The similarities to past bubbles, including the housing bubble, the dot com bubble, and the tulip mania way back when, are striking.
In all of these you have an asset that’s either new or experiencing new popularity, being bid up quickly by an influx of inexperienced and emotional market participants who think asset prices can only go up.
Look up the history on some recent bubbles and the tulip bubble, and I guarantee you will see the similarities very clearly. Irrational exuberance abounded then, abounds now, and will likely increase for a while until the tides turn.
To be fair, there are a good number in the bitcoin market expressing doubt and putting forward pullback scenarios. Not everyone in the market is irrational, not by a long shot, and I’m not sure the level of irrational exuberance or emotion even matters. The market will continue to go up so long as buyers bid the price up, and we could well have all the emotional market participants bail on the next pullback and be replaced by a group of more aggressive institutional investors who have by then found a new way to value bitcoin and believe fervently that it will reach a million dollars per coin.
Potential Financial Crisis Scenario
So here’s a potential scenario for how the bitcoin mania could kick off the next financial crisis and recession.
Now, do you need a catalyst such as a credit crunch or an asset bubble burst for a recession to occur? Not necessarily, but it certainly helps.
All you need for that recession is for consumer spending to drop significantly. And a good way to get to that consumer spending drop is by inflating and then popping an asset bubble, such as the one that could now be forming in bitcoin.
The reason that the popping of bubbles causes spending to drop and leads to recessions is that it is the average consumers who are sucked in at the top of these bubbles and who experience the largest losses.
After losing money in the bubble, these consumers are forced to sell other assets to pay their expenses and debts, and they are forced to cut discretionary spending to make ends meet. And so you have a drop in consumer demand and spending, and the makings of a recession.
Right now, the bitcoin bubble is attracting more and more people. And it’s not just average folks like you and me who see a hot asset moving quickly and want to join in on the ride.
It’s also savvy, value investors coming in and deciding they’ve changed their mind and weren’t valuing this asset correctly, rationalizing a way to get in. And big institutional buyers may join them too, and God forbid, pension funds.
And you’ll also have emotional momentum players who are wont to step in at the late stages of the dot com, housing, tulip, or any bubble for that matter. These are the most inexperienced and immature of investors, who know little to nothing about bitcoin except that it is bound to make them rich, and they will lose their minds if you say anything even remotely negative about their newly-beloved asset. Recent surveys show that many who buy bitcoin don’t know a thing about the technology, and can’t even articulate a reason for why they’re buying. And this may be only the beginning.
The bubble may pop for any one of a number of reasons, including new regulatory controls placed on bitcoin by governments, exchange fraud, or simply the realization of a large number of bitcoin holders that the asset they own may be highly overvalued.
It would be sufficient if bitcoin investors and speculators simply began focusing on the downside risk and begin taking money off the table and stampede toward the exits at the same time, causing the selloff to feed on itself by drawing other sellers in via panic and fear.
When this bubble pops, the consumers who got pulled in will find their spending power significantly cut back and will pull the economy down with them. And if the bubble is large enough prior to popping, let’s say at least several trillion dollars of market cap, it should have a significant impact on the rest of the economy. We are very far away from that valuation as of the date of this post, with a total crypto market cap of about $200 billion, but we could have a 10x increase in that market cap in a year or faster if the rise of crypto assets continues at the current pace or accelerates.
Assuming the bubble is large enough before it pops, and the meltdown creates a recession, the Fed will likely respond by cutting rates and expanding quantitative easing, and eventually the consumer will recover and so too will the economy after a period of financial healing.
The bubble will clear, and then it will be time to watch vigilantly for the next one.
Great YouTube Resources
Here are some excellent and balanced bitcoin and crypto resources for your listening pleasure:
If you’ve yet to make a play on cryptos and you’re interested in doing so, you can check out Coinbase to create an account and begin investing in or trading cryptos. If you use the link in the previous sentence and purchase $100 or more of crypto, you will receive $10 of free Bitcoin. If you use Coinbase, you can trade on the integrated GDAX platform using limit orders to minimize fees and costs.
If you’re interested in a good selection of altcoins, you can check out Binance. No fiat there, however, so you’ll have to transfer btc, ltc, eth, or other cryptos from another platform, such as Coinbase, to get started at Binance.
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