Bitcoins: A GIANT BUBBLE? Maybe, but currency could still be worthwhile

Lessons from tulip-hoarding Dutch speculators of 1634

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The Bitcoin economy is a bubble and it'll all end in tears. Bitcoin is the greatest thing since sliced bread and will change the world forever. What might surprise some of you is that there's no contradiction between these two statements.

Whether the internet currency is in a bubble or not, and whether that bubble bursts and causes tears all around, is almost entirely unrelated to whether it's a useful thing to have around, whether it will indeed change the world and even whether it will eventually be used by real people for anything more than online trading, speculation and money laundering or to pay for more than just drugs, other illegal activities and the odd pizza.

Indeed, economists often point to world-changing technologies as being introduced along with that same mess of screams, blood and shite that accompanies any newborn into the world. In other words, financial bubbles - and resulting crashes - often accompany new technologies.

Looking at Bitcoin with that economist's eye (and no, I'm not actually an economist, just informed on the matter) then yes, obviously it's in a bubble. Purely the price volatility of the currency would be sufficient indication of that. It's up and down more often than a Pirate Bay proxy: yup, that's a bubble being played out for financial reasons.

Hoarders: Don't trust the gubmint, or planning on making some cash?

We also have some deeper insights. For example, there's very good evidence that people are hoarding Bitcoins - or at least they were until they all tried to cash out through the same stuttering exchange. Major Bitcoin exchange MtGox was hammered last week by too many micro trading requests, leading to a drop in value of BTC from $260 to $160. Of course, holding onto an asset simply because you think the price will rise - and for no other reason than market momentum - that's the perfect recipe for a bubble.

However, it's also worth looking at this from the other side. There have been plenty of bubbles that have indeed gone on to change the world. The one that many people are comparing Bitcoin to is Tulipmania, widely seen as the first recorded instance of a financial bubble. From 1634 to 1637, the Dutch went wild speculating on the value of the recently introduced tulip bulb. The tulip went from being a new and interesting flower to a good that was worth more than a house - and then back again to being an interesting flower. Vast fortunes were won and lost. Most involved knew it was a bubble and played on regardless.

But it's worth noting that before tulipmania, a tulip really was a rare flower and worthwhile asset. Even today, the Netherlands plants 10,000 hectares a year of them, produces some 3 billion bulbs and has by far the large majority of the both cut-flower and amateur-gardener seed market. Kenya and Uganda might be where roses are grown these days, but they still get auctioned off in Amsterdam. Even the method used to sell wholesale flowers is known as a Dutch Auction (start the price high and drop until someone buys). There is a goodly number of economists who would argue that that industry wouldn't have happened without that burst of speculation at the beginning.

Pets.com and the dotcom boom

We can look at more recent events too: the dotcom boom, say. Sure, Pets.com got funded but so did Amazon. In normal times, Jeff Bezos wouldn't be able to say: “Well, I'm going to try real hard for 20 years not to make a profit” and still get funded. A market mania is required for that.

Similarly with English canal mania of the late eighteenth century, the railway speculations of the 1840s and so on. New technologies turn up and financial markets go wild. There is often indeed that bubble and the bubble pops. But, sometimes, real investment does happen that makes the world which comes after it a better place.

Most of the investors lose everything, but that real stuff that got built - the canals, the railways - get used for decades afterwards. Fibre in the telecoms boom is another example: Global Crossing may have lost everything for its investors but there's a reasonable possibility that the photons that make up this piece are travelling over some of the fibre that they, or similar now-bust firms, had laid down.

There have been many other bubbles - for example, the South Sea Bubble, or the commercial property boom of the early 1970s - which were just bubbles and didn't leave anything of any great value behind.

Which is where we come back to Bitcoins. It's possible that the virtual currency meets some real world need, or some future need. I struggle to think of what governments are going to allow it to do (some have speculated that the IRS may soon regard Bitcoin stashes as "foreign bank accounts" for tax purposes). But I'm entirely happy if I'm proved wrong about that. I make no claims to omniscience.

But my main point here is that whether there's a bubble going on now or not is an entirely different question from whether Bitcoin is going to be successful or not. For the truth is we rather expect new technologies to go through a bubble stage as people bet money on whether they're going to succeed or not. That betting then becomes a self-fulfilling frenzy - and thus bubbleicious. But none of this has anything at all to do with whether the new technology is actually useful. ®

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