Bitcoin: New Paradigm or Another Bubble?

Bitcoin: New Paradigm or Another Bubble?

By Dimitri Elkin

August 27, 2017

 “I think bitcoin is definitely a frenzy.  Eventually the media gets bored, and moves to the next thing that that will leave a much lower price for Bitcoin,” said Gavin Andressen, chief scientist at the Bitcoin Foundation, in an interview for the New York Times.  On the surface, this warning seemed like a piece of prudent advice.  Knowing that, Mr. Andressen was one of the most informed people in the world about the exotic world of cryptocurrencies.

But those followed Mr. Andreessen’s intuition and sold their bitcoins after reading the New York Times came to regret it.
The said article appeared in April 2013.  At the time, bitcoin was trading just north of $100.  Four years and four months later, the price of bitcoin would rise above $4,200.

The returns realized by bitcoin speculators have gone from impressive to astronomical.  If you invested one thousand dollars in bitcoin in 2011, by August 2017, that investment would be worth 40 million dollars.

The combined value of bitcoin and other cryptocurrencies had recently passed over 150 billion US dollars, which is ten times bigger than the value of gold ever found in California during that after the famous Gold Rush of 1849.  Starting with a modest White Paper, the distributed financial ledger idea has spawned the universe that starts to resemble the Internet wave of the mid-1990s, and has touched an increasing number of industries from banking to logistics.

It is hard to retain sober thinking during a gold rush, but since the concerns about a bitcoin bubble appeared as early as 2012, it may be healthy to pause and ask, yet again, are we in a cryptocurrency bubble?  The answer to this question carries very practical implications, both for people who own bitcoin, and for those who are thinking about a career change to pursue the blockchain riches.

Many economists have been amazed that despite skepticism bitcoin keeps going up.  Over the years, bitcoin price crashed several times by more than 50%. It recovered every single time.
Not only that.  Several more successful cryptocurrencies appeared, including the second largest currency, Ethereum.  During the course of 2017, several companies has raised over one billion dollars via Initial Currency Offering.

This Time is Different?

There are two types of market bubbles.

The first type is when a valuable asset becomes too expensive.  The 2008 real estate crash in the United States is a good example.  When the American real estate prices fell across the board, the fundamental usefulness of the residential dwellings in America did not change, and the U.S. housing market eventually recovered.

The second kind is when an asset’s intrinsic value is negligible, and the increase in the asset price is driven only by speculative frenzy.  When such an asset price bubble pops, the value of investment goes to zero.  History has many example of such bubbles, includes the Dutch tulip mania in the 17th century or the Russian MMM craze in the 20th.  Many early Internet companies in the U.S. also fall in that category: when the Internet bubble burst in 2001, and many other early internet companies disappeared from the face of the earth forever.

Many bitcoin critics say that cryptocurrencies fall into the second category of market bubbles, and have no value whatsoever. If you still own the shares of MMM, at least you can frame it and put it on the wall. Bitcoin cannot even be served such collector’s purpose.
Every bubble is based on self-referential logic, say the critics.  The price has gone up, and therefore the price will continue to go up.  In line with this logic, bitcoin and other cryptocurrencies are a classic bubble.  And the fact that bitcoin has appreciated so much recently is a sign that a major crash is around the corner.

The case against bitcoin is compelling.  But the other side also has many convincing arguments.

Bitcoin defenders argue that the emergence of cryptocurrencies represent a “new paradigm,” in according to which entrepreneurs enabled by technology can create viable financial infrastructure better than any government can.  The initial rise of bitcoin occurred in 2011, when many investors were concerned about the viability of paper, or “fiat,” currencies, and looked-for alternatives.  Gold, the traditional alternative to paper money reached the high of $1800 per ounce during that time. Bitcoin started rising rapidly during that period as well, and its wild upward ride has continued.

Now, one bitcoin is worth more than three ounces of gold.  And it must be noted that an investment in bitcoin has been a safer investment than keeping deposits of Russian banks.

Gaining Mainstream Acceptance

Over the past several years, the case for cryptocurrencies has grown stronger.  Even critics acknowledge that bitcoin and other cryptocurrencies has some useful properties.

First, the blockchain technology for keeping records of transactions has won many proponents outside of the cryptocurrency world.  For example, the recent ICO of Filecoin aims to bring the blockchain philosophy to the data storage industry.

Second, bitcoin is different from the MMM Ponzi scheme because the bitcoin creation process is transparent, and the supply of bitcoins is limited.  In fact, as the number of available bitcoins goes down, the cost of bitcoin mining goes up.  This, in theory, can set the floor to the price of bitcoin.

Third, bitcoin does not disappear, and it’s cost of storage is negligible.  To borrow a familiar refrain: bitcoins are forever.

The property of the limited supply and “eternal” value make bitcoin like another asset has remained extremely resilient as a storage of wealth: gold.
Gold has no practical value beyond some industrial application, but the noble metal has been serving as a remarkably reliable way to store value.  The amount of food or other staples you can get with a gold coin today is not very different from what it was during the times of Julius Caesar.  This remarkable value endurance is largely driven by the fact that the amount of gold that has ever been mined in the world can fit in one Olympic size swimming pool.

So, the New Paradigm argument states that bitcoin is like gold for the twenty first century. Yes, bitcoin may not have any intrinsic value. But once humans establish the tradition of using bitcoin to store value and to buy and sell goods and services, this tradition will continue, just like with gold, silver or diamonds.
But even if one accepts this argument about bitcoin, what to make of all other cryptocurrencies that appeared recently?
Gold is an element of the periodic table, and its supply is limited by nature.
Bitcoin is different.  It was created by people.  Initially, bitcoin was like gold: unique and limited supply.  Then Ethereum came.  Now ICO’s create another cryptocurrency almost weekly.  The creation of new cryptocurrencies is only limited by human imagination.

Let’s have a simple mental experiment.  If tomorrow some alchemist announces the discovery of Philosopher’s Stone, capable of turning inexpensive metals into gold, what will happen with the gold price?  It is obvious that the value of bullion will fall sharply.
In 2017, something rather remarkable happed to bitcoin.  Despite the rise of Ethereum and several other cryptocurrencies, the price of bitcoin has increased.
This makes no economic sense, and should have set off the alarm bell ringing.  Instead, serious investors have recently jumped on the bitcoin bandwagon. For example, in June 2017, the American investment bank Goldman Sachs issued a research note to its clients in which it predicted that the price of bitcoin will rise to close to $4,000.  Two months later, that’s exactly what happened.

What Goes Up Must Come Down?

It is difficult to explain the recent investor exuberance about bitcoin.  Perhaps it reflects the fact that the world is awash in cash, and the price of many assets have increased in 2017.
The real test of the value of bitcoin and other cryptocurrencies will come when the traditional financial markets decline. If, during a general market sell off, bitcoin prices continue to be strong, then it will be a very serious argument for the long-term viability of cryptocurrencies.
Investors are looking for assets that are “not correlated’ with the stock and bond markets.  This is why gold has been popular.  Maybe bitcoin can join that list of unique assets.

It the meantime, predicting the future of bitcoin, or other cryptocurrencies, remains as hard as ever.
But here is a couple of views, one pessimistic and one optimistic.
Sheba Jafari, the head of technical strategy at Goldman Sachs, predicts after the recent run up, bitcoin would fall back to $2,221.
But on the other hand, Jeremy Liew, an early investor in Snapchat, recently came up with a bullish view on bitcoin, and predicted where bitcoin would be trading in 2030.  His price target: $500,000.  Yes, that’s not a typo.  Half a million dollars for one bitcoin.

Whether in many years from now, bitcoin will be worth half a million, or half a dollar, is hard to know. The one thing is certain, if you invest in bitcoin, be ready for a wild ride, and most certainly, as they say in Texas, don’t bet the ranch.