Boon or Bubble?

Is Bitcoin a bubble, a scam, a Ponzi scheme? Or a transformational innovation which will change forever the functioning of the global economy?

Begin by defining a bubble. People often use the term bubble to describe assets which they think are overvalued. But I find it more useful to define a bubble more narrowly. An asset can be held by someone who prizes its fundamental value – the use they will obtain from it, the income which it will yield over the years, or the pleasure they derive from owning it. Or it may be held for essentially speculative reasons by someone who hopes it to sell it on to someone else. A bubble exists when the asset is mainly held by the latter group, who hope to sell it on, rather than by people who are interested in its intrinsic value.

The bubble bursts when there is no longer ‘someone else’, when the last guests arrive at the party and discover that the punch bowl is empty – and perhaps always was.Then price reverts to fundamental value – or perhaps below, as participants in the bubble are forced to realise their positions regardless of price. The Dutch tulip mania remains the most widely quoted example of a bubble, but the Japanese property and securities boom of the late 1980s, and the dot-com boom a decade later were recent clear examples.

So what is the fundamental value of bitcoin? Some people suggest that since the future supply of bitcoin is limited, by design, the crypto-currency must not only have value, but increasing value. This is nonsense. I still have, or I may have lost, a sheet of World Cup stamps of 4d, overprinted “England Winners’. As a boy I queued to buy them in 1966. The Post Office had announced that the supply was strictly limited; but so, it proved, was the demand. The price rose, for a few days, as buyers who had been disappointed in the queue arrived late at the party; but the bubble lasted only a week or two. The best use of the stamps was to recover their fundamental value by sticking them on a letter. Last week, I was quoted the price of such a stamp at 15p offer, nothing bid.

It was my first lesson in economics, although I had yet to begin formal study of the subject. And when I did, Professor Youngson began the lecture course by drawing on the board those familiar curves that demonstrate that price is determined by the intersection of supply and demand.

Can a bubble persist indefinitely? Can an asset price that permanently exceeds its fundamental value be sustained forever by speculative purchasers? There are three assets for which this might plausibly be, or have been, true – gold, old master paintings, and paper currency. But look more carefully at each of these.

Gold

The World Gold Council estimates that the total amount of gold which has been mined is about 200,000 tonnes, of which around half is incorporated in jewellery. Private investment holdings amount to 40,000 tonnes, official stocks of gold comprise a similar quantity – the US government’s pile at Fort Knox is by largest hoard – and the balance of mined gold has gone for industrial and other uses.1 Gold is a very good – and indestructible – conductor of electricity. But more importantly, it is lustrous, malleable and beautiful and for thousands of years rulers have adorned their monuments with it, devout believers have adorned their shrines with it, and wealthy men have hung it around the necks of their women.

And, for a few centuries, gold and silver coins were used as medium of exchange. In Britain, gold coins were effectively withdrawn from circulation at the outbreak of war in 1914. And the US made private ownership of gold illegal in 1933. But this history casts its shadow.

The price of platinum today (around $1000 per ounce) is not much less than the price of gold (around $1300 per ounce). The earth’s crust is thought to contain almost as much platinum as gold (silver is much more common than either).2 But a much smaller proportion of these deposits have ever been mined, since uses for platinum are mainly industrial, and both speculative and cosmetic applications are relatively modest. It is rarely possible to escape from supply and demand.

Old Masters

The price of some major paintings seems to defy any measure of fundamental value. Damien Hirst’s diamond studded skull was supposedly sold to an unnamed investment purchaser for $100 million dollars.3 The market for old master paintings whose merits have stood the test of time – those which were painted before 1900 – looks a lot less like a bubble.

Most of the old masters which been sold in recent years have been purchased by, or for, public galleries. From which they will never re-emerge. Leonardo’s Salvator Mundi, Cezanne’s Card Players, and Gauguin’s When Will You Marry? went to Gulf museums. The most recent Rembrandts to come to market were purchased for the Louvre and the Rijksmuseum; the most valuable van Gogh to be sold recently is in New York’s MOMA, Rubens’ Massacre of the Innocents was purchased by by a Canadian philanthropist for the the National Gallery of Ontario, and Titian’s Diana and Callisto is in the National Gallery of Scotland. (The painting alternates between Edinburgh and London.)

The Australian fraudster Alan Bond bought van Gogh’s Irises, but could not pay for it; and the work is now in the Getty Museum. The disgraced Japanese magnate who within a few days bought both van Gogh’s Portrait of Dr Gachet and Renoir’s Moulin de la Galette ( a smaller version of the one in the Musee d’Orsay) probably couldn’t pay for them either, and these paintings have disappeared from view.

The recent example of a purchase of an old master by a private individual is the acquisition by the American financier Leon Black of one of four versions of Munch’s The Scream for $120 million. Mr Black is an art lover, a major philanthropist, and a trustee of MOMA. It seems unlikely that this painting will ever be resold. Not one of the most valuable old masters to be traded recently has been sold on to someone else at a profit.

The outcome of the auction of David Rockefeller’s collection later this year will provide further guidance on the state of the market in old masters. Rockefeller decided he would leave the money, rather than the paintings, to his philanthropic causes. The proceeds of the sale are likely to be the largest in history, perhaps $650 million.4 A tiny fraction of the endlessly fluctuating total market value of crypto-currencies which at the peak passed $700 billion.5

And the supposed value of these currencies is many times the $3 billion value attached to the collection of the largest known investor in art, David Nahmad.6 Nahmad’s collection consists almost entirely of twentieth century artists – he owns many Picassos but also works by much less established artists. His strategy, like that of the numerous hedge fund managers and other financiers who have inflated the price of modern painting – is to try to benefit from the minority which will become old masters. And therefore end in public collections, like almost all established old masters. Perhaps a forlorn speculation for the owners of Damien Hirst’s skull.

Rai

The island of Yap, population around ten thousand, is one of the Caroline Islands in the south west Pacific. For many centuries, its currency was Rai, large limestone circles with a hole in the middle to facilitate transportation. A Rai might way several tons. But such transportation was rarely necessary because rights to the stones were transferable regardless of the location of the stone itself. Famously, one of the stones fell into the sea, but it didn’t matter, because you could still transfer claims on the unrecovered Rai. The islanders anticipated the modern concept that you could use a unit of exchange you did not physically possess so long as you had a charge against someone who did.

Initially, the stones acquired value because there was no limestone on Yap. Material for the Rai was imported from other Micronesian islands, in return for local produce. But the system did not survive contact with the outside world. The basic problem is clear. Anyone in the world will sell you limestone to make Rai, at the prevailing global price of limestone, in return for your goods. But no-one outside Yap will accept Rai for any value other than the fundamental value of the stone. Today the currency of Yap is the US dollar.7

Paper currency

Long after the islanders of Yap, bankers discovered that they could, in similar fashion, issue paper claims on the bullion in their vaults, and bank notes came into being. Once these notes were widely accepted, banks could issue them for amounts in excess of the assets the held, and fraudulent and foolish bankers, a breed that has not yet entirely disappeared, did. In the wake of financial crises, and their own funding needs, nineteenth century states took control of this process, and paper currency became a government monopoly.

The US dollar may assure you that ‘in God we trust’, the Bank of England promises to pay you five pounds on demand, and Euro notes bear the signature of Mario Draghi, who ‘will do whatever it takes’ to preserve the Euro; but what is the fundamental value of such paper when all the Bank of England will do ‘on demand’ is give you another similar bit of paper?

One might observe, as the Caroline Islanders have discovered, that the dollar is valuable because you can go almost anywhere in the world and find that people will trade whatever they have in return for greenbacks. And despite the exaltation of Donald Trump, and the scale of Congress’s unfunded tax cuts, that certainty remains.

And the fundamental value of the US dollar has a further underpinning. Even if traders began to look askance at paper bearing the portrait of Abraham Lincoln and a sketch of the US Treasury Building, the people in that building will certainly accept their currency in payment of US taxes. The total value of greenbacks in circulation equates to about 4 months of US tax revenues.8 There will be no conceivable difficulty in getting one dollar’s worth of value for your dollar.

Bitcoin and other cryptocurrencies

Any illusions that holders might have had that the limited supply of bitcoin would maintain its value should have been dispelled by the arrival of other competing crypto-currencies. If the US Treasury perversely decided to limit the supply of dollar bills, then Americans would start using Canadian dollars, or euros, or IOUs from Berkshire Hathaway, or just their credit cards, to buy their gas and tip their cab drivers, and the official dollar might at best command a marginal premium to its equivalent value in these other currencies. But in any event the US Treasury has no present or likely future intention to do anything but provide supply to meet demand for its notes.

The dollar is far more widely accepted than any cryptocurrency, is much more predictable in value, carries lower transaction costs, and can be transferred instantly in cash or electronically. Remove the hope that speculative demand for bitcoin will increase its price, and you need to ask why anyone would trade in bitcoin, or any cryptocurrency, when they can trade in dollars. And there is only one answer to that question: the belief that transactions in the crypto-currency will be subject to less regulatory surveillance than transactions conducted through the existing financial system.

It is already apparent that a primary – perhaps the principal – use of existing stocks of cash is in the illegal or informal economy. Although honest people make less and less use of currency in everyday transactions, demand for paper currency has continued to increase, and a greater proportion is in high denomination notes. Half the value of euros in circulation is comprised of notes of €100 and above.9 But since a suitcase even of €500 notes is insecure and heavy to carry, there is a convenience in being able to transact electronically undetected.

But there is still a difficulty in transforming ill-gotten gains denominated in cryptocurrency into a private jet or a beachfront villa without entering into the regulated economy. And perhaps a more serious difficulty still in conducting business beneath a flag that advertises ‘FBI – investigate here’. Regulation is slow to act – witness the proliferation of so-called ‘initial coin offerings’, some representing an evasion of SEC rules about public offerings and others probably simple fraud. But once roused, regulation is tenacious. Anyone who imagines a long term future for financial instruments whose principal purpose is to fly beneath the radar of the governments of the world is naive. And so is anyone who believes that their savings will flourish in an environment mainly populated by crooks.

‘This time it’s different’

Usually there is a kernel of truth in the narrative that attracts investors into financial follies. In 1720, people were right to believe that international trade was set for exponential growth, even if they were wrong to believe that would be translated into exponential growth in the value of shares in the South Sea Company. In 1999, they were similarly right to recognise that the internet would have major economic impact, though not on a scale or time horizon that could come close to justifying the inflated valuations of that time.

The underlying narrative of cryptocurrencies is, by the standards of historic bubbles, unusually weak; more akin to tulips than to ultimately transformational innovations such as railways or electricity. The power of the current narrative is that it brings together so many features which make for an attractive and infectious story.

There is the component of magic – the incomprehensibility of blockchain technology to all but aficionados, the preposterous mystery of founder Satoshi Nakamoto. That aura of magic contributes to the sense of induction into a cult, as participants are swept up in enthusiasm for a new world which traditional authorities do not understand and in which they play no role; sceptics such as banker Jamie Dimon ‘just don’t get it’, to revive the 1999 phrase used to describe non-believers in the ‘New Economy’. The 61 year old Dimon is an old fogey, like the crusty Warren Buffett who ‘didn’t get it’ in 1999. Look instead to the future, which lies with the teenagers who have made fortunes speculating in cryptocurrencies from laptops in their bedrooms.

Of course, it was Buffett, not the New Economy evangelists, who did get it. And perhaps it is significant that Dimon was the bank CEO who ‘didn’t get’ the game changing impact of mortgage securitisation back in 2006 as the subprime bubble was about to burst. Old fogeys are the people whose experience is sufficiently lengthy that they have seen it before, and doubt the claim that ‘this time it’s different’. They may even be old enough to remember when England won the World Cup. But it is hard for leaders of the financial world to stand aside when so much money is being made from, and by, the gullible. ‘When the music’s playing you’ve got to get up and dance’ explained Chuck Prince, Dimon’s counterpart at Citigroup, who did not survive the 2008 crisis.

The crypto-currency movement chimes with Silicon Valley’s current libertarian fantasy; new technology connects us all as individuals, and so makes government redundant. And the creation of money is a process which has attracted the attention of cranks and amateur economists from time immemorial – the gold bugs, the bimetallists, the advocates of social credit and other generations of debt obsessives, and today those who would create universal prosperity by scattering money from helicopters.

It’s a heady mix. And the bubble in cryptocurrencies may have some way to go since ordinary investors have barely started to engage with the cryptocurrency world. The only safe bet is that a decade from now people will look back, shake their heads in incredulity, and wonder ‘what were they thinking?’.

Citations

(1) “How much gold has been mined?”, World Gold Council, accessed 23 Feb 2018

(2) The Royal Mint. “How Rare Are Precious Metals.” Royal Mint Bullion, accessed 2 Mar 2018

(3) D. Connect. “The Mystery of the £50m Skull: Is Hirst’s Record Sale All It Seems?”, The Independent, 1 Sept 2007

(4) J. Reginato. “David Rockefeller and the Largest Art Auction of All Time”, Vanity Fair, 14 Dec 2017, accessed 23 Feb 2018

(5) W. Martin. “The Global Cryptocurrency Market Hit a New Record High above $700 Billion”, Business Insider, 03 Jan 2018, accessed 23 Feb 2018

(6) S. Adams. “The Art of the Deal”, Forbes, 16 July 2012, accessed 23 Feb 2018

(7) For more information, see F. Martin, Money: The Unauthorised Biography (2014)

(8) “Revenue Statistics 2017 – the United States”, OECD Revenue Statistics 2017, p2; “Statistics on payment, clearing and settlement systems in the CPMI countries – Figures for 2015”, Bank for International Settlements, Table 4, p. 428

(9) H. Mai, “Cash, Freedom and Crime: Use and Impact of Cash in a World Going Digital”, Deutsche Bank Research: EU Monitor: Global Financial Markets 23 Nov 2016, accessed 27 Feb 2018