When Your Only Instrument Is Looking At Charts, & Everything Looks Like A Bubble

TL;DR The only obvious bubble that appears to exist in the crypto space is this one.

The recent dramatic rise in the market value of cryptocurrencies - especially of the giants BTC and Ether — has predictably caused a lot of anxiety and lazy shouts of a bubble. It’s a bubble! Bubble!!! Bub-b-b-b-le! Bu-u-u-u-u-b-ble! Even various crypto communities are accusing other cryptocurrencies of being a bubble.

As a free-market economist, I am generally skeptical about the notion of bubbles. In the crudest, most vulgarized sense it implies that assets have inherent values, which they don’t. Even financial assets don’t have inherent value, despite the attempts to calculate it using discounting of the expected profits, because in an economy characterized by genuine uncertainty, there is no way to predict with certainty the future revenue flows.

Even if we take a bubble to loosely mean a situation where an asset class is evidently valued above its reasonable market value because of irrational investor overoptimism, there is the problem that once one starts analyzing actual historical bubbles, one can see that those that do not look like myths never arose truly spontaneously.

Rather, they were usually preceded by waves of artificial credit creation enabled by central banks and other enabling conditions created by government. Take the latest home price bubble, for instance. People who bought second houses with mortgages with zero down payments would not have been able to do that if the Fed had not injected a lot of new money for banks to lend out, Fanny Mae and Freddy Mac had not been eager to purchase mortgage claims from banks, and lenders had a recourse beyond seizing the home. Similarly, the infamous dot com bubble was preceded by similar credit expansion, and the particular niche the artificial credit went into was determined by the circumstances of the time.

Now, of course, in principle, the rapid price and trade volume increases in the crypto space may have been driven by a similar mechanism. However, this is unlikely because major institutional investors who are usually the biggest beneficiaries of central bank largesse face a lot of regulatory and other obstacles to investing into crypto assets. They are also actually generally relatively risk-averse, which should not be surprising. If you look at what they did during the housing boom, they invested into what was perceived by almost everyone as a pretty safe asset class, not a bleeding-edge technology.

Nonetheless, there are several lingering doubts that people may have that I try to formulate and address below.

Why can assets even appreciate so much?

Most invocations of bubble are probably motivated by people’s sheer disbelief that a domain can exist where it is possible to earn truly enormous profits over short periods of time. When Laszlo Hanyecz purchased two pizzas for 10,000 BTC, one BTC did not even sell for one cent. Now, one BTC approaches $3000.

There is, however, nothing magical about such price increases, if one understands how entrepreneurs, including asset speculators generally earn money. The only way for someone to gain in a competitive market is to find a resource that is currently undervalued and resell it later at a higher price. Until very recently, there had been ample space just for that because very few very geeky people knew about the existence of cryptocurrencies and followed their evolution.

You can argue that the great enrichment of a few geeks is unfair (which is a matter for another discussion) but there is nothing truly mysterious about the mechanism.

Money Prices, Exchange Rates and the sources for doubt

Another genuine reason for doubt may arise from something like the following. Cryptocurrencies like BTC or Ether are by design very highly divisible. Any amount of them can be used in transactions so why can’t there be a situation where the bulk of the relevant cryptocurrency just sits still in the holders’ wallets while only a small amount of it circulates, and one BTC exchanges for $1 instead of almost $3000?

Here, one needs to understand that the case of cryptocurrencies is not inherently different from that of the more familiar means of exchange like dollars and euros and exchange rates among them. They are less divisible but there is no inherent reason why a bottle of Coke should cost around 1.80 EUR in Aix-en-Provence rather than 2 euro cents.

Let us try to look at an exchange rate between three currencies and compare their money stocks. This will of course be a very rough, surface-scratching analysis but it will suffice for the purpose of showing that there is probably no magic involved.

The latest M2 figures for the US, UK and EU at the time of writing are around $13.5 trillion, 1.66 trillion GBP and 10.9 trillion EUR. The exchange rates are as follows:

USD/EUR — 0.89

GBP/USD — 1.27

GBP/EUR — 1.14

It is true that the exchange rates between GBP and USD and EUR are much lower than the ratios between their stocks would suggest but when it is taken into account that the UK economy is relatively small compared to the US and the EU, those rates seem more intelligible. And the USD/EUR exchange rate is amazingly in line with the fact that the ratio between the EUR and USD money stocks is 0.81, and the economies are of roughly the same size.

As was mentioned above, this analysis is very rough but you would probably admit that even it is sufficient to remove the veneer of mystery over exchange rates. And this analysis suggests something important to consider. Despite the divisibility of the relevant currencies, some of them do not have very low exchange rates. The reason for this is that holders of a currency will not exchange it at a very low rate if they know that there are people who can propose higher rates, and that people on the other side of the market incur opportunity costs for waiting for someone to accept the very low rates they propose. There is no reason to believe that this reality will not hold for exchanges from crypto to fiat currencies, provided that fiat currency holders incur opportunity costs from waiting.

But All The Cryptos/ICOs Can’t Succeed?!

Another puzzling phenomenon demonstrated by the crypto space are almost across-the-board price rallies. This seems to suggest that people are just buying whatever cryptocurrencies they can without doing a lot of research.

The real explanation may be less disquieting, however. In a domain characterized by bleeding-edge innovation, it is not easy at all to predict which projects will work and which will not. Hence, a large amount of trial and error, and failure is inevitable. This does not remotely render the domain a bubble.

But If The Prices of Cryptocurrencies Fall Across the Board Will It Not Prove They Were A Bubble?

There certainly are potential risks that may prove to be a major setback for the whole space. For instance, if mathematicians suddently find a quick way to factor large numbers into primes, or if governments prohibit exchanges into fiat.

These events, however, are rather unlikely, especially the former. Even with, for instance, the Internet governments can in principle decide to cut underwater optic cables but this does not mean that the Internet industry is nowadays a bubble.