Bob Murphy correctly described a bubble:

Note that all prices are driven by supply and demand. But when we say that an asset is in a bubble, what that means is that the demanders (i.e., new buyers) aren’t buying because of “fundamental” reasons, but rather for speculative reasons. In other words, they are only buying because they think the price will go up.

Why do bubbles burst? Because sooner or later, due to general economic conditions, people start needing cash. The time has come to sell my Thing X, and reap all the huge profits. But lo and behold, everyone is thinking this. The market is flooded with X. Better sell for the pittance I can still get for it, before it drops even more.

Devils’ Advocate: So, Dave, you are saying people are only buying bitcoins to speculate with? But what about all the people who actually are buying pizzas with it?

SD: You mean the 3% that aren’t hoarding it? We’ll talk about them. But I hope you realize that in any bubble not everyone is gambling with thing X. During the housing bubble, plenty of people bought houses to actually live in. But plenty more were buying them as a gamble, enough to influence the price of houses and give them a bubble price.

DA: So how do you know that the 97% who have never spent a bitcoin are just buying them as speculations? Maybe they intend to use them soon, but haven’t gotten around to it. I mean, you aren’t a mind reader, Dave.

SD: I’m not reading anyone’s mind, and I am not saying all 97% are just speculating. I am saying something more subtle, that the price of bitcoin is not influenced by the ones who plan to spend it, but only by the speculators.

DA: Dave, have you forgotten the laws of supply and demand? No matter what the reason someone has for wanting something, he is part of the demand which determines the price.

SD: Let me explain. Unlike any other money in the world, the price of nothing is fixed in bitcoins. A Swiss watch has a price fixed in Swiss Francs. The price of that watch in Switzerland does not go up and down depending on the relation of the franc to the dollar, or to any other currency. Certainly not from day to day or minute to minute.

But that same watch, or anything else, when it’s offered for sale on a website in bitcoins, will change its bitcoin price constantly. Since bitcoin is so volatile, going up and down like waves in a choppy ocean, no one can stay in business if he fixes his prices in bitcoin. When it drops from $266 to $90 in a few minutes, he can’t sell his Swiss watch at a discount of 65%, he’ll go broke.

DA: And if bitcoin goes up in price ten percent compared to other monies, he can’t sell his watch for that 10% higher, because his customers will flee to amazon.com and buy it in francs or dollars. I get that. Just today, bitcoin moved between $175 and $233, currently at $209 for the moment. So yes, it’s plenty volatile.

But what does that have to do with your claim that only speculators set the price of bitcoin, not normal people buying Swiss watches or what have you?

SD: Very simple. Since Swiss watches are priced in other monies, but never in bitcoin, then the fellow buying that Swiss watch could not care less what the price of bitcoin is.

DA: I’m just an imaginary being, Dave. I need you to give me an example.

SD: Sure. Say the watch costs $100. Let X be the current dollar price of a bitcoin on mtgox.com.

If X=$50 for one bitcoin, the guy buys 2 bitcoins, and uses them to get his watch. Cost of watch, $100.

If X=$100, he buys one bitcoin, and buys the watch with it. Cost of watch, $100.

If X=$200, he buys half a bitcoin….

DA: OK, OK I get it. So the buyers of bitcoins don’t care about the price. They spend a hundred bucks on that Swiss watch no matter what the selling price of bitcoin. I Get that. But the sellers of bitcoin care. They want to set the price so that they sell as many bitcoins as possible, don’t they? I mean it’s like apples. If the price of apples is too high, not enough people will buy them for the seller to make money.

SD: Nopers. Because the sellers of bitcoins can set the price as high as they want, and they buyers will buy the exact same dollar amount of bitcoins. If X= $50…etc. So that the sellers can set the price as high or as low as they want, and nothing will change, as far as people buying bitcoins to buy Swiss watches are concerned. The difference is that at a high price, the sellers get to keep more bitcoins hoarded away. So if we are looking only at the use of bitcoin as a medium of exchange [=to buy Swiss watches], its price will tend to go up and up, up to infinity.

DA: What about people who are buying it to speculate?

SD: Same thing, really. If they think it will go up, they don’t care what the price is. if they have $100 to gamble with and X=$50, etc.

DA: So why is the price what it is? Why did the price dip up and down today between $175 and $233?

SD: The price depends on the cash needs of the sellers at the moment, and on any bad news causing a panic among the speculators, such as mtgox going bankrupt, say.

DA: So what will happen?

SD: Same as with every bubble. Sooner or later, due to general economic conditions, people start needing cash. The time has come to sell my bitcoins, and reap all the huge profits. But lo and behold, everyone is thinking this. The market is flooded with bitcoins. Better sell for the pittance I can still get for it, before it drops even more.

DA: So not only is bitcoin doomed because it is a phony money like the Ithaca Hour and others, as you wrote about in the past, and because of Gresham’s Law, as you explained recently, but because it is something unseen until now, something whose price is determined by pure bubble reasons.

SD: Don’t forget to check my article Bitcoin All in One Place, for further analysis of that sad, sad bitcoin.

[SIX MONTHS LATER]

Turns out the above analysis has a mistake in it. It assumes there are actually people out there besides hoarders, buying things with bitcoins. It also assumes confidence among the hoarders that everything will be fine.

Both those assumptions, it turns out, are no longer true. Which is why bitcoin has been dropping like a stone since December 2013. See my humble article here.