What is a bubble?

Not a day goes by without crypto being called a bubble or a Ponzi scheme. This has a quite negative connotation, as bubbles or Ponzi schemes are understood at investment opportunities that are bound to fail and live from the shifting money from some people to others. As bubbles in the real world, they are bound to pop eventually. In this column, I will argue why indeed most crypto currencies are bubbly assets and why this is not necessarily a bad thing.

The economic understanding of a bubble

Let's start off with an explanation of what a bubbly is in economic terms. Economists usually refer to (pure) bubbles as an asset which is bought (solely) for its resale value. A pure bubble asset does not promise any cashflow and is bought because buyers think they can earn a return. Ignoring that the government accepts tax payments only in its own currency and that it enables transactions, fiat currency has those exact properties. We are holding fiat currency, because we believe that also tomorrow we will be able to buy groceries and pay our rent using fiat money. If for whatever reason we all concluded that starting from tomorrow all fiat money will be worthless, we will try to get rid of it immediately. Moreover, we will not find any buyers, because starting tomorrow it will become worthless. Therefore, coordination is vital for the value of fiat currency.

Fundamental or underlying value

Historically, we have seen several episodes that we consider to be bubbles, for example the Dutch tulip bubble, the South Sea bubble and more recently the dotcom bubble and the housing bubble. Bubbles in stocks and housing are different, since those also have fundamental value, that is the possession of those assets entitles you to dividend payments in the future. Since we cannot observe the stream of dividends in the future, we are uncertain about the true fundamental value of most assets. Therefore, we also cannot observe any bubbly component in the asset price. Only after a bubble bursts, i.e. the asset price declines drastically and does not recover soon, we have reason to believe that the asset price we have seen might indeed been driven by speculation instead of fundamental developments (of course we can discuss the plausibility of asset prices before a bubble popped).

Coordination is key

Because coordination is at the heart of (rational) asset bubbles, they do not burst if the coordination continues. Gold and silver have been valued for a long time above a price that would be justified solely based on industrial demand. In my opinion, bitcoin falls in a similar category as gold. People buy it because they perceive it as valuable and they believe that other people will continue to hold on to this belief in the future. In this sense, bitcoin is a bubble, just like gold is a bubble. People who trade on bitcoin agree to accept bitcoin as a store of value. Bitcoin’s value fluctuates with the number of people accepting bitcoin as a store of value and their demand for such a store. People investing now in Bitcoin who are speculating on a high increase of its value essentially take a wager on the popularity of bitcoin as a store of value.

Technology does not bring value on its own

Bitcoin brings of course new technology to the table and has a hard cap, if miners do not decide to inflate it and create new bitcoins. These are, however, mostly features which make it more appealing as a store of value, but don’t give it value on their own. If nobody thinks that bitcoin will remain valuable in the future, its value today will take a dive as well.

Conclusion

To sum up, bubbles get their value from coordination of beliefs. Gold is valuable, because we perceive it as valuable today and in the future. The same holds for most crypto currencies in general, although some have also uses besides being a pure store of value. This does not mean that it eventually has to burst all the way to zero value, but instead that the price of most crypto currencies will stay volatile.