Monday, December 2, 2013

Micro-Modeling a Bitcoin Bubble with Selection Effects

Tim Worstall from Forbes has declared Bitcoin to be in "South Sea Bubble Territory" as other crypto-currencies are swept up in Bitcoin's dramatic rise past the $1000 mark. Lots of possible explanations for why this might be the case, but I'll start with two stylized facts about Bitcoin and see how far they can go in explaining why it is a bubble, and perhaps make a few predictions about how it will all shake out.

"Fact #1": by design, Bitcoin is deflationary, that is, the value of each unit will increase over time. This is contrary to most "fiat" currencies, which can have their supply expanded by a decision from a central bank. Unlike the number of dollars (or pesos or Yen), the amount of Bitcoins available is capped.

"Fact #2": most of the things that people use Bitcoins for exclusively are illegal or unsavory. While Bitcoins are not really anonymous, the difficulty of tracking any particular transaction makes them a useful medium for shady business on the internet.

Starting with #1, the deflationary nature of Bitcoin is a serious obstacle to it becoming a mainstream currency. If a Bitcoin tomorrow will be worth more than a Bitcoin today, your incentive is to save it rather than spending it. Investing in Bitcoins is largely based on the hope of a "greater fool" who will eventually purchase them from you. The exception to this is #2, the people who get Bitcoin for quick, often shady transactions.

So, you're a ForEx trader looking at bringing Bitcoin into the portfolio. The high volatility does create opportunities for arbitrage, and the prospect of future deflation in value should make it an easy profit. However, knowing that Bitcoin is commonly associated with risky transactions, the chance of a regulatory crackdown and collapse in value is high.

To put it bluntly, if Bitcoin investors are hoarding Bitcoins in anticipation that others will come along to buy those Bitcoins and in turn use them for recreational chemicals (the "greater fools"), and suddenly lots of people are being tracked down for those illegal purchases, the bottom falls out of the Bitcoin market and the currency collapses.

Anticipating this risk, mainstream currency investors stay out of Bitcoin. The ones who are left holding the bag are more risk-loving by definition. It sounds like a classic case of irrational exuberance in action. Risk-averse investors are scared away from Bitcoin by the threat of a regulatory action, justified or not, and the resulting selection effects make a bubble more likely.

This does not imply that all Bitcoin enthusiasts, or even most of them, are illegal or should be stigmatized. But you can see in some of the fervent defenses of the alternate currency that most do not have "mainstream" economic views, either, and might be subject to some bias which would prop up a bubble.

There is reason for optimism in Bitcoin as a new technological medium, but until more hurdles have been passed and it has entered into more mainstream usage, it's far too risky to think of as more than an ongoing (but promising) experiment. At the current prices, I'd say it's likely that a few of the current adopters will be losing their shirts before the experiment is over.


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