Bubble in Bitcoin or elsewhere?

In general terms, cryptocurrencies are online ‘peer-to-peer’ currencies or assets. Bitcoin was the first such currency, which came into being in 2008-09. The operations involved in the use of these currencies are decentralised; they do not require financial intermediaries or even central banks for their functioning.

They are based on blockchain technology. (Harvard Business Review defines blockchain technology as "an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.") By design, there is a restriction on the quantity that can be issued or mined, which helps in avoiding a fall in the real long-term value of such currencies.

The costs of operations are very low. These features can make cryptocurrencies particularly useful in developing economies − just as, in a different area, mobile phones have brought about a sea change there (Antonopoulos 2016).

There are many different currencies in the world economy. However, each currency is the national currency of a given country. In such a context, is it at all conceivable to have another different currency that is operational alongside a ‘traditional’ currency within a given country? This question had been answered in the affirmative long ago, even before the new currencies taking the form of cryptocurrencies came into existence (Klein 1974, Hayek 1976).

It was argued that macroeconomic stability can not only be maintained but that this can be done more effectively in the presence of a different private currency or several different private currencies rather than in the absence of any such currency at all (Hayek 1976). This literature suggests that cryptocurrencies are indeed meaningful from an economic point of view.

The issue here is that the price of Bitcoin has skyrocketed from about Rs 50,000 to about Rs 9,00,000 in less than a year! There is a similar story with other cryptocurrencies. Is this a bubble?

Possible absence of a bubble
Unlike assets such as stocks, bonds, and bank deposits, some other assets like gold and fiat money do not derive their value from underlying assets. Instead, the value is derived basically from factors like status of currency as legal tender, convention, and confidence in the marketplace.

Now cryptocurrencies are quite like gold and fiat money in this respect. Accordingly, cryptocurrencies can have value even if there are no underlying assets. So, it is not obvious that a bubble is present in cryptocurrencies…What can explain the possible demand by actual users for cryptocurrencies in the future? The demand can be high if we have serious macroeconomic and financial instability and there is loss of confidence in the more familiar assets.

It is true that the developed countries have succeeded in coming out of situations such as the Great Depression in 1930s and the Great Recession in and around 2008. It is also true that the worst stories of inflation (and hyperinflation) may be said to be over. This may suggest that there is hardly any long-term and sustainable need for substitute currencies like cryptocurrencies in which case the high price at present can be a bubble.

However, we cannot be sure
Very high and volatile inflation is still present in a few countries in Africa and Latin America. More important, the ratio of public debt to GDP (gross domestic product) or the ratio of public debt to taxes is very high in many countries. It can be tempting for public authorities to tolerate, if not engineer, high inflation for short periods and/or sustained inflation at ‘moderate’ level for several years.

This can happen despite inflation targeting, which is anyway typically flexible inflation targeting, by constitution (the flexibility can provide an excuse in various ways for high inflation in future). In such countries, ‘traditional’ currencies can lose value over time, and so there can be good demand for cryptocurrencies that are expected to show stability or appreciation in the long run.

Even where macroeconomic and financial stability is not in question, there are other issues like the high costs of financial intermediation at present. This is true not just in the developing world but also in developed countries once we consider the costs of bailouts, huge bonuses to ‘expert’ senior professionals, etc. So, there is, prima facie, considerable scope for cryptocurrencies, given that these are economical to use. All this suggests that a bubble is absent in cryptocurrencies. However, there are some counterarguments.

Possible presence of a bubble
It is possible that due to competition from cryptocurrencies, policymakers and financial institutions will be compelled to deal more effectively with macroeconomic stability and with high costs of financial intermediation than they have done so far. If they do so in future, then the strong case for cryptocurrencies will be missing.

Also, people just may not feel comfortable using cryptocurrencies for various reasons. Furthermore, though cryptocurrencies like Bitcoin have been running well for a few years already, there can be technical glitches in the use of such currencies in future. Then, the high and rising prices of cryptocurrencies can collapse, in which case we do have a bubble in cryptocurrencies at present.

This conclusion is in sharp contrast to what we saw earlier, which is that there may not be any bubble in the price of Bitcoin. So, the simple conclusion is that we do not know for sure if there is a bubble in cryptocurrencies. But suppose we consider the optimistic case for cryptocurrencies and assume that there is hardly any bubble there − does that mean we have no problem at all?

Implications for other assets
Observe that in the aggregate the demand for assets like central bank money, gold, and cryptocurrencies has a cap; this follows simply from the premise that people have limited purchasing power and that money (affluence) does not grow on trees in the real world. This is, as Singh (2017) shows, a simple, general and useful principle that helps in identifying a bubble per se (rather than when a bubble will end).

So, if the demand for cryptocurrencies goes up considerably, then this implies that there will be a fall in the demand for other assets among actual users in the future! In the future, the demand for gold as a ‘financial asset’ can keep falling due to competition from cryptocurrencies as a store of value…Popularity of Bitcoins can also adversely affect the demand for current and savings accounts in commercial banks.

This is because there can be competition between cryptocurrencies and bank money as both can be used in facilitating payments. Profits and the market capitalisation of banks can fall (incidentally, the ratio of price to book value is very high for several private banks in India at present). Also, there can be an adverse effect on market valuation of asset management companies that derive good income from money market mutual funds, which are also used as money.

So far, a jump in prices of cryptocurrencies has not been accompanied by a fall in the price of gold and in the prices of stocks of commercial banks and asset management companies, or by a rise in yields on government bonds. But this is understandable, given that (a) asset markets are not always informationally efficient in the short run, and (b) in any case, even a very large percentage rise in the prices of cryptocurrencies warrants only a small percentage fall in the prices of other assets.

The reason is as follows. Despite the huge appreciation in the prices, the market value of cryptocurrencies is still very small: it was just about US$316 billion on 30 November 2017 the world over (of which the market value of Bitcoin is about US$178 billion). This is in sharp contrast to the US currency alone the market value of which was about US$1.58 trillion on 20 September 2017.

The comparison is also stark if we consider the estimated value of gold in the world which is about US$7.8 trillion. So, even if there is a shift of demand to the tune of a few hundred billion dollars, the percentage fall in prices of other assets is going to be small.

It follows that if there is hardly any bubble in cryptocurrencies then there is a small bubble in prices of other assets. Though it is small at present, this bubble in other assets can be significant going forward, if the demand keeps shifting to cryptocurrencies. (Reprinted with permission from Ideas for India - www.ideasforindia.in)

By Gurbachan Singh