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Bitcoin and the bubble theory

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[dropcap]T[/dropcap]his has been the Bitcoin week. The price of the cryptocurrency peaked last month at somewhere over $19,000 but on Wednesday the market collapsed with some exchanges showing prices as low as below $10,000.

Bitcoin investors were left pondering the implications on the market collapse and what course of action to take to manage the uncertainty in the now hard to understand market. Despite taking off at a fast speed, many have failed to understand the cryptocurrency market, how it works and the possibilities it might generate.

Hyman Minsky’s model of how bubbles operate, as explained in The Economist magazine online version, offers a better understanding of the cryptocurrency market.

What is a bubble?

Business dictionary defines a bubble as a surge in the market caused by speculation regarding a commodity which results in an explosion of activity in the market segment, causing vastly overinflated prices. The prices are not sustainable and the bubble is usually followed by a crash in prices.

The bubble model 

According to the Economist, The classic bubble model, and to which the Bitcoin rise has parallels, has five stages: displacement, boom, euphoria, financial distress and revulsion. The displacement is some technological development that can be used to justify a “new era”— railways, canals, the internet or blockchain.

A boom then occurs and drags in more and more investors; at some stage, we reach euphoria, where the boom is widely known to the public and there is talk about those who made millions from the trade.

In the euphoria stage, people buy because others are buying and because they anticipate being able to sell quickly at a higher price. For a while, this trend is self-reinforcing.

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At some stage, however, doubts set in; some people decide to take their profits while they can. Bad news occurs; with bitcoin, it seems to be reports that authorities in South Korea (where trading has been particularly active) are going to crack down.

Once the price starts to fall, the psychology changes. People who bought early and were counting their millions suddenly see a dent in their wealth (and it is worth noting that you are not really rich unless you have got into the asset class and out again).

Other people may have bought above the current price and are bitterly regretting their mistake. Bargain hunters jump in and temporarily drive the price higher but it doesn’t last.

At the distress stage, the price could fall as quickly as it rose —as the saying goes “up like a rocket, down like a stick”. Investors may well reflect that bitcoin had not become a means of exchange for day-to-day transactions, has not proved to be a reliable store of value and thanks to the proliferation of cryptocurrencies, does not really benefit from a limited supply.

 Is cryptocurrency a bubble?

The unpredictable rise and fall in the cryptocurrency market that is seen as a threat to bitcoin investors has sparked a debate that has attracted different views and opinions from different scholars.

William Deringer  an Assistant Professor of Science, Technology, and Society at the Massachusetts institute of technology opines that bubbles tend to be driven either by new technologies (like railroads in 1840s Britain or the Internet in the 1990s) or by new financial innovations (like the financial engineering that produced the 2008 financial crisis). Bitcoin, of course, is both a new technology and a major financial innovation.

He says that a lot of bubbles historically involve some kind of new financial technology with the effects of which people can’t really predict.

These new financial innovations create enthusiasm at a speed that is greater than people are able to reckon with all the consequences.

Brent Goldfarb, a business professor at the University of Maryland, argues the shifts depicts clear signs that often occur at the near end of the bubble, which comes with “a high amount of volatility and a lot of excitement.

Expects more stories about people who got fabulously wealthy on bitcoin in the next months that, in turn, could draw in more and more novice investors looking to get in on the action. From there, some triggering event will start a panic that will lead to a market crash.

Derringer adds that uncertainty of valuation is often a huge issue in bubbles because unlike a stock or bond, Bitcoin pays no interest or dividends, making it hard to figure out how much the currency ought to be worth and making it hard to pinpoint exactly what the fundamentals are.

According to him, this uncertainty has allowed Bitcoin’s value to soar a 1,000-fold over the last five years. But it could also make the market vulnerable to crashes if investors start to lose confidence.

READ: Five ways to become a billionaire without going to school

A history of bubbles

The term bubble came into official use with the passage of the “Bubble Act” in 1720 by the British Parliament. England granted the South Sea Company the right to take over its war debt in exchange for exclusive trading rights in the gold and silver rich South American colonies. Investors quickly inflated the share prices of South Sea, similar trading companies, and other “bubble” companies that the act sought to curb.

Some of the world’s history’s big bubbles include;

Tulip Mania – During the height of the Dutch tulip craze, the price of a bulb could run as high as 5,500 guilders, the equivalent of a nice canal house in Amsterdam. The collapse probably had little impact on the overall economy, but it damaged trust and financial markets would never be the same.

Great Depression -The heady years of the 1920s gave rise to technological innovation and towering skyscrapers in Manhattan, such as the 77-floor Chrysler building. But by the time it opened in 1930, the country was already mired in the Great Depression.

BubbleSouth Sea Bubble – From August 31 to October 1, 1720, the share price of the South Sea Company, which had taken on England’s war debt, crashed from 775 British pounds to 290.

Latin American Debt Crisis – Valuable timber and a strategic location near where a canal would be built were among the amenities Gregor MacGregor touted to lure investors in his fictitious land of Poyais, depicted in his publicity material.

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CAVIN ODHIAMBOhttp://www.businesstoday.co.ke
Cavin Odhiambo is a reporter with Business Today. He has passion in dealing with socio-economic and political matters . You can reach him on [email protected]
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