As a Bitcoin enthusiast, I would quite like it to crash. And not these pathetic 30% crashes that recover after a week. I mean 75% for a good long while. Maybe 95% just to be sure. It’s the best thing that could happen at this point. If this makes total sense to you – maybe you agree! – then you can stop reading here. If you are a little confused, this post ties my thinking on Bitcoin to the broader historical pattern of capital cycles. ‘Capital cycles’ refers to flows of investment capital in and out of exciting new industries. It can be thought of as a mechanical theory of ‘bubbles’. I claim that Bitcoin is the most relevant contemporary example of an industry that is being dramatically affected by cycles of capital - that is thought of as being in a bubble - and so it is with capital cycles I begin ...
Investors want to put their capital to the best possible use. As such capital will often chase high returns, flowing into ‘hot sectors’. Often, too much capital is thrown after a limited opportunity set, forcing returns down for everybody. The reason capital cycles often lead to both excess allocation and excess valuations is erroneous extrapolation. If the first company to try a new technology, product, or business model makes great returns, everybody believes that they too can make great returns. The ‘return’ is composed of the money coming out over the money going in. As capital floods in to fund new projects in said industry, both are affected. The money going in has to increase as the finite natural capacity in the industry is bid up by the flood of capital. The money coming out decreases since the original rate reflected the first mover advantage and lack of competition faced by the first company. So returns in general eventually drop to unreasonable levels. Depending on the exact sources of funding, this may lead to defaults, bankruptcies, or massive losses, as the accounting assumptions are adjusted to reflect real, sustainable returns, not those briefly achieved at the beginning of the excitement.
The ‘bubble’, insofar as one develops, is allowed to continue for as long as new speculators are willing to bid up the price of the under or undeveloped assets and buy them off the previous crop of speculators. It pops when the yield gets so low that there is nobody left to sell to. At that point, everybody will cry, and the capital will all flood out. Only the best ideas will be left standing, forcing some soul searching and possibly enabling consolidation. Notice that none of this has mentioned the relative merits of the technology at issue. It may have been perfectly innovative and valuable, just bid to insane prices by people with very little interest in developing it. In fact, what has happened through this process is that now only the very best versions of it remain. From this slimmer base, and with the investors who really know their stuff demanding higher yields over longer time periods than the heady days of the bubble, development of the technology becomes the mandate of people wanting to finance the innovation rather than wanting to speculate.
This has happened, and happened dramatically, at several points throughout industrial history and is not solely theoretical. From the Railway Mania in the UK in the 1840s to the Technology, Media, and Telecoms (TMT) or ‘dot-com’ bubble inflating, popping, and deflating around 2000. Both followed entirely predictable patterns. Both started with profound technological shifts with enormous potential to increase productivity, but ended in implosions of frenzied and short term speculation by people who had no idea what was actually going on.
I am reminded of Andy Kessler in Wall Street Meat describing his days as a tech analyst at a Silicon Valley hedge fund during the dizzying heights of the TMT bubble when he decided to turn down a $500m capital injection from a Saudi oil prince, figuring the existence of the offer surely meant that things had gotten out of hand. The money doesn’t get much more ‘dumb’ than this.
As Marc Andreessen, professional baller, is fond of pointing out, most of the ideas that lost spectacular amounts of money in the TMT bubble are now the bases of healthy, profitable, growing businesses. “There are no bad ideas, only early ones.” It is wrong to say the bubble was in tech; the bubble was in finance. Those who paid attention to the developments in technology did absolutely fine and if they timed it just right they did fantastically. The key difference is between ‘smart money’, which thinks about the long term productivity-enhancing potential of new technologies, and ‘dumb money’, which merely gravitates towards high returns without understanding the technology. Speaking of developments in technology and financial crashes, how about that Bitcoin all the kids are talking about?
Bitcoin last crashed following the MtGox hack / bankruptcy / all-around shit show in 2014 (em-tee-gocks by the way, or Magic the Gathering Online Exchange. The only ‘mountain’ was one of sorrows)
What happened after this crash was that all the people who had no idea what was going on and had bought in near the top started to make losses and sold out in panic. In order to sell, however, you must have somebody willing to buy. When there are many more sellers than buyers, the price goes off a cliff. Those few, those happy few who scooped up the remains were the true believers. They knew and cared about what they were doing and they bought in at the bottom.
The dumb money and useless talent was driven away. The people left were not in it for the short term or for the money. They were in it for the long term and for the building of something great. And they were allowed to do so. The media attention disappeared and the focus was reset for the future.
What has happened since will probably go down as one of the most incredible episodes of creative and spontaneous technological development in history, once people eventually understand what has actually happened. Since Mt.Gox we have had Ethereum, the infrastructure for Initial Coin Offerings, vital distributed computing functionality such as Filecoin, Storj, Augur, Golem, and more, to industry consortia forming around Ethereum, Ripple, and others, and various attempts at scaling the protocol that ultimately led to the Bitcoin Cash fork. This final episode is worth drawing special attention to since it was painted in the mainstream financial media as a horrifying indication of impending collapse. As usual, this commentary was ignorant and absurd: the fork was a successful proof of concept of the most radical innovation in finance this young century: a company not splitting in two, but rather cloning itself and having shareholders retain stakes in both clones as they go their separate ways.
And yet, precisely zero of the fastest build-out of fundamental infrastructure in history, which happens to have been totally decentralized, is making the news. What is? The price of Bitcoin. You can’t read The Financial Times or The Economist without being told every single day how this both has no power whatsoever and also is ruining everything. You actually shouldn’t read The Financial Times or The Economist at all. It’s bad for your soul.
The price of Bitcoin is completely immaterial in relative terms. It matters in absolute terms, of course. It’s extremely pleasant for my net wealth but it is almost entirely irrelevant to what technology is being built. There is a minor benefit in that many holders will have been early adopters, as above, and hence some of the lunatic money flying around is helping them trim their holdings to fund yet more real experiments.
But in aggregate, the focus is shifting away from technology and towards value, and away from the future and towards the present. This will undoubtedly retard the underlying development and shift capital and energy towards garbage at best and scams at worst.
I hesitate to say that this is a genuine financial bubble, for two reasons. Firstly, I think there is a foolproof case for Bitcoin to at least equal the market cap of gold over the long enough term, which from 30 seconds of googling tells me gives it at least 30x further upside. It is not at all the price of Bitcoin that scares me, it’s the acceleration of the price and the asinine media commentary the acceleration is receiving. Secondly, as I’m sure somebody wise once said, a bubble is a bull market that you aren’t in. Maybe Bitcoin was never a bad idea but just an early one. Maybe it won’t crash. Who knows?
That’s a good question, actually; who does know? How would a person know such a thing? In other words, how do you value Bitcoin? That depends what kind of asset it is. I suggested above it might be like gold, and hence a commodity. In order to cover the topic as quickly as possible, I will abstract this to a slightly silly higher level and claim that gold sits within the asset class of ‘stuff’, along with all other commodities, solid goods, and real estate. Debt is the other pre-civilisation asset class. With the dawn of civilization we get cash, and around the Renaissance we get equity and what I will call ‘monopoly rights’, covering things like intellectual property, the value of contracts and the like. The latter is kind of ‘miscellaneous’, but they do exist, they do constitute important financial instruments, and hence they are worth mentioning for completeness. Things like derivative instruments could be thought of as combining this category with cash, debt, equity, etc. (whatever it is on which they have a derivative claim). The value of cash is self-evident. The typical way to value ‘stuff’ is to project supply and demand for the stuff. The other three are financial instruments with different risks and rewards which you would value by summing the discounted expected future cash flows (which is a piece of cake, by the way).
For most of recorded history there have been three asset classes, and in the past five or six hundred years, another two. People have a pretty good idea of how to value all of these. In 2009, Satoshi Nakamoto invented a sixth: the blockchain token. This sweeping claim could fill a separate blog post, or a series of posts, or a book, but exploring it is besides the point I’m making here. While it is questionable that anybody has really worked out an intellectually sound way to value a token, it seems to me that tokens are being treated as a combination of two asset classes they most certainly are not: early stage equity that is not subject to SEC accredited investor requirements on the one hand, and OH MY GOD THIS SHIT IS GOING UP YOU GOTTA BUY IT! on the other. And so I think it’s due a nice big crash. Let’s have 2014 all over again so people can get back to doing real work.
I’m short Bitcoin short term because I’m long Bitcoin long term. A final reminder that this borderline nonsensical statement does not constitute investment advice. Don’t touch this stuff. It’s crazy. It’s a bubble. And it’s taking over the world.
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