Two UK academics, William Quinn and John D. Turner, have written a very engaging book – ‘Boom and Bust A Global History of Financial Bubbles’, which, as it says on the tin, looks at financial bubbles- a fascinating topic.
Wouldn’t be nice if we could detect a financial bubble and head it off before it caused too much damage?
Easier said than done. But the authors have a pretty good go.
Now what is a ‘financial bubble’?
Quinn and Turner use a very sensible definition of ‘bubble’ from Charles Kindleberger, an economic historian from MIT, who describes a bubble as an
‘upward price movement over an extended range that then implodes’.
In other words, what goes up quickly then comes down. quicker
While that is a good definition, it is not of much practical use, since a bubble cannot be predicted and we do not know what causes a financial bubble to start and we don’t know when it will implode, though implode it will – if it is indeed a bubble.
The Bubble Triangle
To their credit Quinn and Turner try to answer the question “What are the factors that cause ‘financial bubbles’?” and in doing so they invented the Bubble Triangle[1] as illustrated below.
The authors describe the three factors identified as being similar to the requirements needed to start a fire: oxygen, fuel and heat. Two out of the three factors present and a fire will not start but add the third and a fire can take off with just a spark. Interestingly the corollary is also true; remove an element from the fire (such as oxygen) and the fire can be dampened.
Figure 1 – The Bubble Triangle
The first side of the Bubble Triangle, is called Marketability or the ease with which a financial asset can be freely bought and sold and is the ‘oxygen’ needed to fire up a boom. Marketability relates to how easily a financial asset can be bought and then sold and how easy it is to find a buyer or seller. Marketability is also related to how divisible a financial asset is. For example, if a buyer can buy just a small amount of an asset that means they will be more likely to do so as the initial investment is not that risky. How easy it is to transport and store a financial asset is also important for marketability; as something that is heavy and dangerous is unlikely to cause a bubble, but a weightless digital asset is perfect.
The second side of the Bubble Triangle is Money and Credit (or the ‘fuel’). If money and credit are tight it will be difficult to borrow money from banks to purchase new, especially risky, financial assets. But if banks are extending credit freely, investors can borrow in the ‘sure and certain’ hope they can make a profit and repay the loan. If the asset appreciates as hoped then everyone will be happy.
The last leg of the triangle is Speculation (or ‘heat’). Unless sufficient heat is applied to the fuel, a fire will not take off and similarly with a financial bubble. The authors describe Speculation as the “purchase (or sale) of an asset with a view to selling (or repurchasing) the asset at a later date with the sole motivation of generating a capital gain”.
In other words, speculators are not looking for a long-term income stream, as in buying a bond or stock, but looking to get in and get out quickly, hopefully with a profit.
Although it has a somewhat bad name, Speculation is essential in all financial markets as someone must take a risk somewhere in order for a financial market to operate efficiently and effectively.
If an asset is appreciating in value quickly, speculators will be drawn in with the belief that they cannot lose, particularly if they can liquidate their holdings very quickly (that is before a ’greater fool’).
So, Marketability, available Money and Credit and Speculation are all needed to ‘fire up’ a financial bubble.
However, this does not mean that even if these three factors are present, a bubble will always occur as timing may change the trajectory, for example the timing of money/credit policy change may not coincide with changes in marketability. Likewise, even though marketability is high, speculation may not emerge to create a bubble, there may be some speculation but not sufficient to get the bubble growing.
It is the alignment of the three factors emerging at the same time with sufficient force that creates and feeds the bubble. But what is the ‘spark that ignites the fire?
Quinn and Turner argue that the spark can becaused by Technology Innovation and/or Political decisions for example to generate economic activity in a particular sector. For example, the Dot.Com bubble was initiated by the emergence of Internet technology and the Subpirme bubble of 2008, was generated by government policies affecting housing markets, around the world, although the actual trigger mechanisms differed by jurisdiction.
Obviously, neither technology innovators nor governments deliberately set out to create a financial bubble, but it appears that such bubbles are the unintended consequencesof a series of decisions unrelated to the bubble that is eventually created.
So, if Bitcoin is a financial bubble, does it fit the Bubble Triangle model? And can we learn from it?
We have been here before!
Quinn and Turner have already called Bitcoin a Bubble! In their 2020 book the authors described the rise and fall of Bitcoin in 2017/2018 as a classic financial bubble. But calling something a Bubble does not mean that it is ended merely that different conditions can set the bubble off again
In 2017, Bitcoin was indeed a bubble, although it seems tiny in the diagram, but only in comparison to the bubble of 2020-2022 (Twin Peaks) which is so enormous. Between January and December 2017, the price of Bitcoin rose by a spectacular 1,341% before dropping by some 75% during 2018, so qualifies as a financial bubble.
But ardour for Bitcoin was not finished!
In 2019, the price of Bitcoin rose over 200% between January and June, before falling by 2/3rds in March 2020. Spectacular but not compared to what happened next.
Between March 2020 and March 2021, the price of Bitcoin rose by a spectacular 815% and then rose again in October to some 855% of the March 2020 price – the Twin Peaks. But that was the high point of the Bitcoin price, as, at the time of writing November 2022, the price has fallen nearly 75%.
While smaller bubbles present many of the same features as the Bitcoin Twin Peaks bubble, here we will concentrate on the period from the low point in March 2020 to mid-November 2022, the current low point, over which period the Bitcoin price rose rapidly to fall back, but where the price still remains some 1.5 times the March 2020 price.
THE BITCOIN BUBBLE
The diagram below shows the Bubble Triangle overlaid with its components, which will be examined individually below
Figure 2 – The BITCOIN Bubble
Politics/Technology
Bitcoin is a so-called ‘Crypto-currency’, described first in a White Paper by the pseudonymous Satoshi Nakamoto in 2008. While many of the concepts in the paper, particularly ‘digital currencies’ and cryptography had been discussed previously, Nakamoto’s key contribution was to develop working computer code that was ‘open’ to use by anyone interested.
Note, Bitcoin is just one of many copy-cat ‘cryptos’ but is the largest and most well-known and is the model[2] for all others. And Bitcoin is a social media phenomenon with over 700 million Google references, so is very, very well-known – a key factor in Marketability.
Crypto currencies are indeed a genuine Technology Innovation, which fulfills one of the drivers of the Bubble Triangle.
But Politics also played a critical role in creating the Bitcoin Bubble through the monetary polices undertaken by governments around the world during the Covid-19 pandemic, of 2020-2022 (and onwards). During the extended pandemic, enormous amounts of money were injected into economies around the world to stave off a ‘pandemic recession’.
Money/Credit
The chart on the top left of Figure 2 illustrates the trajectory of official Federal Funds Rates set by the US Federal Reserve which shows that the Fed started to reduce its key rate in March 2020 as Covid-19 began to rage across the country and then retained a very low rate (circa 0.10%) until mid-2022. This permitted banks to lend large sums of money at minimal rates.
In line with Bubble model this allowed people to borrow at very low rates and to use that money inter alia, for various ‘investment’ purposes, including investing in/speculating on Bitcoin. Similar rate cuts were implemented by governments around the world.
Furthermore, and adding massively to the amount of money in circulation, governments began to provide direct support, often in cash, to citizens and businesses around the world. For example, the USA government provided some 4 TRILLION dollars in ‘emergency' consumer and business support over the pandemic.
So, in the period 2020 to 2022 there were enormous amounts of funds available in cash and credit some of which could be siphoned off for speculation/gambling. The reference to gambling is important since, as a result of reduced opportunities for relaxation during the pandemic, many people around the world turned to on-line gambling. As Speculation is a form of gambling. it is not surprising that that too would grow.
So, the first prerequisite for the Bubble model, that of easy access to money and/or credit, was in place from 2020 onward.
Marketability
Access to native Bitcoin on the Blockchain is very difficult as one has to purchase a not insubstantial computer, download the required software and run Bitcoin ‘node’ software 24*7, which, even if only a ‘light node’ is created, is a very geeky undertaking. Furthermore, there was no easy way to find other people who had the necessary software and hardware and who wished to buy and sell Bitcoin. This explains the low flat-line Bitcoin ‘price’ of the first 5 years of the Bitcoin chart.
However, the development of Bitcoin ‘exchanges’ changed the dynamics of the market. From about 2011/2012, firms such as Kraken and Coinbase created easy to use exchanges whereby people could buy and sell Bitcoins, albeit with a loss of the anonymity that was one of the attributes of Bitcoin itself.
From 2012 onwards, a number of new exchanges entered the market and liquidity in the market improved and people could, if they wished, trade (i.e., speculate in) Bitcoin around the clock.
So, in terms of the Bubble model the proliferation of new exchanges increased the Marketability of Bitcoin markedly.
Speculation
Because of the structure of underlying Bitcoin, and its deliberate secrecy, and the exchanges that operate on top of it is extremely difficult to identify not only the number of users of Bitcoin and other cryptos website but also what they actually do.
Though many of the statistics reported are to be taken with a pinch of salt, it is estimated that there are some 190 million bitcoin usersworldwide with about 85 million ‘unique bitcoin wallets’.
But what is actually happening?
A recent study by the Bank of International Settlements (BIS) found that
“Bitcoin price increases have been tied to greater entry by retail investors”, In particular, with data over 2015–22, we show that users are more likely to make active use of crypto exchange apps in months after a rise in the price of Bitcoin.”
That is, if the BitCoin price increases that drags in ‘investors/speculators’.
The report added:
“Our findings shed light on the motivation for retail investors to enter cryptomarkets. They support the notion that, by and large, investors view cryptocurrencies as a speculative investment (a “gamble”) rather than a means of payment for real economic transactions. They also raise concerns around consumer protection: if users are driven primarily by backward-looking price movements, are they fully prepared for the potential consequences of a price correction?”
In other words, there has been a massive increase in the number for new ‘investors’ in Bitcoin over the past 7 years and their motivations are primarily speculation.
The Bitcoin Bubble
So, in 2020, the three prerequisites for a financial bubble were in place:
1) Cheap money and credit;
2) Easy access to Bitcoin trading; and
3) Lots of speculators with time on their hands and money to play the 'market'.
Why did the bubble burst?
After a fall and a smaller rise from its peak in November 2021, the Bitcoin price fell precipitously from about March 2022. This coincides (but cannot be proved to be caused by) the US Fed, and other central banks, increasing interest rates in the economy to tackle inflation.
This rise in borrowing costs most certainly effected the costs of speculation but the jury is out so far as to how many speculators exited the market. While that is unknown, the precipitous fall in Bitcoin prices is real.
Whatever its cause, the Bubble has burst!
Will there be a new Bitcoin Bubble?
Will the Bitcoin market take off to even greater levels, as many believe? Of course, we cannot say. It is the future after all!
But if the Bubble Triangle model holds, then a few stars have to (re-)align for Bitcoin to take off again.
First, money and credit will have to become readily available again. However, central banks efforts to rein back inflation will mean that interest rates in many economies will continue to stay high for some time. Cheap money, for speculation, will remain elusive.
Will Bitcoin become Marketable again? Two factors will mitigate against this.
First financial regulators are beginning to regulate crypto markets which will naturally force exchanges to implement new and more onerous processes, such as Anti-Money Laundering checks, making access by speculators more onerous. Furthermore, as speculators return to work on-site rather than Working From Home (WFH) usage of crypto trading sites will naturally diminish.
Lastly, the current turmoil in the Crypto exchange markets, such as bankruptcies of leading firms, will have two effects: first it will diminish the marketability of exchanges and second, trading will be perceived as riskier and speculators will exit the market.
The Bitcoin Bubble will probably deflate slowly!
Will the Bubble expand again?
Possibly, but only if economies return to a low interest, free-wheeling market where speculators can easily trade.
You pays your Bitcoin and take your chances!