When economic historians and financial market experts discuss asset price bubbles, market instability, or irrational exuberance, one example that often crops up is what is famously referred to as “tulipmania”—a speculative price bubble in tulip bulbs that gripped Holland in the mid-1630s. At its peak, the rage for trading tulips was so high that one Viceroy tulip bulb sold for as much as $51,945 in 2017 US dollars. Understandably, back in the mid-1630s, the Dutch buyers had to trade fortunes for one tulip.
As happens with most price bubbles, however, the tulip bubble burst and prices collapsed to a negligible fraction of their peak levels as buyers began to withdraw from the market. It should come as no surprise, therefore, when analogies are drawn between the tulipmania of the 17th century and the dynamics surrounding cryptocurrencies, especially bitcoin. The former president of the Dutch central bank, Nout Wellink, for instance, called the hype surrounding bitcoin worse than tulipmania. “At least then,” he said, “you got tulips in the end, now you get nothing.” The chief executive officer of JPMorgan Chase & Co., Jamie Dimon, seconded that view at an investor conference a month ago.
To be sure, the comparison between bitcoins and tulips may seem far-fetched, even unfair. Blockchain, the technology underpinning bitcoin, promises to revolutionize the traditional way of maintaining records—thereby helping facilitate secure land transfers, ensure efficient delivery of public services, or reduce transaction costs for businesses.
But do cryptocurrencies merit a position as an asset class in an investor’s portfolio? That question requires us go back to the first principles of investing and draw a distinction between value and price.
As New York University professor and valuation expert Aswath Damodaran explains that value is essentially derived from the fundamentals of an asset—its present or expected cash flows, growth prospects, competition scenario, market structure, and so forth. Making investment decisions require us to assess this value and compare it to the current market price. If the fundamental value is higher than current market price of that asset, then the asset merits a position in the portfolio because the market price is expected to eventually converge to its fundamental value.
In contrast, pricing requires us to make a judgement about the future market price of an asset, mainly based on the market mood and momentum. It ignores the fundamentals because the objective is to profit from short-term movements in prices irrespective of the underlying value. This raises the question: Can bitcoin be valued, or priced? Or both?
As bitcoin does not generate cash flows, it is not possible to value it as an asset. Like any fiat currency, it must be priced relative to other currencies. But unlike fiat currencies, bitcoin is neither a relatively stable store of value nor a widely accepted medium of exchange. Its prices are highly volatile, swinging wildly in response to new information. It is, therefore, neither as safe as gold nor as trusted as fiat currencies. High price volatility makes it impossible for businesses to price their goods or services in bitcoin.
In their 2008 white paper, the bitcoin creators had proposed the new system chiefly as a means to enable electronic transactions in a more robust manner than the existing technologies, including those that involve digital signatures. But the trajectory of the bitcoin market has hardly echoed that intention. This is reflected in the fact that since the beginning of 2013, while the price of bitcoin has risen by as much as 456 times, the number of daily transactions has risen only by about eight times. For bitcoin to be viewed as a credible currency, it must gather steam as a medium of exchange than merely being a speculative bet.
One of the cardinal reasons why bitcoins, or for that matter any other cryptocurrencies, are not trusted enough for actual transactions is their lack of legal tender and the absence of regulations. But this may change soon.
The Securities and Exchange Board of India, for instance, is working on a framework to regulate bitcoins. Kenneth Rogoff, professor of economics and public policy at Harvard University, views regulatory pressure from governments as a major reason for the prices of bitcoins to collapse in the long run. Monetary authorities do not tend to view competing currencies on favourable terms. Anonymous transactions in bitcoins not only encourage tax evasion and capital flight but also aid criminal activities because both the source and end usage are unknown.
In 1936, British economist John Maynard Keynes, in his magnum opus The General Theory Of Employment, Interest And Money, proposed that stock prices are based not on their fundamental values but on people’s perception of what others would pay for it. In other words, equity prices were influenced more by crowd psychology than intrinsic value. Keynes illustrated this through the example of a beauty contest, where participants are asked to rate the most beautiful faces from a hundred options. Those who voted for the most popular option, not necessarily the most beautiful, would win. The best strategy in this case, Keynes noted, would be to choose the face that you believe others would find beautiful. This would ensure that you ended up choosing the most popular face.
Bitcoin must be viewed in a similar context. Like any fiat currency, its success hinges on the trust it may or may not eventually build among its intended users—merchants and consumers. Devoid of that trust, however, bitcoin will continue to be a speculative bet driven by market momentum until its prices eventually collapse under its own weight.
Receive Daily Updates
Recent Posts
Steve Ovett, the famous British middle-distance athlete, won the 800-metres gold medal at the Moscow Olympics of 1980. Just a few days later, he was about to win a 5,000-metres race at London’s Crystal Palace. Known for his burst of acceleration on the home stretch, he had supreme confidence in his ability to out-sprint rivals. With the final 100 metres remaining,
[wptelegram-join-channel link=”https://t.me/s/upsctree” text=”Join @upsctree on Telegram”]Ovett waved to the crowd and raised a hand in triumph. But he had celebrated a bit too early. At the finishing line, Ireland’s John Treacy edged past Ovett. For those few moments, Ovett had lost his sense of reality and ignored the possibility of a negative event.
This analogy works well for the India story and our policy failures , including during the ongoing covid pandemic. While we have never been as well prepared or had significant successes in terms of growth stability as Ovett did in his illustrious running career, we tend to celebrate too early. Indeed, we have done so many times before.
It is as if we’re convinced that India is destined for greater heights, come what may, and so we never run through the finish line. Do we and our policymakers suffer from a collective optimism bias, which, as the Nobel Prize winner Daniel Kahneman once wrote, “may well be the most significant of the cognitive biases”? The optimism bias arises from mistaken beliefs which form expectations that are better than the reality. It makes us underestimate chances of a negative outcome and ignore warnings repeatedly.
The Indian economy had a dream run for five years from 2003-04 to 2007-08, with an average annual growth rate of around 9%. Many believed that India was on its way to clocking consistent double-digit growth and comparisons with China were rife. It was conveniently overlooked that this output expansion had come mainly came from a few sectors: automobiles, telecom and business services.
Indians were made to believe that we could sprint without high-quality education, healthcare, infrastructure or banking sectors, which form the backbone of any stable economy. The plan was to build them as we went along, but then in the euphoria of short-term success, it got lost.
India’s exports of goods grew from $20 billion in 1990-91 to over $310 billion in 2019-20. Looking at these absolute figures it would seem as if India has arrived on the world stage. However, India’s share of global trade has moved up only marginally. Even now, the country accounts for less than 2% of the world’s goods exports.
More importantly, hidden behind this performance was the role played by one sector that should have never made it to India’s list of exports—refined petroleum. The share of refined petroleum exports in India’s goods exports increased from 1.4% in 1996-97 to over 18% in 2011-12.
An import-intensive sector with low labour intensity, exports of refined petroleum zoomed because of the then policy regime of a retail price ceiling on petroleum products in the domestic market. While we have done well in the export of services, our share is still less than 4% of world exports.
India seemed to emerge from the 2008 global financial crisis relatively unscathed. But, a temporary demand push had played a role in the revival—the incomes of many households, both rural and urban, had shot up. Fiscal stimulus to the rural economy and implementation of the Sixth Pay Commission scales had led to the salaries of around 20% of organized-sector employees jumping up. We celebrated, but once again, neither did we resolve the crisis brewing elsewhere in India’s banking sector, nor did we improve our capacity for healthcare or quality education.
Employment saw little economy-wide growth in our boom years. Manufacturing jobs, if anything, shrank. But we continued to celebrate. Youth flocked to low-productivity service-sector jobs, such as those in hotels and restaurants, security and other services. The dependence on such jobs on one hand and high-skilled services on the other was bound to make Indian society more unequal.
And then, there is agriculture, an elephant in the room. If and when farm-sector reforms get implemented, celebrations would once again be premature. The vast majority of India’s farmers have small plots of land, and though these farms are at least as productive as larger ones, net absolute incomes from small plots can only be meagre.
A further rise in farm productivity and consequent increase in supply, if not matched by a demand rise, especially with access to export markets, would result in downward pressure on market prices for farm produce and a further decline in the net incomes of small farmers.
We should learn from what John Treacy did right. He didn’t give up, and pushed for the finish line like it was his only chance at winning. Treacy had years of long-distance practice. The same goes for our economy. A long grind is required to build up its base before we can win and celebrate. And Ovett did not blame anyone for his loss. We play the blame game. Everyone else, right from China and the US to ‘greedy corporates’, seems to be responsible for our failures.
We have lowered absolute poverty levels and had technology-based successes like Aadhaar and digital access to public services. But there are no short cuts to good quality and adequate healthcare and education services. We must remain optimistic but stay firmly away from the optimism bias.
In the end, it is not about how we start, but how we finish. The disastrous second wave of covid and our inability to manage it is a ghastly reminder of this fact.