Bitcoin's fall from glory

The Nobel Prize in Economics was last year awarded to Professor Richard Thaler for his pioneering work in establishing that people are predictably irrational – “that they consistently behave in ways that defy economic theory”.

The Nobel Prize in Economics was last year awarded to Professor Richard Thaler for his pioneering work in establishing that people are predictably irrational – “that they consistently behave in ways that defy economic theory”.

Thaler is a controversial Nobel Prize winner, but one whose theory could explain what has been going on lately, with Bitcoin’s rise to glory.

People’s irrationality was at its peak in the past few months, when the parabolic price increase of Bitcoin caught on like wildfire. For many, evidence against Bitcoin was just noise.

For example, in an article I wrote in December for The New Times, warning that Bitcoin was not a sustainable asset or investment scheme, all comments to my article were testament that no one was having it – even in the face of evidence, commentators did not budge.

They argued that Bitcoin was the next big thing; that central banks had lost the game and the only way for Bitcoin was up. These comments were a clear sign that Bitcoin was in what the classic models of bubbles call – the euphoria stage.

In his 1986 book ‘Stabilising an Unstable Economy’, economist Hyman P. Minsky developed the Minsky’s theory of financial instability, where he created a model of bubbles.

In the model, he defined bubbles to have five steps: Displacement – investors get enamored by a new paradigm, such as an innovative new technology (like blockchain/DLT) which is used to justify a new era.

Boom – when a positive buzz creates price increases and drags more people in. Euphoria – where the boom is known to the wider public and more and more people are buying because others are doing so, with a promise to sell on a higher price.

Profit taking – when doubts start to set in and some people decide to take their profits while they can.

Panic – bad news pours in, asset prices reverse course and descend as rapidly as they had ascended. Those who bought with expectations for higher prices see their wealth diminish and now want to liquidate at any price.

Bitcoin has passed many of these stages, Displacement started with the talk of how blockchain, a technology that supports many cryptocurrencies, is promising to change the world. This led to the belief that Bitcoin like many other cryptocurrencies was here to stay, a boom happened and prices soared.

This massive price increases became mainstream news, leading us to the euphoria stage. However, as countries like China started clamping down on cryptocurrencies and reports of more countries like South Korea joining this movement, it set stage for bad news, which seems to have pushed to the panic stage, where prices of Bitcoin are falling, day in day out.

As I argued in my article, Bitcoin’s price increases were not sustainable because, it is denominated in its own units of value, do not have intrinsic value, it is not tied to a sovereign currency and therefore not a liability of any person or institution.

The belief that it would be widely adopted as a global currency was therefore suspect; partly because of regulatory reasons and partly because, creating a world currency from scratch, especially given the mandatory limitations on bitcoin creation, is no mean feat.

I also argued that because of the risks the emergence of Bitcoin poses; risks to financial stability, use in illicit activities such as money laundering and circumventing of government controls; it would soon or later push authorities to ban the use of Bitcoin.

This we have observed in many countries, like in China, where authorities have increased efforts to ban the use of cryptocurrencies.

As Bitcoin prices continue to fall, some people have lost so much of their wealth. Some may have been counting millions before the downward price movement kicked in, but unless you are out of the asset class, you cannot count as rich. Getting out however may be tricky for many, since lots of value has already been wiped out.

People may expect the prices to go up again in future, but it is worth noting that the factors leading to price falls such as governments’ cracking down on Bitcoin have just started. Any price increases will be small and will not last.

Valuing Bitcoin is very difficult, if not impossible. There is no single model that can at least predict what its price will be. It was very difficult to put a price target when Bitcoin prices were rising and it will be difficult to set a floor on how much it will come down. 

As the saying goes – what goes up must come down. It is clear that Bitcoin is falling from glory; even worse, it is hard to tell how low it will go.

The author is an Economist in the Monetary Policy and Research Department at the National Bank of Rwanda.

The views expressed in this article are of the author and do not necessarily represent those of The New Times.

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