The Amsterdam Stock Exchange (AEX), regarded as the predecessor of contemporary investing, paved the way for modern stock exchanges. However, it was also responsible for facilitating the first financial bubble in history, namely, the ‘Dutch tulip bulb market bubble’. It happened in Holland during the early 1600’s when speculation drove the value of tulip bulbs to extremes. At the market’s peak, the rarest tulip bulbs were traded for as much as six times the average person's annual salary.
Tulips first arrived in Western Europe from native Turkey in the late 1500’s. Initially purchased as a status symbol by the wealthy, they attracted the attention of the middle class. In 1634, tulip mania swept through Holland. Charles Mackay stated: "The rage among the Dutch to possess (tulip bulbs) was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade." According to McKay, a single bulb could be worth as much as 4,000 or even 5,500 florins. In today's monetary terms, the best tulips would cost upwards of $750,000.
By 1636, the demand for the tulip trade was so high that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Haarlem, and other towns. Professional traders joined in at that time, and everyone seemed to be making money just by purchasing these rare bulbs. The price of tulips seemed to only go up. People began buying tulips with leverage, using derivatives contracts to acquire more than they could afford. Despite the promising start, confidence got quickly shattered.
By the end of the year 1637, prices began to decline and then never really went up. The rapid decline was largely caused by people purchasing bulbs on credit in the hope of repaying their loans when they sold them for a profit. As prices fell, the bulb holders were forced to liquidate and declare bankruptcy. By 1638, tulip bulb prices had crashed, returning to the price levels they had once commanded upon their arrival in Holland. As a result of the Dutch tulip mania, the economy slowed down in the Dutch Golden Age. As the prices fell, demand decreased along with household spending, resulting in a shrinking economy.
However, the actual impact of the incident is often questioned by cynics. Irrespective of the scale of the event, it does teach us an important lesson in investing: be wary of financial bubbles. Bubbles occur when market value erupts rapidly, particularly in the price of assets. Following this rapid inflation, a subsequent contraction occurs. A bubble usually forms when asset prices surge due to exuberant market behaviour. During a bubble, assets typically trade at prices that exceed their intrinsic value by a significant margin.
Several such economic bubbles have occurred throughout history, such as the South Sea Bubble of 1720, Japan's Asset Price Bubble of the 1980's, the Dotcom bubble, and the 2008 US Housing Bubble. These are some of history's largest financial bubbles, but in recent times, Michael Hartnett, Chief Investment Strategist at Bank of America, has dubbed Bitcoin "the mother of all bubbles."
The scenario around Bitcoin has almost all of the signs of a financial bubble. Bitcoin was launched in 2009 and took two years to reach the price of $1 in February, 2011. However, ten years later, in 2021, at one point it was worth just under $45,000. Hence, it has grown a staggering 45,000 times in ten years, a CAGR (compound annual growth rate) of 191.16%.
Even now, when Bitcoin has become culturally mainstream, it continues to be volatile. It doubled investors’ wealth in 2020, but it also halved in 30 days from mid-April to mid-May in 2021. These fluctuations have started to have major impacts on conventional markets such as the stock markets. Bitcoin reached a market cap of over $1 trillion in May of 2021, which is more than the combined market cap of Visa and JPMorgan. Due to its sheer size and the amount of money tied up in this cryptocurrency, when the bubble bursts and Bitcoin hits near-zero, it will be the 'mother of all financial bubbles'.
Besides the inexplicable astronomical rise in value, there are numerous other indicators that point to Bitcoin being a quintessential financial bubble. Bitcoin has been labelled as a speculative bubble by eight winners of the Nobel Prize in Economics namely, Paul Krugman, Robert J Shiller, Joseph Stiglitz, Richard Thaler, James Heckman, Thomas Sargent, Angus Deaton, and Oliver Hart. While these economists have discussed a variety of issues concerning Bitcoin and cryptocurrency, the following are the primary reasons for classifying it as a speculative bubble:
Lack of Intrinsic Value: While fiat currencies, which have been in use for as long as one can remember, have no intrinsic value and are backed by faith in the government, they work as a store of value because they can be used to trade almost anywhere and anytime. Furthermore, fluctuations in these currencies are effectively monitored by governments in order to avoid excessive volatility and protect people from unwarranted losses. It is in this regard that Bitcoin completely fails. According to Maddie Shepherd of Fundera, out of an estimated 582 million entrepreneurs in the world, only 15,174 businesses accept Bitcoin as of December 2020. Since it is not an effective medium of exchange, it also fails as a real store of value since it lacks real utility. Furthermore, its volatility is another reason why it is not a reliable store of value. As a result, it is not a real asset and has no intrinsic value.
Susceptibility to market manipulation: Bitcoin has been artificially driven by tweets from eminent personalities such as Tesla CEO Elon Musk, demonstrating how fickle this market is. The Tesla boss initially supported Bitcoin. In February, he purchased $1.5 billion in Bitcoin for Tesla's balance sheet, and a month later, he announced that the company would begin accepting Bitcoin for electric vehicle purchases. After 49 days, he tweeted that Tesla would no longer accept Bitcoin due to the adverse environmental impact of mining it and subsequently turned his attention to Dogecoin. Thus, tweets with little or no substance are creating and erasing hundreds of billions of dollars in Bitcoin market value. This is a clear indication that a bubble has been brewing for some time.
Price is driven by momentum and attention from retail investors: Two factors that are behind the soaring price of Bitcoin are momentum and the attention that people pay to it. Momentum means that if Bitcoin goes up more than usual, it will, on average, continue to rise. The fear of missing out on this supposed ‘get rich quick scheme’ keeps the prices high. Similarly, if there are more Google searches for the word Bitcoin, for example, Bitcoin prices tend to go up. Hence, a large proportion of Bitcoin's gains are due to hype, as Bitcoin seems to be at the ‘Peak of Inflated Expectations’ phase on Gartner’s Hype Cycle for Emerging Technologies.
Another noteworthy point is that there are no readily identifiable real-world correlations. For example, it is well-known that gold and the US dollar have an inverse relationship. When the dollar is declining in value, gold is likely rising in value. This is a correlation that's been established over a long period. Enthusiasts have pointed out how Bitcoin is a hedge against inflation, but they forget that Bitcoin has both risen and fallen when the money supply expanded rapidly or slowly. Cryptocurrency is driven by emotion and technical analysis, primarily because it has no real-world correlations.
Due to its monumental returns and growing popularity, Bitcoin has gone from being a relatively small niche of the tech industry to a cheat code for institutional investors to boost fund returns at the expense of ignorant retail investors. While the arrival of these investors triggers a spurt in prices, it also marks the beginning of the end for most financial bubbles. There is very little contrast between the Tulip Mania of 400 years ago and the current Bitcoin situation. Both started insignificantly, only to become public frenzies very soon. And in the pursuit of making an easy profit, the Tulip Bulbs imploded, which points to what is inevitably coming for Bitcoin. The bubble will eventually burst.
Subscribe to The Pangean
Get the latest posts delivered right to your inbox