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Boom and Bust

Updated: May 17, 2022

Speculative bubbles – famous examples of which are tulips in the 17th century, the South Sea Company in the 18th, British railways in the 19th and dotcom stocks in the 20th – are fascinating. Why is this?

"Why should they care if the life savings of others were to be lost?"

Speculative bubbles, also known as economic bubbles, are more social than financial phenomena. They involve the price of some novel ‘thing’ or group of ‘things’ being driven up several-fold in a short period of time, 4-5 years say, followed by a price collapse.

The exponential price rise creates huge but illusory value out of thin air but sucks in those who dream of getting rich quick and have been convinced of the real merits of the object or theme in question.

The bursting of the bubble begins when there is no one left to be sucked in, and a price collapse ensues, driven by the increasing realisation that it was all or mostly just an illusion.

Use of the word bubble with respect to such speculation dates to 1720 and the passing in June of that year by the British Parliament of the Bubble Act, a response to the 87% collapse in the stock price of the South Sea Company and consequent bankruptcy of numerous and important investors.

You may note that I did not include cryptocurrencies such as bitcoin – those that are particularly risky and classified by the Bank of International Settlements as Group 2 ‘cryptoassets’ – in the list above. Strictly speaking, bubble status can only be bestowed ex post, i.e. after things have gone ‘pop’. ‘Cryptos’ have not gone ‘pop’ and until or unless they do, whether they are in a bubble is a matter of opinion only.

However, this opinion – on the way up and during the first stage of the way down – is invariably extremely polarised. Indeed, it is this polarisation that is a key and necessary feature of any bubble.

On one side are those convinced that it is madness to pay £100,000 – today’s money – for a single tulip bulb. On the other are those convinced that the tulip bulb is genuinely worth that amount, and probably much more. It is quite hard to get a reasonable debate going.

Those in the former camp of course would have been sceptical at £1,000, and as prices rose ever higher, they retreated to lick their wounds. After all, why should they care if the life savings of others were to be lost?

In free-market economies it is deemed that individuals have the right to lose their life savings, provided they have been warned of the possibility of such. Cigarettes may cause lung cancer and other diseases; the rest is up to you.

The problem comes when authorities believe the speculative instruments in question pose a risk to the system, not just the individual, either because their total value becomes so large that they have the potential to destabilise financial systems and economies more broadly, or for other reasons such as them facilitating illegal activity.

It and other cryptocurrencies utilise a novel technology that allows decentralised, safe, anonymised ownership of digitised assets that are easily transferrable and thus exchangeable for goods and services.

They purport to be currencies, a concept that most grasp easily – they’re what you buy when you go on an overseas holiday, right? At the same time, they are complicated to the extent that authorities have not been able to decide how and whether to regulate them.

They must be ‘mined’, giving the impression that they are somehow tangible, like precious or industrial metals, and thus possess real value. And they have generated a huge cult following.

As you may have guessed, I am sceptical about Group 2 cryptoassets like bitcoin. However, when $2.5trn of total ‘value’ has been created from virtually nothing, I’m not going to doubt the potential for them to go higher. I was sceptical at $10,000 and look where that got me!

Until there are no more buyers or authorities decide bitcoin and co need to be regulated, perhaps heavily, it’s far from obvious that prices won’t continue to rise.

Tom Farley, former New York Stock Exchange president and current chief executive of soon-to-be-listed crypto group Bullish Global – the clue is in the name – said last month that “we’re only in the first or second inning of the cryptocurrency market”. I hope, for his sake, that he does not turn out to have been referencing, unwittingly, another, more globally popular sport.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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