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July 27, 2019, 9:44 a.m. EDT

Bitcoin buyers are only fooling themselves — again

The second cryptocurrency bubble will end just like the first

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By Gary Smith


Universal/courtesy Everett / Everett Collection

Money is the lynchpin of modern economies. We do not need to grow our own food, make our own clothes, and build our own furniture. We can specialize in what we do well and use the money we are paid to buy what we want. 

It hardly matters what is accepted as money — seashells, whale teeth, and woodpecker scalps have all been used. The people of Yap used stones canoed in from hundreds of miles away. People have been willing to be paid in shells, scalps, and stones because they were confident that they could use them to buy things.

Money doesn’t need to be something you can hold in your hands; indeed most of us choose to live in an essentially cashless society. Our income goes directly into our bank accounts and our bills are paid out of our bank accounts. Bills that are not paid electronically are paid with a check, debit card, or credit card. We only need cash for paying people who won’t take checks or credit cards, or for transactions we don’t want the government to know about.

Which brings us to bitcoin /zigman2/quotes/31322028/realtime BTCUSD -0.24%  and other cryptocurrencies. Unlike electronic money that flows through the banking system and is monitored by central banks, bitcoin uses cryptography and decentralized control maintained by blockchains. Here is a quotation from the original paper that launched bitcoin: 

“[W]e proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power.” 

Doesn’t that sound impressively mysterious? Part of the allure of cryptocurrencies is that a great many people worship computers, while few understand blockchain. If bitcoin was an accounting system maintained by an army of accountants with pencils and paper, it wouldn’t be nearly as cool or alluring. 

As an investment, a bitcoin is no better than a woodpecker scalp or a Yap stone.

As an investment, a bitcoin is no better than a woodpecker scalp or a Yap stone . Real investments — like stocks, bonds, and apartment buildings — generate real income: bonds pay interest, stocks pay dividends, and apartments pay rental income. Bitcoin generates no income whatsoever. 

Speculators buy bitcoins because they think they will sell their bitcoins a short while later for an even higher price. This is the Greater Fool Theory — buy at a foolish price and sell to an even bigger fool for a profit. During the Tulip Bulb Bubble, for example, bulbs that might have fetched $20 (in today’s dollars) in the summer of 1636 were bought by fools for $160 in January of 1637 and $2,000 a few weeks later. The prices of exotic bulbs topped $75,000.

During the South Sea Bubble in the 1700s, fools bought worthless stock that they hoped to sell to other fools. One company was formed “for carrying on an undertaking of great advantage, but nobody is to know what it is.” The shameless promoter sold all the stock in less than five hours and left England, never to return. Another stock offer was for the “nitvender” or selling of nothing. Yet, nitwits bought nitvenders. 

Bitcoin is a modern-day nitvender, in that the price of bitcoin is no more related to economic fundamentals than was the price of the South Sea nitvender stock. Bitcoin prices are supported by nothing more than the faith that greater fools will pay higher prices. 

In 2017, as the bitcoin bubble picked up speed, the stock price of Long Island Iced Tea Corp. increased by 500% after it changed its name to Long Blockchain Corp. At the peak of the bitcoin bubble, a company introduced a cryptocurrency that didn’t even pretend to be a viable currency. It was truthfully marketed as a digital token that had “no purpose.” Yet, people spent hundreds of millions of dollars buying this nitwit coin. 

Here we go again. Last April 1, the volume of bitcoin trading more than quintupled, to 815 million from 153 million, and its price jumped 18%. The rally was concentrated in a one-hour interval when the price jumped 21% between 5:30 a.m. and 6:22 a.m. London time.

Who let the fools out? The only plausible explanation was an article written as an April Fool’s joke reporting that the SEC had held an emergency meeting over the weekend and voted to approve two bitcoin-based exchange traded funds (ETFs). For true fools, it hardly mattered what sparked the rally. As long as prices are going up, fools will buy in hopes of selling to greater fools.

At some point, the supply of greater fools will dry up and bitcoin’s second bubble will end just like the first.

Gary Smith is the Fletcher Jones Professor of Economics at Pomona College and co-author of “The 9 Pitfalls of Data Science.” (Oxford University Press, 2019)

Read: Donald Trump is right about bitcoin

More: Bitcoin’s crash hurts the latecomers once again

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