Why Bitcoin is not in a Bubble

“It’s up 400% this year and 1000% over the last two years: Bitcoin is clearly in a bubble.” How many times have you heard this? And what percentage of the people saying it don’t own any Bitcoin? Probably all of them.

When you have not been invested in the best performing investment asset in recent times it’s reassuring to write it off as a bubble. OK I missed it but it’s about to crash so I actually was right all along not owning it. Feels good right?

Let’s start by defining what a bubble is: it’s when the value of something goes from fair to abnormally high. So in the classic tulip bubble in Holland prices went from reflecting their value as something pleasant to look at (fair) to one where they could be used to buy houses (abnormally high). The Nifty Fifty US stocks in 1972 went from P/E ratios of around 20 (fair) to in some cases 80 (abnormally high).

The starting point for anyone who regards Bitcoin as being in a bubble is logically that prices previously were fair and now they are abnormally high. However this betrays a fundamental misunderstanding of how Bitcoin was created.

The first Bitcoins were mined in January 2009 and at that time had a value effectively of zero. The first recognised transaction with Bitcoin took place in 2010 when a developer used 10,000 Bitcoin to buy 2 pizzas. That valued each Bitcoin at less than 1 cent compared with over $4,000 today.

Bitcoin is a unique asset in modern times

Unlike every other asset in modern times Bitcoin started life worth nothing and is now on a journey to a “fair” valuation. Even other cryptocurrencies started life with at least some speculative value because of the precedent set by Bitcoin.

Bitcoin therefore started life at an abnormally low value (zero). As demand for it has grown the price has risen, but when exactly was the price ever “fair”? Basic laws of supply and demand show it wasn’t fair value when it was zero based on the millions of people who have paid higher prices for it.

Many bulls argue that the fair value for Bitcoin is the same as Gold (it has the same utility in terms of storing value and is more convenient to transact). That would imply a price of about $500,000.

Personally I’m not convinced that Bitcoin will ever displace Gold but I don’t understand why the values of the two should be completely different orders of magnitude. If Bitcoin were valued at just 10% of the value of Gold that would imply a price 10 times higher than currently.

Whatever the “fair” value of Bitcoin should be, fresh demand is pushing the price up until the laws of supply and demand get us to it. As Bitcoin gains recognition, and even some Government approval, new buyers are emerging all the time: we have clearly not yet hit the fair value equilibrium.

Yes, Bitcoin prices have risen fast, but that’s because they started at zero. To argue this to be a bubble you have to have a view about what the normal valuation should be (or was). It’s not enough to say it may have been a normal price two years ago without having a thesis about why that was the case.

Bitcoin is on a journey from zero to fair value. Its rapid rise does not prove anything about what that fair value is.