I bought Bitcoin in 2013. My friend Alex and I sat on the floor of his Chicago apartment. He had been making money trading magical internet money. I didn’t understand it all, but the price of a BTC had risen from $20 to nearly $1200 that year. So I created a Coinbase account.
You know how 2014 went. My $1,200 BTCs became $200 BTCs and sentiment hit all time lows.
How stupid I was to buy in a the top of a bubble!
Now those $1,200 BTCs are $15,000 BTCs and sometimes $19,000 BTCs. And along the way BTC has picked up some companions that collectively triple the cryptocurrency market cap. BTC is up 15x YTD and everybody is wondering: are we in a bubble and is it bursting?
Some think it’s a massive Ponzi (or Nakamoto) scheme that will crash to zero and some predict $1M+ BTC. People seem to either think it’s a bubble and the price is going to zero or it’s not a bubble and the price is going to the moon. So which is it?
What makes a bubble?
We seem to define bubbles as overpriced markets that will eventually pop — correcting to its much lower deserved price. We also seem to attach to it a fatality: if it’s a bubble and it pops, it’s dead. And that’s that.
Let’s start with how a market gets so high. We’ll use a dumb example to illustrate the principles.
 People make money and tell their friends
John buys an asset and the next day someone buts it from them for 1.5x. That’s great. The next day, people buy it for 2x.
 People tell their friends
John goes and tells Susan about this asset and how it keeps going up in value. Susan buys the asset, increasing demand for it. The value continues to go up. Susan tells some of her friends and they buy it, further increasing demand.
This cycle continues as long as the number of people willing to buy the asset is higher than the number of people willing to part with it. Nobody is selling, because the asset holders have high confidence that the price will continue up. Increased demand drives the price of the asset up.
 The media tells the people
The news media starts to cover the rapidly rising price and suddenly more and more people are hearing about how great an investment this asset is. They’re hearing that people are getting rich by investing in this asset.
Tim is skeptical. But isn’t this crazy? Why would something be worth so much more now than before?
 A new era is declared
Well Tim, everybody explains, it’s a new era. This asset introduces a whole new level of productivity or technology or whatever. That’s why it is fundamentally valued so much higher than prior markets.
 Sentiment is overwhelmingly positive
On and on it goes. More and more people are more and more willing to invest in this market while existing participants continue to hold onto their assets because they too believe the price will only grow, rationalizing it with the belief that they’re participating in a shift into a new era.
What’s happening here? The key outcomes are twofold: (1) participants in the market are highly confident that the price will continue to go up and (2) new participants, emboldened by the confidence of the market, enter the market and continue to drive demand.
A positive reinforcement loop is at the core of this dynamic. Participants keep making money so they think that they’ll continue to make money. New participants are exposed to this confidence through word of mouth, the media, etc. and develop the same confidence that the market will continue to go up and invest their own money in.
Everybody is making money but at some point, enough is enough, right? Smart money will look at this ever-increasing market value and say, “boy this looks overvalued, why would I buy into this? Maybe I should sell.”
That’s where the “new era” outlook kicks in. A story spreads that this market reflects a new era (e.g. technology, productivity, earnings). Prior earnings in other markets don’t reflect the potential of this one. This is the new thing and you’re smart for catching the rise of the new era. Belief in the new era instills confidence that the price will continue to rise, even if all prior data points suggest that it’s overpriced.
Isn’t this a Ponzi/Pyramid/Nakamoto scheme?
No. While the flow of capital resembles a Pyramid scheme where new participants drive increases in price to the benefit of prior participants. But this is how speculative markets work.
Let’s take a look at the years leading up to the 2000 dot com bubble and crash.
- People make money: The stock market was soaring. Everybody was making money in the stock market.
- People tell their friends: Friends and family shared investment tips and got more and more people into the market.
- The media tells the people: The media reported on massive gains in the stock market, increasing the legitimacy and salience of the market.
- A new era is declared: The dot com concept was accepted as a “new era” in the economy. This new technology would fundamentally raise the economy to the next level, which is why there were these crazy returns to be had.
- Sentiment is overwhelmingly positive: Sentiment was so high that 95%+ of individuals believed the price of stocks would be higher in the future than they were at the time of being surveyed.
Altogether, these factors produced an environment where people felt like stocks were the safest, most effective way to invest money.
Then the crash. The NASDAQ fell 78% over a three year period. It felt like the end of the world and it depressed the market for quite some time, but look where we are now: 50% higher than the previous peak.
The dotcom bubble also had some critical positive externalities in the development of the internet. Without the wildly bullish outlook, we collectively would have invested less in the innovation that powers our lives today.
BTC follows the same bubble-making pattern:
- People make money: BTC is soaring. Everybody is making money on BTC.
- People tell their friends: Friends and family shared crypto tips over Thanksgiving and stuff.
- The media tells the people: The media can’t shut up about Bitcoin. Twitter, reddit, telegram communities spread like dengue. A 24h market accelerate the velocity of news.
- A new era is declared: Crypto becomes a religion to many — freedom from fiat and government, an open and decentralized future.
- Sentiment is overwhelmingly positive: Sentiment is so high that the twitter polls I’ve seen show people think the price is going up.
So is a crash coming?
Only if the mechanics of the bubble stop working:
The positive feedback loop breaks
- People stop making money (this is why periodic corrections are good)
- We run out of people to tell
Faith in the new era is lost
- The technology is proven to be fundamentally broken
- A new technology disrupts the current market
- Regulatory and other risk threaten the vision of the new era (includes theft, seizure, exchange closing, etc.)
How are we doing? The positive feedback loop is working great and faith in the new era is still largely intact.
But what if there’s a crash?
As the dotcom bubble shows, a popped bubble isn’t always fatal. We’ve seen four massive “bubbles” and subsequent crashes in Bitcoin alone (one in 2011, two in 2013, and one in 2017) and it’s not dead. We’ve also seen some epic bubbles to crashes in the US market in the 20s, 60s, 2000, and 2010. Neither are dead. In fact, both are higher than ever.
Luckily for us, crypto moves faster than normal markets. So even a dotcom crash with a 10+ year recovery might look like a 1 year recovery (like the 2014 BTC crash) or shorter (like the summer 2017 crypto crash). Even if the bubble pops today and the market crashes, we may see it recover to the same, and if history is any indication, higher, levels.
So yes, we’re in a bubble, but there’s no alternative. Speculative bubbles fuel innovation but bubbles are not fatally risky. Even if the bubble bursts, if you zoom out, there’s still a good chance we end up on the moon.
Thanks to Lakshman Sankar, Gary Sheng, and Anthony Gonzales for reading early copies of this draft