Irrational Exuberance in the Bitcoin Market: Failure to Learn from History

Irrational Exuberance in the Bitcoin Market: Failure to Learn from HistoryEyub YegenSThe Role of Information in Economics and FinanceGuidance to make effective and efficient decisions. Achieve the optimal level of benefit.Rational Behavior (Marschak, 1950).Data is used to develop empirical models.

The Neoclassical School of ThoughtNo government regulation that interrupts the normal business cycle (Friedman, 1990).Market efficiency hypothesis (Fama, 1998).Investors always behave rationally.Chicago school of economics.Influence on Wall Street.

SHistory tells a different storyMiscalculation of the true value of an innovation.Irrational exuberance (Shiller, 2008). The subprime mortgage crisis & the Dutch Tulip Bubble of 1637.Innovation (MBSs, tulip contracts).Speculation & over-optimistic expectation of prices.Ignoring information that is provided by the market.

History tells a different storyLong-term cost of having a crisis > short-term cost of government regulation (Stiglitz, 2009). Destroyed over $10 trillion worth of economic value (Baker, 2008). No regulation (primary cause of crisis).

BitcoinDigital Currency (innovation).Peer-to-per payment system.No transaction costs (short-term benefit).Limited supply (no inflation).Not backed by a central bank.No regulation in the U.S. Complex Bitcoin Mining Algorithm.

Similar characteristics to previous bubblesNo intrinsic value such as gold.Not regulated by the government.Difficult to calculate the true value.Overestimation. Speculative purpose.

Kindleberger-Minsky Model of Panics and CrashesIdentifies the stages of a bubble by using empirical data. Three stages: manias, panics, and crashes.Mania: A business cycle expansion. Cash chases assets. Panic: Demand for liquidity and safe assets. Crash: The Final Outcome. Price returns to its overall mean.The Tulip Bubble of 1637More than 10 times the annual income of a skilled craftsman. (Mania)Some investors decided to sell. Prices began to dive. (Panic)Dealers refused to honor contracts. Prices went down suddenly. (Crash)

The Subprime Mortgage CrisisSome house prices appreciated by 80% from 2001 to 2006. (Mania)In 2007, house prices went down by approximately 20%. (Panic)In 2008, value of MBSs went down to almost zero. (Crash) Fannie Mae and Freddie Mac lost $5 trillion.

The Mt. Gox Exchange Market CrashIn October 2013, 1 bitcoin = $1,200. (Mania)In December 2013, China banned bitcoin transactions. (Panic)February 25th, 2014, last day of trading before the crash.1 bitcoin =$173.20.

The Mt. Gox Exchange Market Crash

Exchange Market

Mean of weighted prices

Standard DeviationTrading DateTrading PriceTrading price/MeanMt. Gox Bitcoin Exchange Market

$148.47$267.99

02/25/14

$173.20

117%

All Bitcoin Exchange Markets

$113.13$228.19

05/13/14

$439.40

338%All Bitcoin Exchange MarketsHigh volatility. (Speculation)Overall Mean =$113.13Standard deviation=$228.19Price of 1 bitcoin = $439.40(Mania)

All Bitcoin Exchange Markets: When will the bubble burst?

The Argument of Neoclassical School of Thought has failedU.S. government officials has raised issues. Banning bitcoin transactions will create panic in the market.Investors ignore information that is provided by the market.Investors behave irrationally.Still millions of dollars invested in the bitcoin market.History repeats itself.

Conclusion: Failure to Learn from HistorySir Winston Chruchill: Those who fail to learn from history are doomed to repeat it. Investors in general behave irrationally from time to time. Ignoring information provided by the market. Bitcoin investors have failed to take a lesson.Have to face the consequences of their erroneous and ignorant actions.

SourcesData: www.quandl.comPictures:www.nytimes.comwww.taxresearch.org.ukwww.geek.comwww.extremetech.comwww.matemedia.comwww.media.spokesman.comwww.ibreak4bacon.comwww.2.bp.blogspot.comwww.kilianbutler.wordpress.comwww.cagle.comwww.chrispacia.files.wordpress.comwww.econ.yale.edu/~shiller/www.uchicago.eduwww.threattracksecurity.com

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