Bryan Caplan  

Illusory Bubbles

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Scott Sumner succinctly explains how illusory bubbles can appear in a world ruled by the Efficient Markets Hypothesis:

How should Bitcoin be priced?  If there is a 95% chance that it will soon be worthless and a 5% chance that it will soon hit $1000, then $30 seems like a relatively fair price.  That allows for a substantial expected gain ($50 minus interest costs would be the risk-neutral price.)  But Bitcoin is very risky, so investors need to be compensated with an above average expected rate of return.

Now consider a point in time where the asset is selling at $30, and investors have not yet discovered whether it will eventually reach $1000.  Should you predict that the price is a bubble?  Yes and no.  It is likely to eventually look like it was a bubble at $30.  Indeed 95% of such assets will eventually see their price collapse.  That's "statistically significant."  It's also significant in a sociological sense.  Those that call "bubble" when the price is at $30 will be right 95% of the time, and hence will be seen as having the "correct model" of bubbles by the vast majority of people.  Those who denied bubble will be wrong 95% of the time, and will be seen as being hopelessly naive by the average person.  And this is despite the fact that in all these cases there is no bubble, as by construction I assumed the EMH was exactly true.

Conclusion:

I predict that eventually the price of Bitcoins will fall sharply (from some level of which I am not able to predict) and people will vaguely recall:
"Wasn't Scott Sumner the guy who denied Bitcoins was a bubble?  What an idiot."
Of course, this story is a lot easier to believe for weird new assets like Bitcoin than for familiar old assets like the entire U.S. housing stock - especially when investors actually wrote down their probability distributions.



COMMENTS (6 to date)
Andre Mouton writes:

Agreed - probabilities change, and even to invoke them is to turn economics into an actuarial exercise that it certainly is not. The relevant probability here is that, given Sumner's staunch support of monetary largess, there is a 100% chance that he will deny the presence of a bubble; just as there was a 100% chance that, given Krugman's views on currency, he would predict that Bitcoin was in one.

Probabilities tend to measure the bias of the person making them, and I don't see how we can discuss either bubbles or economics without giving due weight to the role played by belief -- that capricious wind that drives so many things *cough efficient market theory cough*.

Hazel Meade writes:

IMO, Bitcoin is clearly a classic bubble. And it is so precisely because there are a sufficient number of people who deny it.

Bubbles can't exist without true believers. This was the case with the housing bubble, where it was conventional wisdom that housing prices would always rise. It was the case in the dot-com bubble, where people were writing DOW-50,000 books, and predicting the singularity in 10 years. It was the case with "Peak oil" and oil prices.

It's so terribly frustrating because lots of people WANT to believe in Bitcoin as an alternate currency. But the enthusiasm of the true believers is precisely what is driving the ability of the bubble to inflate, and it will be the true believers who get left holding the bag (of worthless Bitcoins) when the bubble pops.

Wonsil writes:

Sometimes the answer is just simple supply and demand. There is a new piece of malware that encrypts all of your files on your hard drive. In order to decrypt your files, you must pay a ransom in Bitcoin because Bitcoin is anonymous and harder to trace than credit card transactions. The original price to get your files back was two Bitcoins but since the rise in price, the thieves have found that people weren't paying the $2000 ransom so the they are are now asking for less. $300 - $500 US seems to be the sweet spot.

http://arstechnica.com/security/2013/11/soaring-price-of-bitcoin-prompts-cryptolocker-ransomware-price-break/

It would be interesting if the thieves change their pricing to equivalent dollars and then see what the price of Bitcoin does.

PJ hatz writes:

Bad:
if genghis khan was beheaded, he is dead
GK is dead
therefore, GK was beheaded

Even worse:
if EMH is true, falling prices can happen but are not bubbles
falling prices do happen
therefore there are no bubbles


Hamood writes:

Hi Bryan,
I am taking an economics class, and we discussed bit coin as an accepted form of money.
Do u personally think it is going to be an widely accepted form of payments in the near future?why?

Please reply.

David James writes:

Widely accepted in the online world might be feasible, because as we progress into future alternative and more secure ways of making payments while not actually having the cash on you makes doing bitcoin business relatively safe once proper security protocols are established.

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