Bitcoin: A tulip-mania blended with hawala?

Economic bubbles, such as the dot-com bubble of the late 1990s and the subprime mortgage crisis of 2008, occur when too much money chases too few assets. Such bubbles ought to burst.

The dynamics of Bitcoin is often compared with the tulip-mania of the 1630s in the Netherlands, perhaps the most famous bubble in history. Tulips, then newly introduced and fashionable flowering plants, became a status symbol for Holland’s newly wealthy merchant class around that period, and the price of tulips skyrocketed because of speculation in tulip futures among people who never saw the bulbs. At the peak of tulip-mania, some single tulip bulbs sold for more than 10 times the annual income of a skilled artisan.

The world’s first futures contracts emerged in Holland when the tulip bulbs couldn’t be moved during October through March and in 1636, the Dutch created a formal futures market, where contracts to buy the bulbs at the end of a season were bought and sold. Such tulip contract trading was known as ‘windhandel’, meaning ‘wind trade’ – the tulip bulbs themselves weren’t traded, only the ability to buy the bulbs at a certain price at a certain point in the future was traded.

The prices of the contracts kept rising with every changing hand – people purchased tulip bulbs at astronomical prices, with an intention to make profits by selling them in the future. Some bulb contracts were reportedly changing hands 10 times a day. The bubble intensified. However, an outbreak of bubonic plague in the Dutch town of Haarlem in February 1637 ultimately caused the bubble to burst. The demand for the flowers disappeared, resulting in a crash in prices, and people holding contracts or having bulbs could see that the tulip was manifold cheaper in the tulip spot markets. In 2013, while addressing students at the University of Amsterdam, former president of the Dutch Central Bank, Nout Wellink, said that the hype around Bitcoin “is worse than the tulip mania. At least then, you got a tulip [at the end], now you get nothing.”

Bitcoin recently slumped over 18 per cent from a lifetime high of around $58,300 within days after Tesla chief Elon Musk tweeted that the prices “seem to be high.” Tesla recently announced that it added $1.5 billion in Bitcoin to its balance sheet and, as a result, its shares slid 8.6 per cent, wiping $15.2 billion from Musk’s net worth. He dropped to second place on the Bloomberg Billionaires Index of the world’s 500 richest people. This might give an indication of the high volatility in Bitcoin prices and the lack of tangible backing. Its price volatility, in fact, is 80 per cent, which is 12 times higher than that of the Euro.

How are crypto-assets like Bitcoin to be characterised? Back in 2015, the US regulator for the futures market, the Commodity Futures Trading Commission, declared: “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”

Nouriel Roubini, a professor of Economics at the New York University, who accurately predicted the 2008 financial crisis two years before Lehman Brothers declared bankruptcy, considers Bitcoin a “pseudo-asset” that is pumped up by “massive manipulation”. Some assets give income, and therefore there is a reason for the capital gain. Assets such as real estate give housing services. And although gold doesn’t have income, it is used for multiple purposes from industry to jewelry and for liquidity and has a store value for thousands of years. Bitcoin, on the other hand, doesn’t have any intrinsic fundamental value – neither income, nor any uses in industry, nor any utility.

Now, about the functioning of bitcoins. Some people find Bitcoin similar to hawala. Hawala is the system of transferring money and property in a parallel arrangement, avoiding the traditional banking system. Suppose that from the country ‘Alpha’ a person named ‘A’ wants to send money to another person ‘B’ located in country ‘Beta’. ‘A’ deposits the money with a specified grocer in his country, passes on the information to ‘B’, and ‘B’ collects the money from a specified shopkeeper in his country. It is as simple as this. The money reaches quickly and also escapes the due tax. Such a fully trust-based system has a long-standing presence in the Middle East, North Africa and the Indian sub-continent and South Asia.

Unlike hawala, which generally has no public (or even written) record of transactions, the details of each transaction report of Bitcoins are available in a secured ledger called ‘blockchain’. From this open source, anybody can tell how many Bitcoins are traded at some specified public key. But nobody knows who the owner of those Bitcoins is, or who is sending and receiving virtual money, with their location also being hidden.

India is very much unimpressed with such a decentalised digital money as it carries great risk of deception, fraud and terrorist financing. Ahead of the government’s plans to introduce a law to ban private cryptocurrencies, the RBI has expressed concern that cryptocurrencies would impact financial stability in the economy. Cryptocurrencies are already banned in some countries.

The bubble of the new tulip-mania is, however, becoming bigger, and a part of the private sector is embracing it. Tesla, for example, said it would start accepting Bitcoin as a payment method for its products. “It’s a totally speculative play on a bubble that is self-fulfilling,” Nouriel Roubini thinks. Its similarity to hawala, its very nature of anonymity and lack of control, however, might be the major reasons for officialdom’s scepticism towards it in many parts of the post-9/11 world. Maybe rightly so.

(The writer is a professor of Statistics, Indian Statistical Institute, Kolkata)