The Bitcoin market isn’t irrational

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Feb 07, 2018

Sections Finance

Bitcoin has been around 10 years, but it’s still making headlines. It has shot up in value in the last year—as I write in December 2017, around $15,000. But the price is volatile. Today, the day I’m writing this, it’s gone from a daily high of $16,269.69 to a daily low of $13,957.91, a 16 percent swing in a day. It’s up more than 650 percent since mid-July, but over two weeks in December, it lost more than a third of its value. [And since this was drafted, it's lost considerably more.—Ed.]

What the heck is up with Bitcoin? Is it a bubble? A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some “excess valuations” in stock markets, gold and commodities, and money itself.

Let’s put the pieces together. The first concept of asset pricing is that price equals the expected present value of dividends. Bitcoin has no cash dividends and never will. So right off the bat we have a problem—and a case that suggests how other assets might have value above and beyond their cash dividends.

If the price is greater than zero, either people see something that acts like a dividend, some value in holding the asset beyond its cash payments, or they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two explanations are called “convenience yield”; the latter is a “rational bubble.”

Rational bubbles are intriguing but fundamentally flawed. If a price goes up forever, eventually the value of Bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. This greater-fool theory, or Ponzi scheme theory, must break down at some point, or rely on an irrational belief in the next fool. The rational-bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let’s think about convenience yield. Why might someone be willing to hold bitcoins even though their price is above their fundamental value—even though their expected return over a decently long horizon is lower than that of stocks and bonds, or even though we know pretty much for sure that within our lifetimes Bitcoin will become worthless? 

The point here is that there is a perfectly rational demand for Bitcoin, as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth.

Well, dollar bills have the same feature. They don’t pay interest, and they don’t pay dividends. By holding dollar bills, you hold an asset with a fundamental value of zero, and with an expected return lower than that of, say, one-year Treasuries. One-year Treasuries are completely risk-free, and over a year they will give you about 1.5 percent more return than dollar bills. This is a pure arbitrage opportunity, which isn’t supposed to happen in financial markets!

It’s pretty clear why you still hold some dollar bills or their equivalent in noninterest-bearing accounts. They are more convenient when you want to buy things. Dollar bills have an obvious convenience yield that makes up for the 1.5 percent loss in financial rate of return. That convenience acts as a dividend flow, or equivalently justifies the subnormal return. If you do not measure the dividends of stocks or the coupon payments of bonds, they look overpriced too. 

Moreover, nobody holds dollar bills for a whole year. You minimize the use of dollar bills by going to fill up at the ATM occasionally. And the higher that interest rates are, the less cash you hold and the more frequently you go to the ATM. So, already we have an overpricing—dollars are 1.5 percent per year higher priced than Treasuries—that is related to “short-term investors” and lots of trading—high turnover—with more overpricing when there is more trading and higher turnover—just like Bitcoin. And just like 1999 tech stocks. And 1630s tulip bulbs.

Where is the convenience yield for Bitcoin? Some of the convenience yield of cash is that it facilitates tax evasion, and allows for illegal voluntary transactions such as drugs, bribes, and hiring undocumented workers. 

These arguments for the convenience yield of cash hold at least as well for Bitcoin, and this yield seems to be one obvious reason some people are willing to hold Bitcoin for some amount of time, even though they may know it’s a terrible long-term investment. It certainly facilitates ransomware. It’s great for laundering money. And it’s great for avoiding capital controls—getting money out of China, say. 

One can have a fun argument whether these uses of cash for anonymous transactions are good or bad. But that is beside the point here. The point here is that there is a perfectly rational demand for Bitcoin, as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth.

We can think of Bitcoin as an electronic version of gold. And for those economists who long for a return to gold-based currency, Bitcoin’s wild price swings should serve as a clear warning.

On top of this fundamental demand, we can add a speculative demand. Suppose you know or you think you know that Bitcoin will go up some more before its inevitable crash. In order to speculate on Bitcoin, you have to buy some bitcoins. So as we also see in high-priced stocks, houses, and tulips, high prices come with volatile prices and large trading volumes. Someone speculating on Bitcoin over a week cares little about its fundamental value: even if you told her that Bitcoin would crash to zero for sure in three years, it would make essentially no dent in her trading profits, since you can make a lot of money in a volatile market over the course of a week if you get on the right side of the volatility. 

Moreover, there is good reason to suspect a lot of the asymmetric information that motivates trading. There are no earnings reports or analysts to tell you just how many drug lords or ransomware hackers are likely to want to buy Bitcoin next week. 

To support a high price, you need restricted supply as well as demand. There are only so many bitcoins, as there are only so many gold bars, at least for now. That will change. The Achilles’ heel of Bitcoin’s long-term value is that there is nothing to stop people from creating Bitcoin substitutes—there are already hundreds of similar competitors. This is why I have such low expectations for Bitcoin’s long-term value. Moreover, there is nothing to stop people from creating private claims to Bitcoin (Bitcoin futures) to satisfy speculative demand. In fact, Bitcoin futures began trading through both the CBOE and the Chicago Mercantile Exchange in December 2017. 

But all that takes time. And the demand I’m describing doesn’t come from people who want to hold Bitcoin for very long. Ice cream is also a fast-depreciating asset, but people are willing to hold it for a little while. In this view, however, Bitcoin remains a terrible buy-and-hold asset, especially for an investor who plans to pay taxes.

In sum, what’s going on with Bitcoin seems to me like a perfectly normal phenomenon, one that we have seen many times before. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus a temporarily limited supply of substitutes, and you get a price surge and great price volatility. Unlike the bubble and irrationality views, this view makes definite predictions: an “overpricing” relative to dividends comes only with restricted supply, limited substitutes, and large volume. The bubble and irrational views neither require nor explain the latter connections. (I describe this view in more detail with several other instances of the phenomenon in a paper titled “Stocks as Money,”* which is available here.) 

Bitcoin is not a very good currency. It is a pure fiat money (no backing), with a value that comes from limited supply plus the sources of demand I’ve outlined. As such, it has the huge price fluctuations we see. 

In fact, we can think of Bitcoin as an electronic version of gold. And for those economists who long for a return to gold-based currency, Bitcoin’s wild price swings should serve as a clear warning.

My bet is that alternative cyrptocurrencies with stable values—always worth a dollar—and very low transaction costs will prosper in the role of money, at least until there is a big inflation or sovereign-debt crisis, at which point a stable-value cryptocurrency not linked to government debt will become awfully attractive.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.