Bitcoin kills the efficient market hypothesis (now with full article)

I have a piece in the New York Times looking at the implications for the bitcoin bubble for economic theory and, in particular, for the (Strong) Efficient (Financial) Markets Hypothesis (EMH) which states that prices determined in financial markets reflect all the available information about the value of any asset. If that’s true then governments can’t improve on a policy of allocating investment to those assets with the highest market return, which can be achieved by letting private capital markets determine all investment decisions.

Bitcoins have no inherent usefulness, being a record of pointless calculations. They are useless as a currency (their putative purpose) and are now being promoted as a store of value on the basis of scarcity alone. This leaves supporters of the EMH with a dilemma.

If Bitcoins are indeed worthless, then financial markets should price them at zero. But the introduction of futures trading actually boosted the price in the short run. Even after recent declines, there’s no sign that prices will reach zero any time soon.

On the other hand, if Bitcoins are valuable simply because people value them, then asset prices are entirely arbitrary. The same argument can be applied to any financial asset.

Dean Baker at CEPR has a nice followup, making the obvious but crucial point that, since financial services are an intermediate input to production, we want the financial sector to be as small as possible, consistent with doing its essential tasks. As the experience of the mid-20th century shows, a market economy can function perfectly well with a financial sector much smaller than the one we have today. As Bitcoin shows, the massive expansion since then is nothing but wasteful speculation. The financial sector should be cut down to (a small fraction of its present) size.

What Bitcoin Reveals About Financial Markets

The spectacular increase and recent plunge in the price of Bitcoin and other cryptocurrencies have raised concerns that the bursting of the Bitcoin bubble will cause financial markets to crash. They probably won’t, but the Bitcoin bubble should finally destroy our faith in the efficiency of markets.

Since the 1970s, economic policy has been based on the idea that financial market prices reflect all the information relevant to the value of any asset. If this is true, market prices are the best estimates of the value of any investment and financial markets should be relied on to allocate capital investment.

This idea, referred to in the jargon of economics as the efficient market hypothesis (technically, the strong efficient market hypothesis), implicitly underlay the deregulation of financial markets that started in the 1970s. Although rarely stated now with as much confidence as it was during its heyday in the 1990s, the efficient market hypothesis remains a background assumption of much central-bank and economic policy.

The hypothesis survived the absurdities of the dot-com bubble in the late 1990s and early 2000s, as well as the meltdown in derivative markets that led to the global financial crisis in 2007 and 2008. Although the hypothesis should have been refuted by those disasters, it lived on, if only in zombie form.

But at least each of those earlier bubbles began with a plausible premise. The rise of the internet has transformed our lives and given rise to some very profitable companies, such as Amazon and Google. Even though it was obvious that most 1990s dot-coms would fail, it was easy to make a case for any of them individually.

As for the derivative assets that gave us the global financial crisis, they were viewed favorably in light of a widely held theory, known as the “great moderation,” that suggested that major economic crises were a thing of the past, thanks to certain systemic changes in the way developed nations ran their economies. The theory was backed by leading economists and central bankers. Asset-backed derivatives were, ultimately, a bet on the great moderation.

The contrast with Bitcoin is stark. The Bitcoin bubble rests on no plausible premise. When Bitcoin was created about a decade ago, the underlying idea was that it would displace existing currencies for transactions of all kinds. But by the time the Bitcoin bubble took off last year, it was obvious that this would not happen. Only a handful of legitimate merchants ever accepted Bitcoin. And as the Bitcoin bubble drove up transactions charges and waiting times, even this handful walked away.

For a while, Bitcoin was used for transactions that people wanted to keep secret from government authorities, like drug deals. It soon became apparent, however, that if authorities wanted to track these transactions, they could. For instance, Silk Road, the first major online drug market, which made use of Bitcoin, was shut down by the F.B.I. in 2013.

Hardly anyone now suggests that Bitcoin has value as a currency. Rather, the new claim is that Bitcoin is a “store of value” and that its price reflects its inherent scarcity. (By design, no more than 21 million Bitcoins can be created.)

Most economists, including me, dismiss this claim. And if the claim is false, Bitcoin’s value is obviously another deadly strike against the efficient market hypothesis.

But even if the claim is true, the idea that Bitcoin is valuable simply because people value it and because it is scarce should shake any remaining faith in the efficient market hypothesis.

Consider: If Bitcoin is a “store of value,” then asset prices are entirely arbitrary. As the proliferation of cryptocurrencies has shown, nothing is easier than creating a scarce asset. The same argument would apply to any existing financial assets. Any stock in the S & P 500 could be priced not in terms of future earnings prospects but on the basis that people choose to value it highly.

Suppose, more plausibly, that Bitcoin has no underlying value and will eventually become worthless. According to the efficient market hypothesis, financial markets will correctly estimate the true value of Bitcoin and will drive the price to zero immediately.

But that hasn’t happened either. Until recently, it wasn’t even possible because the Bitcoin markets were themselves as opaque as the currency.

Now it is possible: Futures trading for Bitcoin on the Chicago Mercantile Exchange has been going on since December. But Bitcoin prices rose after the creation of futures trading and began their sharp decline only when governments took measures to limit speculation.

Current futures contracts in Bitcoin extend as far as June of this year. According to those contract prices, the market expects Bitcoin to retain its current value well into the future.

Whatever happens to Bitcoin, we must not lose sight of a more fundamental — and more worrisome — development: A financial product with a purely arbitrary value has been successfully introduced in the world’s most sophisticated financial markets.

Bitcoin probably won’t bring financial markets crashing down. But it shows that regulators need to cut those markets down to size.

34 thoughts on “Bitcoin kills the efficient market hypothesis (now with full article)

  1. Icono you are too kind.

    i’ve been wrong so many times in my life it’s no problemo at all to go

    “oh, so that’s how you don’t do it”

    bravery doesn’t come into it.

    what i can’t understand is what possible benefit can be found in grimly holding on to a situation one knows is not in line with reality when doing so is going to cost you.

  2. «Dean Baker at CEPR has a nice followup, making the obvious but crucial point that, since financial services are an intermediate input to production, we want the financial sector to be as small as possible, consistent with doing its essential tasks.»

    Finance like say accounting or firefighting is indeed a cost, an intermediate input, but so are a lot of services. But the national statistics community seem very keen to “improve” GDP by any means available, so they often revise the “methodologies” used to compute the GDP index to includes intermediate inputs, quality improvements, etc., as much possible. Probably it is “just a coincidence” that this ends up flattering the debt-to-GDP ratio.

  3. Bitcoins are just one of the vast array of crypto currencies out there at the moment. The media fascination with only bitcoins is not surprising. The principle of observation is that if it moves around human interest is stimulated. The difference between gold and bitcoins is that sometimes the price of gold is relatively stable. But the price of bitcoins moves continuously. It is the “look at me” syndrome. Meanwhile other crypotocurrency go on their merry way unnoticed by mainstream media outlets. John Quiggin points out the weakness of the efficient market hypothesis for financial assets. Bitcoins and other ‘stealth’ crypto currencies are an excellent case study of the warping of block chains by excessive speculation.

  4. @hc
    Gold has significant inherent engineering value. It is a malleable electrical conductor that doesn’t oxidise in normal conditions. If it was as common and cheap as copper it would be used for house wiring. It is used for special electical applications, eg, connectors and IC chips, among other niche uses. That is not to say that its price is largely determined by the cumulative actions of speculators. It is. I wonder what its history would have been if it wasn’t shiny, after all there are lots of scarce things.

    The only possible real value of bitcoin I see is heating your home.

  5. Even Bloomberg is giving you well deserved plug, John

    The Economy Is Full of Crypto (And Collective Delusion) – Bloomberg
    John Quiggin arguing that “the Bitcoin bubble should finally destroy our faith in the efficiency of markets.” In particular, he notes that Bitcoin is a terrible currency, and then dismisses the alternative argument that Bitcoin’s value comes from its usefulness as a store of value:
    https://www.bloomberg.com/view/articles/2018-02-11/the-economy-is-full-of-crypto-and-collective-delusion

    https://www.theguardian.com/technology/2018/feb/08/bitcoin-what-the-experts-have-said

  6. “That is not to say that its price is largely determined by the cumulative actions of speculators. It is.” I agree.

    There are several other uses of gold – e.g. as tooth fillings etc but most gold is not used, In this sense it is analogous to bitcoin. Something scarce that is “mined” with increasing extraction costs.

    The main difference with bitcoin is that it has relatively low social acceptability and/or a negligible history.

  7. I’m reminded that tobacco was sometimes used as currency. If its value fell too much, you could always smoke it.

  8. A penny dreadful mining exploration company that I have followed in the past (to my regret) has made losses for each of the past 10 years. It has several exploration sites that it owns or co-owns, but none is anything close to a producing mine – indeed at some “promising” sites, only a single drill sample has been analyzed. Several of the sites are in Africa. The firm is capitalized at about $40m but has cash at the bank of only about $500,000. Over the past 6 months, it spent $1.7m on “administrative and corporate costs” (it pays its CEO $700,000 annually) and it spent about $900,000 on “exploration and evaluation” activities. It is scheduled to spend about another million over the next quarter on “exploration and evaluation”.

    To me, it isn’t just Bitcoin that raises questions about the rationality of investor expectations. Of course, the firm might strike it rich – I might win Tattslotto too – but a market capitalization of $40m suggests more than a little exuberant optimism. A reasonable question can be raised as to whether it is a going concern – but new issues of stock to credulous investors can keep it ticking over I suppose. It has 700 million shares out there now. A few more hundred million will not make too much difference and once the amount of script gets to a billion or so the board can decide on a 10 for 1 share consolidation and start off the money-mining operation again.

  9. I don’t advocate a monopoly of metallic monies. But the good thing about metallic monies, if there were enough of them, they would be pretty costless. Now don’t scoff. Obviously historical events like the California gold rush, or worse still the Klondike …. these involved enormous dead-weight loss. But thats because we were so dependent on gold and silver. Gold is way overpriced in my view but silver is way underpriced. If we had a broad base of digitalised metal monies, the premium price of the money metals would reduce the cost of bringing up the base metals.

    Nothing wrong with government fiat money. It is after all a tax voucher. Its debt as money that is the problem. Non-cash money-supply that carries interest. Thats what we want to avoid. We want more cash than debt and many different types of cash that will hold value.

    Bitcoin is really a joke. It costs $1000 dollars to “mine” a bitcoin. And this is pure dead-weight loss with no redeeming feature. Just computers running solving mathematical problems. What a senseless waste of energy. Its failed as a money because there is no stability of value. I like the idea that you can cross borders without carrying a bag of silver, perhaps on the run, and still get value across the border. But that could be achieved with digitised 100% backed titanium. We don’t need to go to the extreme of buying fresh air to get that effect.

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