Bitcoin kills the efficient market hypothesis (full article is now over the fold)

by John Quiggin on February 9, 2018

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.

{ 55 comments }

1

Tim Worstall 02.09.18 at 1:58 pm

Re the value of Bitcoin, to repeat an earlier observation. Options have value. That something crashes to zero does not mean that the correct value was zero all along. If something *might* work then there’s a value, a true and valid one, in between the starting and terminal values of nothing.

This does mean that even in an EMH world (and no, not a huge supporter of the strong, perhaps the semi-strong though) we cannot conclude that markets have it wrong because a price becomes nothing. Carillion went bust recently – that doesn’t mean that it was an EMH violation that the shares had value three years ago. So with Bitcoin. Unless your statement is that it could not possibly, ever, have worked in any manner then the existence of a positive price at some point isn’t a disproof of the EMH.

As to this:

” 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.”

Hmm, OK, but other things have changed too. From Zucman and Saez we can see that there’s been a vast change in the portion of national wealth in pensions. That implies a larger financial sector, no? We do sorta need that given the increase in lifespans. Insurance seems to be a superior/luxury good. A richer world would have more of that, a larger financial sector. Then there’s corporate financing itself. Conglomerates self-financing internally has changed to – to an extent at least – sticking to the knitting in one line of business. Financing new ventures through capital markets, returning profits from successful ones to the markets. Not being allocated internally within those conglomerates. This last, for here at least, is not an insistence that the new method is better. Just that it is different, the difference having import for the size of the financial sector. And reducing – however done – that sector back down to some previous size will, presumably, mean reversion to that older method of corporate financing. Maybe a good thing, maybe not, but still worthy of consideration.

“Works” as Dean says, perhaps, but in a different manner.

2

BruceJ 02.09.18 at 4:04 pm

Well, Bitcoin is a fiat currency, designed by people with no real concept of how fiat currencies work, except the dogma ‘two legsfiat currency bad!four legs hard currency good!’

The scarcity part was a deliberate design decision, building permanent deflation into the very definition of ‘Bitcoin’, again, because it was designed by people without any clear understanding of how currency works.

So they built a fictional gold bar; albeit one that increasingly costs gargantuan amounts of energy and hardware to create and maintain.

They had the noble (in their minds) aim of wresting control of money from (again, by dogma) evil governments and central banks and restoring it to the proud drug and arms dealers, computer ransomers, and the assorted shady folks libertarians who want anonymous, untraceable financial transactions based on imaginary gold bars because liberty and something something something PARADISE! PROFIT!

Because as human history clearly shows adhering to the amassing of random bits of metals as the basis of wealth and power has always lead to peace and prosperity for all!

It feels more than a little ‘Python’-ish: “Strange women lying in ponds distributing swords is no basis for a system of government hackers creating imaginary encrypted gold is no basis for a global economy. “

3

Anarcissie 02.09.18 at 5:49 pm

Bitcoin, like poker or horse races, is not valueless if people want to do it. As long as and to the extent that money is fetishized, the financial sector will grow. It’s efficient in the sense that it is directly producing objects of desire. It doesn’t have to do or enable anything material because value is not material.

4

Brett 02.09.18 at 5:51 pm

Bitcoins have no inherent usefulness, being a record of pointless calculations.

That’s premature, especially since cryptocurrencies in general are a new phenomena. If the value collapses completely and the currency becomes moribund without ever finding a use, then we could say that its value was completely irrational.

But I don’t really want to go to bat for the Strong EMH theory, because I don’t believe it (the weaker EMH theory though still seems largely correct).

5

L2P 02.09.18 at 6:44 pm

That’s a weird way of viewing “value.” An option having value doesn’t mean that the underlying good has any value. I can sell options to buy Phlogiston, but that doesn’t mean Phlogiston itself is worth anything. I can sell options to buy stock in defunct corporations, but that doesn’t mean the corporation has any value. Ideally the two should be linked in some way, but they don’t have to be.

Isn’t that the whole point of Ponzi schemes? You can sell options to whatever the scheme is, but that doesn’t mean there’s any value in the scheme itself. If there was, it wouldn’t be a Ponzi scheme. That’s why we forbid them – they don’t have any underlying value.

6

Stephen 02.09.18 at 10:08 pm

Query: If the Bitcoin apparent bubble collapses, does that disprove the EMH in a way that the collapses of previous undoubted bubbles, from Dutch tulips onwards, did not?

If so, what’s special about the Bitcoin bubble?

If not, how did belief in the EMH survive knowledge of previous collapsed bubbles?

7

peter 02.10.18 at 12:32 am

Cryptocurrencies in general, and Bitcoin in particular, have clear value in aiding money laundering, and in moving wealth across national borders in countries with capital export controls. Indeed, this latter use may have been the primary purpose for Bitcoin’s invention if it was a national intelligence agency that created it as a means of paying their foreign agents. Among the users currently believed to be major holders of Bitcoin are the governments of rogue states eager to evade sanctions. One may deplore these various applications but their value is very definitely not zero.

8

Collin Street 02.10.18 at 12:57 am

That’s premature, especially since cryptocurrencies in general are a new phenomena. If the value collapses completely and the currency becomes moribund without ever finding a use, then we could say that its value was completely irrational.

… no? That’s just arguing post-facto: if it could have had a value but the chances don’t pan out that way, then assigning it a value isn’t necessarily irrational and it doesn’t falsify the EMH.

To falsify the EMH, we need to know a-priori that bitcoin has no potential for value. Which is actually pretty unusual — even the most gratuitous bubbles are usually about things that are real businesses that might potentially make some sort of money — but for bitcoin it’s a pretty solid claim.

[if bitcoin doesn’t fall in value, then the claim “bitcoin doesn’t falsify the EMH” is itself falsified… but that’s because the underlying claim that bitcoin is inherently valueless is falsified, and the logic chain that derives from that claim also vanishes. ]

9

Collin Street 02.10.18 at 1:03 am

10

John Quiggin 02.10.18 at 5:57 am

@6 Excuses have been made for previous bubbles that can’t be made for Bitcoin. This book argues (IIRC) that the tulip boom had sound fundamentals (people really liked tulips) and that the most outrageous prices came from unenforceable bar bets

https://mitpress.mit.edu/books/famous-first-bubbles

I mention excuses for the dotcom and derivatives bubbles in the article.

11

John Quiggin 02.10.18 at 6:00 am

@1 “Unless your statement is that it could not possibly, ever, have worked in any manner then the existence of a positive price at some point isn’t a disproof of the EMH.”

A slight change in tense is needed. Even if it seemed possible in the past, it is now almost universally conceded that Bitcoin can’t work as a currency

12

Hermann Fegelein 02.10.18 at 6:27 am

The expansion of the financial sector is not wasteful speculation; it is grift, made possible by weak regulation, combined with the separation of profits from making decisions on behalf of a corporation, from losses arising from those decisions. The actual human beings who run banks have a powerful incentive to run up the volume as high as possible. If the pay themselves bonuses based on profit, they will gain in years in which the the economic cycle turns positive, and will not have to give back their bonuses during years in which the economic cycle turns negative. The same is true (only amplified) if they make decisions that increase apparent profits at a cost of later enormous losses.

13

bad Jim 02.10.18 at 8:45 am

It might seem obvious that the financial sector ought to wither as transactions become frictionless and wealth management is easily automated, but debt continues to soar; student debt alone has hit a trillion. It’s clearly a problem of scale if profits can be made by shaving milliseconds off trades.

Haldane, in “On Being the Right Size”, might have had the right perspective. A beast as large as the world economy has become is bound to be infested by commensurate parasites.

14

James Wimberley 02.10.18 at 11:53 am

(Cross-commented at JQ’s blog)

The Bitcoin bubble is a real bubble with money changing hands. But it’s paralleled by a virtual bubble in generic blockchain hype, with startups all over the place. The syllogism is classic Underpants Gnome:
1. Blockchain app
2.???
3. Profit!

JQ has a point that finance is too big, and many financial markets are obese. Do we really need a foreign exchange market turning over $3trn a day? (Some say $5 trn, but what’s a couple of trillion between friends?) But they do run efficiently in the narrow engineering sense that the transactions clear quickly and transactions costs are low. The spread on a $1m interbank foreign currency trade is apparently around 0.01%, or $100. If that’s representative, there should be 3m trades a day, between a large number of banks, say 10,000. If this were run on a distributed blockchain ledger, each bank would need a copy of the 3m daily trades, dutifully encrypted. The overhead would be monstrous. At first sight, it would be impossible to get anywhere near the costs of the current system of centralised ledgers. As far as I can make out, this is two-tier: 53 major banks jointly own a specialised settlement clearing-house in New York called CLS, which logs everything and nets out the positions at the end of each 5-hour trading day so only 53 transfers need to be made to make things all square. In turn, the lesser banks use one of the majors in a similar way.

What if anything is wrong with this system? Is it vulnerable to fraud? $3 trn is an attractive target, but when they put their minds to it, big banks are capable of designing security good enough to prevent hacking. Lack of trust? FX trading must be a small share of bank profits, and the reputational costs of cheating to other business lines would be far higher. Herstatt risk? (From a German bank that went bust in the middle of the trading day, causing temporary chaos.) I don’t know if CLS have proofed their system against this, but the blockchain projectors haven’t even heard of it and it’s hard to see how they could deal with the issue.

I suggest that this picture is replicated across other financial markets: central counterparties and settlement avoid duplication and keep transactions costs to professionals low. Trust isn’t much of a problem in practice: you need a public profile to play, and there are enough duplicate records of any transaction to provide an audit trail. SFIK very few frauds are actually committed by falsifying ledger entries, they are too easy to discover. Bernie Madoff’s books were no doubt fine in that sense, as were Enron’s.

15

J-D 02.10.18 at 9:21 pm

The reasoning that leads you to the conclusion that the price of Bitcoins will eventually decline to nil does not enable you to estimate when this will happen. As far as I can figure out, the proposition that the price of Bitcoins will eventually decline to nil is consistent with the proposition that the best estimate we have of what the real price of a Bitcoin will be at any stipulated fixed point in the future (one week from now; or one month from now; or one year from now; or whatever) is the real price of a Bitcoin now. But then, as far as I can figure out, the same is true of an investment in a Ponzi scheme; the proposition that its price will eventually decline to nil, when the supply of innocent suckers runs out, whenever that turns out to be, is consistent with the proposition that the best estimate of what it will sell for in any immediate future, when it can’t be known that the supply of innocent suckers will have already run out, is the price it’s selling at now.

Also, as far as I can figure out, the proposition that a current market price (for anything; not just a Bitcoin, or an investment in a Ponzi scheme) reflects all available information is consistent with the possibility that the available information includes information about how many suckers there are in the market, the level of their disposable funds available to be bilked, and the extent and form of their gullibility. If this is so, doesn’t it suggest that it could be true that current market prices reflect all available information, and true that current market prices are the best available estimate of future market prices, but still false that allowing markets to make all decisions about allocation of capital is the best policy?

16

Josie Wexler 02.10.18 at 11:02 pm

John you don’t seem to ever answer why you are so sure that the value of cryptocurrencies can’t simply come from facilitating illegal activity.

A recent paper found that about half of bitcoin transactions were associated with illegal trade (mostly drugs as I understand it). The ability to make anonymous transfers is clearly very useful for criminals.

17

derrida derider 02.11.18 at 10:19 am

Yes, Josie’s right. Under every bubble lies a good or service of intrinsic value – they don’t start from nothing, and often after the bust they don’t disappear to nothing either.

So long as Bitcoin is anonymously convertible into some currency, itself convertible, somewhere then it will have intrinsic value to all those who wish to avoid undue scrutiny of their business by tax or other authorities. But it will be Gresham’s law with a vengeance – given its volatility relative to useable money no-one sensible should want to hold it a moment longer than necessary. So its velocity of circulation will tend to be very rapid. So much for the “store of value” argument.

18

Collin Street 02.11.18 at 12:51 pm

John you don’t seem to ever answer why you are so sure that the value of cryptocurrencies can’t simply come from facilitating illegal activity.

The basic position is that exchange value has to be underpinned by some sort of desired-for-itself value to remain stably non-zero; there’s nothing special about exchanges for illegal purposes that alters this basic claim/conclusion.

A fortiori, in other words. Noone said it explicitly because, well. Same way nobody explicitly marked out trade in shuttlecock-manufacturing equipment or used welsh tramcars.

19

RJB 02.11.18 at 2:07 pm

I’m not sure how helpful it is to argue that the (lack of) fundamentals of bitcoin make its pricing such strong evidence against the EMH. It seems more useful to focus on the market structure. How costly is it to short bitcoins? What are the costs of holding a speculative position for a long time, long or short? Are transaction costs high or low? If shorting, trading and holding are all fairly expensive, mispricing can persist for a while without violating no-arbitrage conditions, making bitcoin mispricing fairly unsurprising.

20

John Quiggin 02.12.18 at 6:00 am

Comments 16, 17 and 19 were all addressed in the NYT article. If you disagree with what I said, there, please clarify.

21

roger gathmann 02.12.18 at 8:59 am

It is obvious, every time there is a crash, that the expanded financial sector is harmful. And every time there is a crash, the only sector that gets tender loving care from the gov. is – the financial sector.
These two facts are related. One of the great harms of an oversized financial sector is that it injects such inequality into the political economy that it inevitably shapes the government. Or, in simpler terms, with bubble wealth comes plutocrats, and with plutocrats comes plutocracy.
However, the suggestion that the financial sector is too large stops short at saying what should be done to shrink it.
Back in the progressive era, there was a word which has fallen out of use: overcapitalization. The worry, in the first decades of the twentieth century, was that the speculative aspect of the stock market was producing a kind of predator wealth, which preyed on the productive forces in the economy. As a result, the Progressive party and Teddy Roosevelt republicans did generate a program, part of which involved making the commerce department the policeman of the stock market, and part of which involved making stock prices depend not only on the “free market”, but on the real value of the assets and earnings of firms. There was even a bill that was narrowly defeated in Congress, S. 232. I do wish economic historians would look at this episode. S.232 would have prevented companies from issuing new stock for more than the cash value of their assets. It would have prevented preventing corporations from issuing stock except for the purpose of enlarging or extending the business of such corporation or for improvements or betterments, and only with the permission of the Secretary of Commerce and Labor. And – quoting Laurence Sklar, who wrote a book on this topic: ‘whenever the amount of outstanding stock should exceed the value of assets, the secretary [of commerce] would require the corporation to call in all stock and issue new stock in lieu thereof in an amount not exceeding the value of assets, and each stockholder would be required to surrender the old stock and receive the new issue in an amount proportionate to the old holdings.” In other words, there would be a ceiling on the amount of market capitalization. Such a ceiling would make Facebook, for instance, a much smaller company in the stock market then General Motors. That this is not the case is not viewed by mainstream economists as an inefficiency, which show how far the word ‘efficiency’ can be stretched.
The modern stock market is at the heart of all the rococo extravagances of the financial system. And it is treated as though it were a product of nature, instead of a product of legal malpractice. Purging it – making stock, in effect, a product of ownership rather than a poker chip – would do a great deal to cut down on the financial sector. Bitcoin, whatever its ridiculousness, is an indication of how much the financial sector has failed, how expensive it remains as technology has plummeted the cost of loaning, or indeed, moving money. What the financial sector fails to do is, well, finance most people for their needs, over a lifetime of earning in which lifecycle goods, like education, childcare and healthcare, are given the most cursory of glances by economists who believe we have been living in the Great Moderation.

22

SusanC 02.12.18 at 12:09 pm

I’m sceptical about bitcoin too, but I think the NYT article overstates its case.

For example, the arrest of one very prominent drug dealer isn’t by itself sufficient to show that bitcoin doesn’t have a niche application in illegal transactions.

Well, sure, if you were considering setting up the next Silk Road then the arrest of the Dread Pirate Roberts might make you reconsider your plan.

(There are some technical reasons why bitcoin is not ideal as an anonymous payment system. And there is a more general opsec problem, that no matter how good the cryptography is, the user will probably screw up and inadvertently reveal their identity to the authorities)

But getting arrested is a kind of occupational hazard for drug dealers, and the question is not, “has the FBI ever managed to catch someone?”, but “are people who use bitcoin for their illegal transactions significantly less likely to get caught that people using other methods?”, which a sample of one arrest isn’t really sufficient to determine.

I think the argument needs to be that the anonymity advantages, such as they are, are insufficient to make up for its other shortcomings.

23

Layman 02.12.18 at 3:01 pm

James Wimberly: “The Bitcoin bubble is a real bubble with money changing hands. But it’s paralleled by a virtual bubble in generic blockchain hype, with startups all over the place. The syllogism is classic Underpants Gnome:
1. Blockchain app
2.???
3. Profit!”

It’s worse than that. The argument I’m seeing replaces step 3 with ‘Paradise!’

24

Z 02.12.18 at 3:28 pm

I agree with SusanC. Bitcoin are certainly not perfect for criminals, but they are arguably better than many other alternative. The WannaCry ransomware is a case in point. That arguably gives Bitcoin at least residual value.

As an aside, the North Korean regime is apparently holding quite a good deal of Bitcoins. If that is true, I find the idea of crypto-enthusiast “”rationalist” propertarians being scammed by (or at least actively colluding with) North Korea quite delicious in its irony. If that was not wrecking the environment at the same time, I would even smile.

25

nastywoman 02.12.18 at 3:45 pm

To cut down the (US) financial sector to a small fraction of its present is a great idea with just a small problem.

What will US produce if US doesn’t produce just money or Bubbles or Fake Values anymore? We mainly live from selling each other overpriced houses -(or any other other overpriced and constantly bubbling ”assets”) and worthless junk like Bitcoin -(which indeed isn’t as pretty as tulips) – and some of the most wealth in our homeland is created by Americans charging other American an Arm and a few million legs for the financial services to sell each other money.

So what would we do – if we couldn’t meet with our financial advisors anymore – who always love to tell us – that if we invest even more in some ”stuff” which might be worth what the Casinos and the speculators and the gamblers tell us it might be worth – we will have to pay a percentage point less for commission for ”something” which might ”correct” sooner than later – BUT all in all -(thanks god) it will go UP – as sure as the rents go UP in Manhattan or even in South Central LA.

So what would we do??!
As we need the dough to buy all this stuff the Producing Countries are producing – and if we can produce the dough by selling Bitcoins to idiots – that’s at least ‘producing something’?

Right?

26

ThM 02.12.18 at 4:14 pm

The BTC seems to follow a random walk, with a great volatility that reflects the wide disagreements on its fundamental value – this is the weak form of EMH (apologies if the article adresses that, it is behind a paywall for me).

27

mpowell 02.12.18 at 5:31 pm

SusanC has exactly the right point on the value of crypto for illegal activity.

But this isn’t going to persuade anyone on the EMH question. Some people think blockchain has great potential and with enforced scarcity, this drives Bitcoin pricing. Even though I happen to agree with your view on Bitcoin value, the fact that you think this justifies government intervention in the market is a case example of why I don’t trust people such as yourself to make these kinds of calls as a general rule: hubris and the likelihood that you are wrong. The public market takes a look at the facts and comes to a different conclusion than you (or some group of government experts). Instead of understanding that there is some chance you might be wrong, you reach the conclusion that this is a general lesson that an ‘expert’ can decide better than the public market. On average, this will not be true. We should be very careful in drawing out the circumstances where it is likely to be true, and look to defective properties of the public market before reaching that conclusion. But people who are over-confident in their predictive abilities are the last group I would entrust to make these calls.

28

Trader Joe 02.12.18 at 7:18 pm

To the greatest extent, I agree with JQ….but in the interest of counter point I’ll propose the following:

There is at least some efficiency in the pricing of a bitcoin inasmuch as just like in the mining of minerals, there is a fixed and variable infrastructure associated with extraction. What is a lump of coal or a nugget of gold or a chunk of cobalt worth? The cost to extract + its value in productive uses. Accordingly mining of those things occurs when price is greater than variable cost (which varies by producer).

The prior here is that there is at least someone who demands a bitcoin for some purpose (legal, illegal, coolness…whatever). As long as that assumption is met – which I will concede is an if….a person should be willing to mine if the cost is greater than his variable cost and not-mine if it is less.

For early miners this price was low. For current miners it’s higher, but seems to be less (in many geographies) than current market prices.

For future miners – if they ultimately exist – it will be higher still….but logically, efficiently, if the price for bitcoin is high enough they will exist and to that extent the valuation is efficient.

29

J-D 02.13.18 at 4:40 am

mpowell

Even though I happen to agree with your view on Bitcoin value, the fact that you think this justifies government intervention in the market is a case example of why I don’t trust people such as yourself to make these kinds of calls as a general rule: hubris and the likelihood that you are wrong.

To suppose that there is a meaningful question about whether government intervention in the market is justified is a misunderstanding. It is government intervention that creates markets. No government intervention, no markets.

30

alexh 02.13.18 at 6:38 am

If you were a Ukrainian business in mid 2017, your computers shut down by a Russian cyber attack but (supposedly) unlockable by providing bitcoin, having bitcoin had value to you. If you are a major bank stockpiling bitcoin to help you pay off a future cyber-ransom attack you clearly believe it has value to you and you have a specific reason why so.

But one guy using bigcoin for an (entirely different) illegal purpose, who got caught for reasons that have nothing to do with bitcoin traceability, is supposed to prove that the idea “illicit activity can give bitcoin a value > 0” has been “addressed” ??? This seems so wrong, have I misunderstood?

31

Alex 02.13.18 at 12:55 pm

If the value of bitcoin is down to its designed-in scarcity as a store of wealth, presumably something even more scarce would be even more valuable, and the ideal store of wealth would be something so scarce it didn’t exist. That lass selling the imaginary unicorns is on to something!

32

RJB 02.13.18 at 1:32 pm

You say the NYT article addressed my point, but I am having trouble seeing it. Maybe the issue is that the EMH as you describe it is long dead already in my field of accounting. Drawing from my take here , we can start with the pursuit of profit as being the engine of efficiency. If investors do this job well, markets achieve ‘no-profit efficiency’ (or ‘no arbitrage efficiency’), meaning there are no profits left on the table. If the costs are trading, holding and shorting are low, no-profit efficiency can yield ‘fair-price efficiency’, meaning that everyone earns the same price regardless of their information. If information is costly, fair-price efficiency is equivalent to the weak-form EMH (all public info is incorporated into price). If information is costless fair-prices satisfy the strong-form EMH (all private and public info is incorporated in price). At this point, accounting research suggests that it is costly to acquire and process information, so a lot of us weak forms of the EMH as a good approximation of market behavior.

Your NYTimes version of the EMH is that

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.

Your definition of EMH I would call ‘right-price’ efficiency, because “all information” is far broader than “all available information, even if available only privately”, and because you are saying prices are “best estimates”. But it takes heroic assumptions to say in any circumstance that fair-price efficiency implies ‘right-price’ efficiency. At a minimum, that assumes that it is enough for all relevant information is available to someone. And given that markets allow speculation, it is entirely possible for fair-price efficiency to allow bubbles and crashes that cause prices to deviate from the right asset values but not allow informed traders to profit, since ‘the market can stay irrational longer than you can stay solvent’.

Your key argument about Bitcoin killing this version of the EMH seems to be that “The Bitcoin bubble rests on no plausible premise”. This might be a good argument that there is enough information out there for many people to know the true value of the asset (which you say is 0). But I don’t see an argument for why this should be relevant to how no-profit prices get converted into right prices, at least in the terms I am used to. This would require frictions to be very low (to get from no-profit to fair-price) and require speculative forces to be small and bubbles and other non-fundamental movements to allow easy trading gains (to get from fair-price to right-price). The obviousness of the mispricing has little to do with that last leap.

Maybe at bottom the issue is that you are arguing to people who use the EMH to debate the wisdom of public investment, while I am typically arguing to people who use the EMH to debate fine-grained price behavior in equity and debt markets. My people therefore propose a far weaker form of the EMH (since we don’t need prices to be right to understand the phenomena that interest us), and rely far more on the small-bore frictions that allow us to understand why wrong prices can still be fair prices, and unfair prices aren’t traded away.

33

Joshua W. Burton 02.14.18 at 12:19 am

If BTC is a collectible (which in my opinion is the natural view, unless someone succeeds against all odds and reason in making it useful for something) then the ultimate measure of its value is the enjoyment it is bringing to its owners, who seem at least to enjoy talking about it a lot. If JQ’s argument applies equally to baseball cards, doesn’t it prove too much? And if it doesn’t, why exactly not?

I own some 1960s-vintage baseball cards and some 2011-vintage BTC, both easily and somewhat frivolously acquired for literally no money and truly negligible unmonetized opportunity cost. They both make me smile sometimes, like other souvenirs of my life’s journey. It doesn’t seem subjectively implausible that my pleasure of ownership (and hence, their value at the margin) is in some degree correlated with the eagerness of potential buyers I sometimes read about.

Note, too, that collectors can go entirely offline, not bearing a joule of guilt for the ever-rising blockchain cost.

34

John Quiggin 02.14.18 at 12:57 am

@32 “all information” is far broader than “all available information, even if available only privately”

An interesting point. In my usage, information has to be discovered by someone before it is information.

A super-strong version of the EMH would include the claim that asset markets provide optimal incentives for the discovery of information. My impression of the literature is that this version is fairly strongly rejected on both theoretical and empirical grounds. Empirically, it seems that too much effort is allocated to being first with the discovery of high-frequency information.

35

John Quiggin 02.14.18 at 12:58 am

BTW, apologies for the paywall problem. I’ll think about the best way to deal with this.

36

Collin Street 02.14.18 at 1:20 am

… the thought also strikes me that the bitcoin-ransom model doesn’t actually require that bitcoin have any liquidity outside being used to pay ransoms: all that means is that the people selling you bitcoin are the people who want the bitcoin in return. Who are they going to get to buy their ransom-earned bitcoins? the next mark.

37

alexh 02.14.18 at 4:31 am

> I agree with SusanC. Bitcoin are certainly not perfect for criminals, but they are arguably better than many other alternative. The WannaCry ransomware is a case in point. That arguably gives Bitcoin at least residual value.

Agreed, but this is the last time I’m going to comment since it’s (IMO) such an obvious point but no one seems to agree. Professor Quiggin seems to be be equivocating between different definitions of the word “value”. I appreciate meanings of ‘value’ that exclude “I can pay off ransomware”. But there are also real situations where someone (rightly!) thinks “if I can acquire x BTC, and I’ll pay real money to get it, I can pay of the extortionists and my business is going to be better off”. For this person, bitcoin has ‘value’ (but not by everyone who has a singular definition of every word.) IMO there are clearly (at least!) two definitions of value at work here. It’s dishonest to bounce between them as your argument suits.

38

ThM 02.14.18 at 10:34 am

The other thing is that BTC does not seem to be traded by institutional investors: the future market is tiny, the liquidity of the spot is relatively low, as shown by the price differences between exchanges. We have very far from a basic, well-arbitraged asset class.

39

Trader Joe 02.14.18 at 12:15 pm

@38
“The other thing is that BTC does not seem to be traded by institutional investors”

This isn’t true.

Its not traded to the same degree as other commodities and average daily volumes aren’t huge in comparison – but its definitely traded and by many quite legitimate buy-side and sell-side shops. In Europe and Asia (Japan for sure) particularly there is usually a desk devoted to crypto (since BTC is one of dozens).

Also there is now a futures contract available which has significantly increased the handle. Indeed – professional traders can now trade entirely through the futures market and don’t need to own underlying which has increased market efficiency and reduced trading/holding costs (and is no small part of why BTC prices fell from 20k to 5k)

40

bruce wilder 02.14.18 at 6:22 pm

alexh @ 37

maybe i’m confused, but isn’t a concept of “value” for a monetary instrument distinct from our usual concept of the “value” of consumable commodities and the services of durable goods inherent in the concept of money itself? The basic idea of money is a unit of account, which may or may not be also represented by a token, useful for denominating the creation of credit and the extinguishing of debt.

Credit and debt have only instrumental “value” as symbolic constructions for structuring social cooperation and so too by extension in some ideal sense should a money, even though people do enjoy their symbols.

For a money to work at all, there have to be control functions governing response to demand for liquidity and the disappointment of expectations as a non-linear world emerges from our linear expectations of it: it becomes a question of what happens when . . . (debts qua incomplete contracts play out), and how much damage that does to the state of affairs and interests (particularly among the powerful).

I don’t think JQ is confused about the symbolic and instrumental nature of money. I don’t understand the appeal of BTC and won’t venture my own judgment, but I can sort of grasp that rising transaction costs and a deflationary bias might doom the fantasy enthusiasm for it. I can also imagine it persists for some time in a niche in a complex world where the burgeoning new technologies of symbol manipulation run out of control.

Because money is at the center of strategic competition and therefore subversive gameplay, the institutional particulars of money are constantly evolving, and have to be effectively re-invented at regular intervals — at least the historical experience has been of a kind of institutional evolution by way of punctuated equilibria. After it happens, one can sort of understand it, but anticipating where evolution is headed is way above my paygrade.

41

John Quiggin 02.15.18 at 1:22 am

Obviously, a lot of commenters haven’t read the article which is understandable as I forgot that it was paywalled. I’ve appended it now.

I think it covers the issue of use in crime pretty well, and the fact that Bitcoin is now traded in mainstream financial markets is central to the case.

42

Faustusnotes 02.15.18 at 6:03 am

John the article barely mentions crime and only to observe that one well known market was closed down. It doesn’t discuss ransomware at all, or the wider use of Bitcoin by drug traders. Silk road wasn’t shut down by tracking the Bitcoins used in purchases there but by tracing deliveries and communication, so your example doesn’t really correspond to your claim Bitcoin is no good for crime. In fact silk road was kind of unique – most drug dealers don’t sell their drugs on eBay, because they are aware they might get caught.

I don’t think it changes your thesis much to admit a lower value for Bitcoin based on its use for crime. Most people aren’t trading it knowing that its only use is criminal so it’s likely it is overpriced. But it appears clear it has some inherent value as a means of exchange for criminals .

43

John Quiggin 02.15.18 at 7:45 am

@42 Some other examples were cut for space reasons. Here’s a recent summary of the state of play

https://darkwebnews.com/bitcoin/dream-market-integrates-bitcoin-cash/

I agree that there will always be some room for some kind of criminal-crypto transactions. But the evidence is that, once it gets big enough that the underlying currency is valuable, the authorities shut it down (or, better still, compromise it, and trap lots of users at once without any need for legwork). And, so far, all of this has been done with the ordinary tools of law enforcement.

44

Z 02.15.18 at 12:46 pm

John the fact that Bitcoin is now traded in mainstream financial markets is central to the case [and] A financial product with a purely arbitrary value has been successfully introduced in the world’s most sophisticated financial markets.

This raises the question: why don’t traders short Bitcoin? Ponzi schemes are nothing new, for sure, but this is something new, in terms of scale. Any idea? (I have none myself, but if I had to volunteer one, I would guess that there must be a significant enough overlap between the population of high-frequency traders and technophile crypto-loving self-described libertarians. That doesn’t seem quite enough an explanation, though.)

45

Trader Joe 02.15.18 at 3:39 pm

@45 Z

There are plenty of traders and trading desks that are utilizing futures to be net short BTC.

Note however, the challenge of being short something requires you to be right about 2 facts: One that the true value of an asset is lower than it is now, and two that such lower valuation will be realized in a reasonable time-frame.

We may all be in agreement that BTC will one day be worth “zero” but your ability to make returns on that certainty varies greatly as to whether that happens in one day, one month, one year or one decade. Simply put, if the valuation doesn’t fall quickly enough, the trading costs (or borrowing costs as the case may be) will eat up 100% of your return before you can realize it.

Somewhat separately – the existence of futures is a critical negative for currencies like BTC that base a substantial amount of their value on scarcity. A futures contract allows the trader to hypothocate supply which inherently erodes scarcity value. One has no need to actually “buy” BTC when they can be long future that would produce the same return. The alternative though is not true – the only way you can “short” BTC is via a futures contract – the blockchain doesn’t allow you to have negative coins.

46

Collin Street 02.15.18 at 8:20 pm

The other thing about a short position is that if it goes right, the profit is limited by a fall to zero, but if it goes wrong there’s no ceiling price you have to pay. Limited upside, unlimited downside, as opposed to a long position where the profit can be as high as it may and the most you stand to lose is your buy-in.

Which means that a short position is inherently riskier than a long.

47

mpowell 02.15.18 at 9:07 pm

J-D @ 29 – I don’t want to get into a language debate on this issue. I’m not a libertarian. A democratically elected government can intervene in the market anytime they want and there are plenty of good reasons to do so. What I am driving at is JQ’s original comment on the topic of allocating investment and whether this should be left to the private market or the government should get involved regularly. JQ wants to argue that he’s found a critical violation of the EMH that should open the door to substantially more government intervention in financial markets. I think is over-confidence in his judgement of the true value of bitcoin is instead a good example of why we should be very wary of those who are convinced the government can do a better job of finding the right price of financial instruments than individuals. The biggest problem I have is that in the public market, if you’re wrong too often you tend to lose the opportunity to play anymore. The response in government to failure comes around much more slowly.

48

Faustusnotes 02.16.18 at 1:12 am

John I don’t think that article says anything except that a website decided to accept Bitcoin as payment. It doesn’t tell us anything about whether eg a drug traffickers in Mexico is using Bitcoin to escape rules on international transfers. I don’t think you’ve made your point.

49

John Quiggin 02.16.18 at 5:19 am

@48 I’ve made the assertion that if authorities wanted to track BTC transactions, they can. I gave an example – there are plenty more. If you want to challenge it, provide some counter-evidence.

50

Collin Street 02.16.18 at 5:19 am

JQ wants to argue that he’s found a critical violation of the EMH that should open the door to substantially more government intervention in financial markets. I think is over-confidence in his judgement of the true value of bitcoin is instead a good example of why we should be very wary of those who are convinced the government can do a better job of finding the right price of financial instruments than individuals.

I’ve bolded the bit that makes your contribution worthless; you probably haven’t realised it, but your “I think” here, without supporting evidence, means that your conclusions are essentially resting on nothing more than your presumptions and your priors.

This is very not strong. As a good rule, “I think I’m right, and this means” is never true; you need to write, “I think I’m right, and this would mean“.

51

Collin Street 02.16.18 at 5:22 am

Plainly bitcoin transfers are trackable; the ledger is definitionally public. Pseudonymous, but that’s not secure against network analysis.

[this, plus the sudden “spontaneous” news reports that show all the sign of a structured covert campaign, plus the mathematical sophistication, is why I think bitcoin was almost certainly developed by the NSA…]

52

alexh 02.16.18 at 6:49 am

@bruce wilder 02.14.18 at 6:22 pm

Thanks for engaging me but, I found your answer near incompensible unless…

> maybe i’m confused, but isn’t a concept of “value” for a monetary instrument distinct from our usual concept of the “value” of consumable commodities and the services of durable goods inherent in the concept of money itself? The basic idea of money is a unit of account, which may or may not be also represented by a token, useful for denominating the creation of credit and the extinguishing of debt.

… you are arguing that bitcoin isn’t valuable as “money”? The rest of your comment, which I confess not to really understanding, only makes a bit of sense to me if you think we are arguing about monetary value.

But if that’s right (I’m very uncertain) that’s not my point. I am claiming (not that I’ve hear anyone dispute this) that there are plenty of situations where rational people would give up real goods (or real spendable currency) “to get some bitcoin now”. That’s value. Not value “as money” but value by at least one reasonable definition. People do give up spending power to get bitcoin, with a rational motive. (Including: major banks,( You can (I wouldn’t disagree) that BTC has no likely future, indeed is doomed, as “money” (I guess, that means somewhat, medium of exchange) but it’s going so much further to say it’s valueless. It’s simply not, and the ransomware case frankly proves it (‘it’ being that bitcoin has some value, under some if not all reasonable definitions of value.)

This kind of matters. If BTC and its ilk shows a clear path as to how to leverage mild extortion capabilities into huge wealth, we need to be vastly more proactive in shutting it and the like down. Complacency – “it has no value [by definition 127-subsection a3], so the bubble will collapse to zero, so we can just sit back and laugh” seems dangerous.

53

faustusnotes 02.16.18 at 8:18 am

Yes John, and while the authorities are not tracking bitcoin, it has a great deal of use for illegal transactions, hence its value. It might be at risk of being a stranded asset, but so are shares in the big carbon emitters, and tobacco companies, but that doesn’t stop them having a real value.

54

J-D 02.16.18 at 10:58 am

mpowellYou seem to be setting up false dichotomies.

What I am driving at is JQ’s original comment on the topic of allocating investment and whether this should be left to the private market or the government should get involved regularly.

That seems to be one, and this seems to be another (unless it’s the same one over again in different words).

JQ wants to argue that he’s found a critical violation of the EMH that should open the door to substantially more government intervention in financial markets. I think is over-confidence in his judgement of the true value of bitcoin is instead a good example of why we should be very wary of those who are convinced the government can do a better job of finding the right price of financial instruments than individuals.

For contrast, an illustrative example of a true dichotomy would be ‘Governments should intervene in the financial markets more than they do now’ or ‘Governments should not intervene in the financial markets any more than they do now’. John Quiggin has a reasonably good case in favour of the proposition that governments should intervene in the financial markets more than they do now, and although you may have a good case against that proposition, I can’t figure out from your comments what the substance of it is.

55

Trader Joe 02.16.18 at 12:20 pm

@52 alexh
“It’s simply not, and the ransomware case frankly proves it (‘it’ being that bitcoin has some value, under some if not all reasonable definitions of value.)”

I’m not sure the ransomeware example proves much of anything. Imagine I were a clever hacker and could capture hundreds of computers around the world and I said I’d give you the secret code if you sent a Mickey Mantle rookie card to some prescribed P.O. address that wouldn’t make Mickey Mantle cards a currency or a unit of exchange.

It might make it a store of value – to the extent that there wasn’t a readily available means to manufacture at will billions of dollars of Mickey Mantle cards that are indistinguishable from the real thing, but BTC doesn’t even have that virtue. A smarter criminal probably should have asked for Mantle cards (at least a classier one).

Bitcoin is neither of these – they are readily replicable hence no scarcity, and aren’t widely usable in exchange (my Mickey Mantle cards wouldn’t get me a slurpee at 7-11) and as JQ and others noted aren’t as anonymous as one would imagine (maybe a little more than a P.O. box, but not a lot more).

I’m willing to go to bat that even worthless things can hold an irrational value for a period of time (think beanie babies) but that doesn’t make them a currency or a store of value – it makes them a novelty.

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