Cryptocurrencies: Another Tulip mania?

The cryptocurrency phenomenon has been compared to previous bubbles such as the Dutch Tulip Mania and the South Sea Bubble. Those bubbles occurred in the 17th and 18th centuries, in pre-technological societies at a time when the concept of market regulation did not exist. 

So the parallels are stretched. However, one thing has remained the same. That is, investor psychology. Once a critical mass of investors starts piling into a tradable instrument, rational assessment of value goes out of the window. The price goes crazy and price-momentum creates its own demand. More money chases that instrument and creates a feedback loop that pulls even more money into the instrument. This continues until there's a sudden switch to sentiment and the price collapses. 

The South Sea Bubble was at best unrealistic in its business mandate. The South Sea Company was a British enterprise, granted an exclusive licence by the British government to trade with South America when it was floated in 1711. It started selling shares in 1719.

This was something over a century after the East India Company received a similar licence to trade into Asia. The EIC was doing well. At the time, India was controlled by different local rulers and the EIC lacked the military power to take any of them on. So it stepped warily around the local powers as it ran its factories. The SSC sold its business prospects to investors by citing the success of John Company.

But the South America of 1720 was controlled by Spain and Portugal. Portugal held Brazil. Spain controlled the rest of Latin America, including large chunks of what is now the USA. Spain and England did not get on and hadn't got on for centuries. 

The chances of the South Sea Company pulling off a version of what the EIC did were very low. Indeed, the SSC never got a meaningful foothold in South America. But the shares went up and up, before the bubble eventually collapsed. 

The Dutch Tulip bubble was more akin to a gold rush, or diamond rush. Precious metals and stones lack much intrinsic value but they are considered valuable because they are considered valuable. Tulips are as gorgeous as any precious stone. So they are also valuable. Indeed, tulips still sell for large sums. However, unlike diamonds, which are famously forever, or gold, which is nearly impervious to chemical action, tulips are perishable. 

Back in the mid-17th century, tulips were in very short supply outside the country of origin, Turkey. Dutch gardeners started breeding new, exotic bulbs. The prices rose as the flower became fashionable. So far, so rational.

Things went over the top in the 1630s as bulbs started being traded in futures markets. Prices rose exponentially, and rose exponentially all over again. In terms of value, tulip bulbs became the fourth-largest commodity in Holland — ranking below fish, cheese, and alcohol. Most bulb futures contracts were cash-settled. The market collapsed in 1638 but by then, many investors had been ruined. 

Cryptocurrencies are less physically tangible than tulips. The story is more difficult to sell than the SSC because it isn't immediately clear what cryptocurrencies are, let alone what they are supposed to do, and how. But somehow, cryptos have tweaked the same emotional reflexes of investors and, thus, created a huge bubble. 

A second parallel is the lack of regulation. There were no regulators in the 17th and 18th centuries, and cryptos have miraculously sidestepped regulators for the better part of a decade. Bitcoin has been publicly available for trade since 2009 or so. It is only now that central banks and market regulators are starting to make regulatory noises. 

I have no idea where these instruments will end up, as a store of value or as a unit of trade. However, I do think they will have a massive impact on "dirty float" currencies, like the rupee and the yuan. Cryptos are very easy to trade cross-border with no traces in the banking system. That ease will force central banks to open up the capital account in order to counter illicit capital flight. That, in itself, has very interesting implications for global trade. 

Twitter: @devangshudatta