Economic bubbles occur when too much money is chasing too few assets. This causes both good assets and bad assets to appreciate beyond their intrinsic value, or fundamentals, to an unsustainable level.
Once the bubble bursts, and they all do, the fall in prices causes a crisis of investor and consumer confidence that may cause a financial panic or crisis.
If there is a monetary authority, such as a central bank, it may be forced to take a number of steps to avoid the collapse of its currency. These actions may include bailouts.
If this sounds an awful lot like the 2008 financial crisis, it's because it is. Then, the asset was houses, but it was far from the first economic bubble. The first, and undoubtedly the most famous bubble is that surrounding tulips during the 1630s in the Netherlands. You may know it as "Tulip Mania".
During the 17th century, the Dutch Republic was the world's leading economic and financial power. From 1600 to 1720, the Dutch had the world's highest per capita income.
Tulips, which originated in Turkey, were introduced to the Dutch by way of Vienna. Dutch botanist Carolus Clusius planted several tulip bulbs and realized that the flowers could tolerate the colder climate of the Netherlands.
The intense color of the blooms made them an instant status symbol for Holland's newly wealthy merchant class. Single-hued tulips of red, yellow, or white were known as Couleren, multicolored tulips with white streaks on a red or pink background were known as Rosen, blossoms with white streaks on a purple or lilac background were called Violetten, and the rarest of all, flowers with yellow or white streaks on a red, brown or purple background were called Bizarden.
It is now known that the multicolor effects were caused by a type of mosaic virus that infected the Dutch bulbs.
Tulip growers gave their varieties names that often started with the word "Admirael" (admiral), for example, the Admirael van der Eijck, and that began with the word "Generael" (general). Standing above all the others was the prized Semper Augustus tulip.
Growing tulips from seed to bulb took seven years, and cultivating the most desired varieties, those with the virus, took even longer. The flowers bloomed for for only about one week during the months of April and May. From June to September, during the plant's dormant phase, tulip bulbs could be uprooted and moved.
This was when bulbs were purchased on what is called the spot market. The other months of the year, October through March when the bulbs couldn't be moved, buyers and sellers entered into contracts which stipulated an intent to purchase the tulip bulbs at a certain price on a certain date.
These were the world's first futures contracts, making the the Dutch the inventors of modern finance. An option contract is similar to a futures contract, but it is not binding.
The Speculators Move In
By 1634, responding to growing demand and higher prices, speculators entered the tulip trading market. In 1636, the Dutch created a formal futures market, where contracts to buy bulbs at the end of a season were bought and sold. The Dutch called this tulip contract trading "windhandel", which is Dutch for "wind trade".
That name signified that the Dutch realized that what was being traded was "air", that the tulip bulbs themselves weren't being traded, but that what was being traded was the ability to buy the bulbs at a certain price at a certain point in the future.
Due to the speculators, the prices of the contracts kept rising, and a single contract could change hands up to ten times in one day. Then, in February 1637, in the Dutch town of Haarlem something bad happened — an outbreak of bubonic plague. Understandably, buyers didn't attend a tulip auction there, and that was all it took. Tulip bulb contract prices collapsed, and the trade ground to a halt.
If we analyze the tulip bubble, we see that people were purchasing tulip bulbs at higher and higher prices, intending to re-sell them for a profit. This only works if there is a new pool of buyers willing to pay the high prices.
In February 1637, that pool dried up, demand for the flowers disappeared, and prices plummeted. People were left holding contracts that allowed them to purchase tulips at a price ten times higher than the current price on the spot market. People who had taken possession of bulbs were holding a product that was now worth a fraction of what they had paid.
The Bitcoin Bubble
Bitcoin reached its highest price of $19,783 on December 17, 2017. That same month, Google searches for the terms "tulip mania" and "tulip fever" spiked.
During the years 2015 to 2017, the Bitcoin market was beset by speculators who drove up the price. Then, just a month after reaching its peak, on February 5, 2018, Bitcoin's price fell to $6,200.
According to a recent New York Times article, every day between $400 million and $800 million worth of Bitcoin is bought and sold, and 60 to 80 percent of those transactions are speculative in nature.
Other than speculation, Bitcoin does have its uses. It is being used by Venezuelans eager to sidestep that country's enormous inflation. The same New York Times article reported that Venezuelans bought over $230 million worth of Bitcoin last year.
Bitcoin is also used in illegal activity. Hackers have demanded ransoms in Bitcoin for unlocking locked-up computer files. Bitcoin is also used to buy drugs on the dark net.
Recently, the investment bank Morgan Stanley began clearing Bitcoin futures for their own clients. They join fellow investment bank Goldman Sachs as the only Wall Street firms operating in the Bitcoin space.
Serious companies seem to be betting on cryptocurrencies, of which Bitcoin is only one. A recent CNBC story said Facebook founder Mark Zuckerberg had sat down with his fellow Harvard classmates and nemeses, the Winklevoss twins, to discuss creating a new cryptocurrency.
Popular online sales site Overstock.com has expressed its desire to exit the sales business and become a cryptocurrency company. So, where does this leave Bitcoin?
The dot-com failures of the early 2000s have turned out to be viable businesses. While Pets.com failed, Chewy.com is successful. Today, the Netherlands commands 50 percent of the $10 billion global market in cut flowers.
An aphorism says: being early or late is no different than being wrong. But, does that mean that the bubble around Bitcoin was one of irrationality, or one of timing? Only time will tell.