Bitcoin, ICOs, Mississippi Bubble and crypto future

Bitcoin’s boom has gone further than famous market manias of the past like the tulip craze or the South Sea Bubble, and has lasted longer than the dancing epidemic that struck 16th-century France, or recent dot.com bubble in 2000. Like many others events such South Sea Bubble, ultimately, it was a scheme. No (real economy) trade would reasonably take place but the company’s stock kept rising on promotion and the hope of investors.

In my view, a more illustrative example, with many parallels for Bitcoin, is Mississippi Bubble, which started in 1716.  Not only was the Mississippi Bubble bigger than the South Sea Bubble, but it was more speculative and more successful. It completely wiped out the French government’s debt obligations at the expense of those who fell under the sway of John Law’s economic innovations.

Its origins track back to 1684 when Compagnie du Mississippi (Mississippi Company) was chartered. In August 1717, Scottish businessman/economist John Law acquired a controlling interest in the then-derelict Mississippi Company and renamed it the Compagnie d’Occident. The company’s initial goal was to trade and do business with the French colonies in North America, which included most of the Mississippi River drainage basin, and the French colony of Louisiana. Law was granted a 25-year monopoly by the French government on trade with the West Indies and North America. In 1719, the company acquired many French trading companies and combined these into the Compagnie Perpetuelle des Indes (CPdI). In 1720, it acquired the Banque Royale, which had been founded by John Law himself as the Banque Generale (forerunner of France’s first central bank) in 1716.

Law then created speculative interest in CPdI. Reports were skillfully spread as to gold and silver mines discovered in these lands.  Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. Law had promised to Louis XV that he would extinguish the public debt. To keep his word he required that shares in CPdI should be paid for one-fourth in coin and three-fourths in billets d’Etat (public securities), which rapidly rose in value on account of fake demand which was created for them.  The speculation was further fed by the huge increase in the money supply (by printing more money to meet the growing demand) introduced by Law (as he was also Controller General of Finances, equivalent to Finance Minister, of France) in order to ‘stimulate’ the economy.

 

CPdI’s shares traded around 300 at the end of 1718, but rose rapidly in 1719, increasing to 1000 by July 1719 and broke 10,000 in November 1719, an increase of over 3,000% in less than one year. CPdI shares stayed at the 9000 level until May 1720 when they fell to around 5000. By the spring of 1720, more than 2 billion livres of banknotes had been issued, a near doubling of the money supply in less than a year. By then, Law’s system had exploded – the stock-market bubble burst, confidence in banknotes evaporated and the French currency collapsed. The company sought bankruptcy protection in 1721. It was reorganised and open for business in 1722. However, in late 1720, Law was forced into exile and died in 1729. At its height, the capitalisation of CPdI was greater than either the GDP of France or all French government debt.

Why did Law fail? He was over-ambitious and over-hasty (like this Bitcoin pioneer?). He believed that France suffered from a dearth of money and incumbent financial system (Bitcoin enthusiasts claim it will revolutionize economies and countries like India are ideal for it) and that an increase in its supply would boost economic activity (Bitcoin aims to implement a variant of Milton Friedman’s k-percent rule: proposal to fix the annual growth rate of the money supply to a fixed rate of growth). He believed that printing and distributing more money would lower interest rates, enrich traders, and offer more employment to people. His conceptual flaw was his belief that money and financial assets were freely interchangeable – and that he could set the price of stocks and bonds in terms of money.

Law’s aim was to replace gold and silver with a paper currency (just like how Bitcoiners want to democratise/replace fiat money and eliminate banks). This plan was forced upon the French public – Law decreed that all large financial transactions were to be conducted in banknotes. The holding of bullion was declared illegal – even jewelry was confiscated. He recommended setting up a national bank (Banque Generale in 1716), which could issue notes to buy up the government’s debt, and thus bring about a decline in the interest rate.

During both South Sea and Mississippi bubbles, speculation was rampant and all manner of initial stock offerings were being floated, including:

• For settling the island of Blanco and Sal Tartagus
• For the importation of Flanders Lace
• For trading in hair
• For breeding horses

Some of these made sense, but lot more were absurd.

Economic value and price fluctuations of Bitcoin

Bitcoin is similar to other currencies and commodities such as gold, oil, potatoes or even tulips in that its intrinsic value is difficult – if not impossible – to separate from its price.

A currency has three main functions: store of value; means of exchange; and unit of account. Bitcoin’s volatility, seen when it fell 20% within minutes on November 29th 2017 before rebounding, makes it both a nerve-racking store of value and a poor means of exchange. A currency is also a unit of account for debt. As an example, if you had financed your house with a Bitcoin mortgage, in 2017 your debt would have risen 10x. Your salary, paid in dollars, etc. would not have kept pace. Put another way, had Bitcoin been widely used, 2016 might have been massively deflationary.

But why has the price risen so fast? One justification for the existence of Bitcoin is that central banks, via quantitative easing (QE), are debasing fiat money and laying the path to hyperinflation. But this seems a very odd moment for that view to gain adherents. Inflation remains low and the Fed is pushing up interest rates and unwinding QE.

A more likely explanation is that as new and easier ways to trade in Bitcoin become available, more investors are willing to take the plunge. As the supply of Bitcoin is limited by design, that drives up the price.

There are governments standing behind currencies and reliable currency markets for exchange. And with commodities, investors have something to hold at the end of the transaction. Bitcoin is more speculative because it’s digital ephemera. That isn’t true for all investments. Stockholders are entitled to a share of a company’s assets, earnings and dividends, the value of which can be estimated independent of the stock’s price. The same can be said about a bond’s payments of principal and interest.

This distinction between price and value is what allowed many observers to warn that internet stocks were absurdly priced in the late 1990s, or that mortgage bonds weren’t as safe as investors assumed during the housing bubble. A similar warning about Bitcoin isn’t possible.

What about Initial Coin Offerings (ICOs)? An ICO (in almost all jurisdictions so far) is an unregulated means, bypassing traditional fund raising methods, of raising capital for a new venture. Afraid of missing out on the next big thing, people are willing to hand their money over no matter how thin the premise, very much like in case of South Sea or Mississippi Bubbles. They have close resemblance to penny stock trading, with pump-n-dump schemes, thin disclosures and hot money pouring in and out of stocks.

ICOs, while an alternative financing scheme for startups, aren’t so far sustainable for business. Despite the fact that more than 200 ICOs have raised more than $3 billion so far in 2017, only 1 in 10 tokens is use after the ICO. And a killer app for most popular public blockchain platform Ethereum, which sees increasing number of ICOs? First ecosystem (game to trade kittens) has been launched and almost crashed Ethereum network. This game alone consumes 15% of Ethereum traffic and even than it’s hard to play due to its slowness (thanks Markus for this info bite!).

So overall, Bitcoin (and other crypto currencies) exist only for the benefit of those that buy-n-hold and use them while creating an explicit economic program of counter-economics. In other words, Bitcoin is not as much about money but power.