The year is mid-2022. We are witnessing a drastic shift in our financial assets. We started from simple stocks, and mutual funds, and are observing mind-boggling NFTs. Considering all these financial assets, you get advice to invest and trade. Following the cycle of trading and investing, you may have come across the term that would be a financial bubble. Moreover, is cryptocurrency a bubble too? If we go and understand the concept of a financial bubble, it can be a little daunting. Moving to cryptocurrencies, they are not new to financial risks. You all have seen the volatile nature of cryptocurrency prices. However, is there more to it? Is cryptocurrency a bubble too? In this article, I will try to explain what is a financial bubble. We will then try to understand the entire concept with some examples. Once you get a basic understanding, we can brainstorm on “is cryptocurrency a bubble too”
TABLE OF CONTENTS
- What Is A Financial Bubble?
- What Are Some Types Of Asset Bubbles?
- Is Cryptocurrency A Bubble?
- Bottom Line
- Related Articles
What Is A Financial Bubble?
Before diving in, we need to understand what a financial bubble generally means. The entire concept can then be mapped to the current scenario of crypto.
A financial bubble is seen when the prices of any entity rise up drastically by large margins. This increase is quite significant as compared to its fundamental and realistic value. The entity can be any individual stock, a financial asset, or even an entire sector. Now, this increase in prices is not because of any actual development but only due to speculative demand. As a result, we witness large amounts of sell-offs and the prices crash and decline abruptly. This crash can have numerous effects on the economy depending on the intensity of the crash and the entity involved.
What Are Some Types Of Asset Bubbles?
You can observe a sudden increase in various financial assets. However, if we were to categorize them into four broad assets, they would be such as mentioned.
Credit Bubbles
A sudden increase in student loans, business loans, mortgages, or consumer loans. You can consider this to be related to the debt sector and any form of credit.
Commodity Bubbles
Commodity refers to assets that are tangible and physically present. These would include gold, oil, crops, metals, and much more.
Stock Market Bubble
These include the values of stocks, exchange-traded funds, or even equities. We can observe these assets going high in price due to speculative demand and then declining sharply.
Asset Bubble
These include sectors or assets other than the mentioned three. These will include real estate or our favorite – cryptocurrencies.
Is Cryptocurrency A Bubble?
If you recall, the first thing to notice in a bubble is a sudden increase in price out of nowhere. The increase is due to speculative demand and certain short-term fads. There is no real or intrinsic worth of the asset that justifies this. We can see the same trend in cryptocurrencies. They have been observing a massive increase in their prices from 2019 onwards. Now is this increase actually proving something? You will find that no remarkable development was done. However, the prices still rose. It can be attributed to the covid-19 lockdown. People were finding a new 24/7 available asset to trade from the comfort of their homes. Moreover, the concept of decentralization was way too interesting for the general public. Many people may also have the fear of missing out (FOMO). Maybe many invested out of this. Now this can answer briefly to is cryptocurrency a bubble for us.
Moreover, if we go into the technical details of the financial bubbles, it moves into 5 phases: displacement -> boom -> Euphoria -> Profit-taking -> Panic.
This was first established by the Economist Hyman P. Minsky in his book Stabilizing an Unstable Economy (1986).
5 Phases Of A Financial Bubble
Displacement
It is the initial phase for any asset. The asset is new and investors are gaining a little interest in its work. Moreover, this also allows investors to invest in the early phase and gain a little edge over the others.
Boom
This phase witnesses widespread attention to the particular asset. The prices start rising but slowly. You will see the general public having more interest in knowing about the asset. The widespread talk remains that everyone should invest in the asset. Some do it because of their own interest and knowledge and some due to FOMO.
Euphoria
You can witness a sharp increase in the prices. Many investors, traders, and the general public are already invested in the asset. The prices become an all-time high. You may think that the prices will maintain themselves, but they don’t. It is just like the prices rise and rise without proper justification.
Profit-Taking
Following the previous phase of euphoria, people tend to doubt the credibility of the asset. They start pulling off their investments and making profits. They are ready to pull out even with low-profit margins. This is due to the fact that the general understanding is that the asset will hit a bubble and decline. People think it is better to have low profits than no profits.
Panic
This phase is exactly when the bubble bursts. The prices of the asset begin to decline more sharply than ever before. There is a constant downward graph in the prices and the asset’s value. Investors are still holding their hopes for profits even though they know the margins would be too low. The only concern for people is not to experience a loss. However, the prices decline so rapidly, that there is hardly any more time to speculate or hope.
At the time of writing this article, we can somewhat say that the current phase is profit-taking for cryptocurrencies. People are selling off their crypto assets even for low-profit margins.
Moreover, there are other indications too for cryptocurrency to be a bubble. You can see unrealistic valuations of crypto startups. Now the valuation of any startup is not an issue. The issue is a sudden and drastic increase in the valuation. If you see successful startups, you will find their valuations to be justified. You can see the numbers growing due to the value the startup offers to the public. Crypto startups do offer value like other startups, however, many are still based on the idea that people are into the idea of cryptocurrencies.
Another aspect to cover would be NFTs. You can observe the sales of NFTs in billions for mere digital products. Now, NFTs are not bad. They are a great concept. But if you can observe clearly, they are clearly based on the hype this industry has created.
Even Bitcoin has been characterized as a speculative bubble by eight winners of the Nobel Memorial Prize in Economic Sciences: Paul Krugman, Robert J. Shiller, Joseph Stiglitz, Richard Thaler, James Heckman, Thomas Sargent, Angus Deaton, and Oliver Hart, and by central bank officials including Alan Greenspan, Agustín Carstens, Vítor Constâncio, and Nout Wellink.
Bottom Line
Every side has two coins. The same goes for this as well. The coming years would be a test for cryptocurrencies. It will decide whether it is a bubble and maybe a hoax or if we have something promising coming. It has to be seen what investors do in the coming years with this asset. They may pull out and the entire sector may decline. Or we can even witness more trading and investments than ever before. However, one thing is sure early crypto investors did get a lot of profits and benefits from this asset. We can see many rags to riches stories from different parts of the globe. And these stories are not a hoax. They have actually realized profits and moved on. Moreover, if you clearly observe, the bubble scenario may not affect these early investors. The reason is that they have already done their part of what they wanted. It is these late investors who may suffer and would want to rethink their entire approach to cryptocurrencies. Many experts have even marked this entire cryptocurrency market as a Ponzi scheme. They say that one invests with the hope that someone else would join too. And once others join, the value of their investments would eventually go higher.
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