Not many of us understand Bitcoin in all of its complexity. Even fewer of us know what's going to happen to its price. However, economic cycles and bubbles have repeated themselves many times throughout history and provide a neat guide for current investors.
John Stuart Mill was a prominent economist and philosopher. He has penned a model to explain the rise and fall of a bubble over 5 stages. This model has provided the basis of much of the current thought and understanding of how bubbles work. While cryptocurrency breaks some of the rules of traditional finance, its price can still be understood within traditional models.
According to Mill, there are five phases to a bubble.
First is displacement. This is the start of a boom where confidence begins to grow but prices typically rise slowly. The creation of Bitcoin in 2008 and other cryptocurrencies thereafter gave rise to the opportunity to speculate in a new class of asset. Prices grew slowly at first.
Second is credit creation. In almost every bubble a period of low interest rates precedes a mania. Perhaps coincidentally (or perhaps not), low interest rates have been an ever-present since the creation of Bitcoin. Although, many people borrowed from non-bank lenders or mobilised their equity to invest in cryptocurrencies.
Third is euphoria. In this phase people think that prices can only go up. Traditional valuation standards are thrown away. A justification can be made for paying any price. Indeed, nobody really knows how to value a cryptocurrency, but many used this justification to pay very high prices for very small shares of a Bitcoin. Euphoria was pervasive.
Fourth is the critical stage. The stage of financial distress, especially for those who used excessive leverage or speculated too heavily on high prices. Insiders cash out, but the majority slip into financial distress (the bust).
Lastly, and perhaps still to come, is revulsion. The speculators are so put off by the events that have occurred that they can no longer bring themselves to participate in financial markets.
Foolish takeaway
Over many centuries, financial bubbles have generally had a common path. This path has been outlined succinctly by John Stuart Mill.
According to his model, Bitcoin and other cryptocurrencies can expect a 'revulsion' phase. However, if you've participated in the cryptocurrency euphoria you shouldn't be put off financial markets altogether.
Bitcoin was unique in its influence over the average person to take an interest in a financial market. But there are other financial markets, like the share market, where the assets for sale represent real businesses that earn real cash, have some intrinsic value, and tend to go up over time. They are great investments.
