Comparing Bitcoin To Tulip Mania: Should We Be Scared?

| About: Winklevoss Bitcoin (COIN)

Summary

People are comparing Bitcoin to the 17th century Dutch tulip craze more and more frequently.

Is there any merit to this comparison?

I will analyze the causes and catalysts of the tulip mania and see if they can be applied to Bitcoin.

What can we learn from it?

This weekend, Bitcoin (COIN) (OTCQX:GBTC) briefly broke $6000. This crazy upsurge of the cryptocurrency currently has full attention of the media, which remains divided. In my previous article about Bitcoin, I argued that though I am bullish on the currency, I am worried about its volatility. Most people see the potential of the underlying blockchain technology, still many individuals are calling Bitcoin and cryptocurrency a bubble or even a pyramid scheme.

Some, like Jamie Dimon of JP Morgan Chase, even compared Bitcoin to the tulip mania which occurred in the 17th century in the Netherlands. He was by no means the first one to use this terminology. Already in 2013 people have been comparing the two, even on Bloomberg. Let us try to fairly compare the two phenomena.


The tulip mania

At the beginning of the 17th century, wealth in the Netherlands was growing. The country was entering what is now known as the Dutch golden age, and was one of the wealthiest countries in the world. This was spurred by very profitable trading with its many colonies around the world.

Tulip bulbs were first introduced in Europe at the very end of the 16th century, and not long after that, it was clear that these flowers could easily cope with the relatively harsh climate of the Netherlands, unlike many other exotic flowers. Tulips became popular quickly, not only in the Netherlands but also in France. Members of the French nobility paid hundreds of Dutch Guilders to let their wives wear tulips as adornments on balls. It did not take long for people to start trading and collecting tulips bulbs for profit. In 1623, a single tulip bulb of a popular race costed around 1000 Dutch Guilders, while the average annual income in the country was 150 Guilders at the time.

semper augustus Semper Augustus, a record-breaking tulip (source: Wikipedia)

It was not before 1634 though, that the market started getting really turbulent. Until then, most of the people involved in tulip bulb trade were professional tulip cultivators or rich hobbyists. But from 1634, outsiders started getting involved in this market as well. This led to very active trading in not only tulip bulbs, but also tulip futures, which were used to have the rights to buy a tulip bulb in the future. These futures were often subsequently sold to others and could be resold multiple times. Prices went sky-high: A single recorded trade of the year 1635 involved 40 tulip bulbs being sold for 100,000 Dutch Guilders. The record was set by the 'Semper Augustus', which was sold for 6,000 Guilders, comparable to the price of a luxurious house at the time.

In the winter of 1636-1637, about 5000 people were involved in tulip trading, which was about 1% of the working population at that time. During this winter, public opinion turned against them: the general public saw the tulip trade as some kind of gambling and warned against it.

tulip index Tulip price index before and after the collapse (source: Wikipedia)

On the 3rd of February 1637, the tulip trade suddenly collapsed. Over the course of a single week, prices dropped dramatically and traders were left with tulip bulbs which were unsalable for previously normal market prices. The result was chaos. Many traders had sold futures contracts of bulbs which they did not possess to people who could not afford them.

In the aftermath, tulip trade normalized and prices stabilized again, but never reached the hugely inflated levels of during the tulip mania.


Causes and catalysts

To truly compare Bitcoin to the tulip mania, we have to identify the causes and the catalysts of the tulip bubble. Let's give it a shot:

  • Huge growth of wealth
    The Dutch golden century supported a huge increase in the wealth of the people of the Netherlands. Especially the nobility and the rich, but later also the normal working population has much more money to spend. In rich circles, it became fashionable to spend this money on luxury products like exotic flowers.
  • Much wealth transferred to fewer people
    In the 17th century there was a new plague epidemic in the Netherlands, and this cost the lives of many people. With our current state of healthcare, we sometimes forget how disastrous this can be: in 1624-1625, 20% of the population of Amsterdam and some other large Dutch cities died from the plague. This happened after a period with relatively few deaths caused by the plague, and it led to much wealth transfer by inheriting. Especially when parents died in rich families, young people suddenly became very wealthy. These people had money left spend on luxury or to invest in, for instance, tulip bulbs.
  • Tightening supply
    By quick cultivation, tulip bulbs became more susceptible for diseases, for instance the tulip breaking virus. This virus led tulips to break its 'lock' on a single color, leading to for instance the Semper Augustus in the picture above. The virus weakens the bulb of the tulip and each new generation of offspring will become weaker, until the bulbs eventually have no strength to flower and produce no offspring at all anymore. This was something which traders in the 17th century did not know. In fact, big bucks were paid for tulips with multiple colors because they were so beautiful. But cultivating it was of no use, leading to a short supply of tulip bulbs.
  • The use of futures contracts
    Trading and reselling futures contracts has certainly been a factor in the tulip trade leading to the bubble. Some traders were simply speculating on the price to continue to rise, which created artificial demand. In combination with the tightening supply, this eventually went wrong.


Similarities and differences

What are the true differences and similarities between Bitcoin and other cryptocurrencies and the tulip mania?

  • Size and scope of the market
    First, as you can read in the description of the tulip mania above, tulip trade only involved about 5,000 people at the height of the bubble. We are thus speaking of two phenomena which are completely incomparable with each other. Bitcoin and other cryptocurrencies operate basically worldwide, while the tulip mania was very local.
  • Wealth increase
    The increase in wealth in the Netherlands was one of the factors leading up to the tulip bubble. How has this been for Bitcoin, has there been a huge wealth increase leading up to the rise of cryptocurrency? Though worldwide wealth has grown, it did so by very small percentages the last couple of years. So though the tulip mania was preceded by a great wealth increase of the population, at the moment we see no such wealth increase leading up to the rise of Bitcoin.
  • The product itself
    Tulip bulbs are a physical product which had an 'end market' eventually: the nobility which used it as a luxury item. It is also a perishable product, susceptible to disease and other hazards. The intrinsic value of a tulip (mostly its beauty) was limited, or at least by no means comparable to the prices which were paid for it at the height of the bubble.
    Bitcoin is a non non-physical token, the only practical use of it is payment or a store of wealth. It is still susceptible to hazards such as hacks of wallets or the loss of codes, but it is a much more durable way of storing wealth than the tulip bulb. The intrinsic value which a Bitcoin has can be very difficult to determine. Some people are arguing that Bitcoin does not have any intrinsic value. But Bitcoin is not created out of thin air: it is mined. Any person around the world with powerful enough hardware can put in the effort to create new Bitcoin by processing Bitcoin transactions. People who do this profit from this activity while at the same time enabling Bitcoin to become a medium of exchange. Bitcoin's intrinsic value is therefore the "representation of the effort it takes to mine it". This effort, leading to the enabling of a worldwide payment network, could represent quite a big intrinsic value in the end. This is one of the aspects which makes cryptocurrency an entirely different phenomenon than tulip bulbs.
  • Tightening supply?
    Unlike with tulip bulbs, there is an upper limit of 21 million Bitcoins. Of course there are already many other cryptocurrencies, which could be good alternatives for Bitcoin. Every ICO increases the supply of cryptocurrency. But it does not increase the supply of Bitcoin, which profits from its first mover advantage in the crypto world. Though there exist many options which are technologically more advanced than Bitcoin, many investors will still choose Bitcoin because of its established name. Hard forks of Bitcoin also create a larger supply of cryptocurrency. But market capitalization is not directly effected by a fork: because every owner of Bitcoin receives one token of forked-off cryptocurrency per Bitcoin he or she owns, the total money invested in the sum of the two branches stays the same. In theory forks do dilute Bitcoin, by creating more tokens which new investors can choose from when investing their fiat currency. It is very likely though, that after a fork one of the two is chosen as a 'winner' by the market, which is what happened with Bitcoin Cash. The absolute value of a single token might go down as a cryptocurrency splits, but the total amount of money invested in the cryptocurrency market is not changed by a fork. Also, the number of 'true' Bitcoins will not be effected.
    Investors which are investing for the long run might be a big factor in decreasing available supply of Bitcoin. In the US and in other countries, changing Bitcoin back to fiat currency would create a taxable event on which these investors would have to pay taxes. This means they have incentives to leave their investments in Bitcoin or other cryptocurrencies. If these investors stay invested, this creates a tightened supply. Also, high prices of stocks and bonds are currently likely contributing to more long term investments in Bitcoin.
  • Futures and derivatives
    In the tulip trade, the futures contracts were an important catalyst leading up to the bubble. With regard to Bitcoin, there already exist futures and derivatives markets. Though Grayscale Bitcoin Investment Trust (OTCQX:GBTC) is a popular option at the moment, continuously trading with a big premium compared to the Bitcoin price, I do not consider it to be a serious alternative for owning real Bitcoin. If there would be a true Bitcoin ETF, more people would have access to it and demand for Bitcoin could increase. On the other hand, this would also increase the chances of a true bubble being created.


What can we learn?

Bitcoin and the tulip mania are in some ways comparable: they both deal with a huge upsurge in price of a relatively new product. Also futures of tulip bulbs existed, which played a big role in the bubble which was created in the 17th century.

This is where the similarities end. First and foremost, the scope and size of the two are completely incomparable: about 5,000 people were active in the tulip bulbs trade, while the whole world can become active in Bitcoin and cryptocurrencies. Bitcoin as a product is used as payment mechanism or storage of wealth, which is completely different from tulip bulbs, which are perishable luxury products. The fact that the blockchain is a decentralized and basically unhackable piece of technology means that Bitcoin by its very nature is a very safe way of storing wealth. Its current volatility does undermine this. Though some argue otherwise, Bitcoin does have intrinsic value: the effort which it takes to mine it. This effort is what keeps the whole payment infrastructure functioning.

It gets very interesting when looking at the supply side. The bubble of tulip bulbs was partly caused by a tightening of the supply because of the tulip breaking virus. Bitcoin has some factors which could influence the supply side:

  • On the one hand you have other cryptocurrencies and hard forks theoretically increasing the supply of cryptocurrencies. But hard forks do not impact the market capitalization of all the Bitcoin branches added together. Though for every single of these 'spinoffs', the supply might have increased, for Bitcoin investors who owned the token before the fork this will not matter, since they own both of the branches.
  • On the other side of the spectrum there are long term investors and people who want to shelter wealth from taxable events, which reduces the supply of Bitcoin. This is also influenced by the high prices at which the stock and bond markets currently trade. When calling Bitcoin a pyramid scheme, you should at least acknowledge the role the other markets are playing in it.


Conclusion

People who are comparing Bitcoin to the tulip mania have not looked into it well. Many aspects are not comparable at all. The tulip mania was caused by three factors: a huge increase in wealth, quickly tightening supply, and artificial demand by traders speculating on higher prices. These factors, except for the last one, do not apply to Bitcoin and cryptocurrency.

Thank you for reading, please tell me what you think about Bitcoin and the comparison with tulip bulbs below! If you liked this article please click the "Follow" button.

I wrote two other articles about Bitcoin, if your interest was sparked by this one, please find them here:

In this article I discussed why Bitcoin will benefit greatly from getting a stable user base, but there are many challenges to overcome:
Would Amazon Accepting Bitcoin Lead To The Breakthrough Of Cryptocurrency?

Here I wrote about the brutal volatility of Bitcoin and cryptocurrency and what to expect about it in the future:
Bitcoin Rises Too High, Too Quickly

Disclosure: I am/we are long BITCOIN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here