What is the greater fool theory? And how does it apply to cryptocurrencies?
Among the most famous critics of Bitcoin and cryptocurrencies in general is American billionaire Warren, who stated years ago in an interview with CNBC: "Cryptocurrencies have no intrinsic value. You can’t do anything with them except sell them to someone else."
In financial literature, this theory is known as the 'greater fool theory.' The idea is that you should not invest in something if its value relies solely on selling it to someone else at a higher price.
This theory says that stocks, bonds, and real estate generate cash flows, and can be evaluated based on that. However, Bitcoin produces nothing at all.
A lesson from the history of crude oil
Before the late 19th century, crude oil was mostly a nuisance. American pioneers who drilled wells for water sometimes found oil and were disappointed. The problem was the lack of a specific use for oil. At a profit margin, it could be used to make asphalt and was often used as medicine, but mostly it was ignored. Finding oil was as interesting as finding mud.
Things began to change when George Bissell achieved a breakthrough in the 1850s: he wondered if 'rock oil,' as it was called, could be processed and used as lighting (to replace 'coal oil' in kerosene lamps) and as a lubricant for machines.
And thus, the oil industry was born: a lonely scientist discovered that a viscous, penetrating, and ugly-looking liquid could be used to generate light.
However, demand for oil remained low in the first few years due to its issues. One was its foul smell, as crude oil naturally contains a high percentage of sulfur. But subsequent chemical refining processes, such as de-sulfurization - which, interestingly, was funded by oil production companies like Standard Oil - created new uses and markets.
The story does not end with kerosene lamps, of course. The dawn of the 20th century saw engineers experimenting with internal combustion engines. As cars grew from toys to necessities, demand for oil skyrocketed. By the end of the 1920s, 85% of oil production was used for fuel production.
Many did not realize the potential of the 'new light' early on, but those who did, like John Rockefeller, were responsible for some of the largest examples of value creation to this day.
Bitcoin today resembles oil after the development of the kerosene lamp, but before cars, airplanes, and others. It is a commodity with limited real uses but meaningful nonetheless. People use it today to store their savings outside the fiat currency system ('digital gold'), to transfer money across borders, and to settle large transactions quickly and irreversibly. In some countries, it provides a safety valve for citizens concerned about oppressive regimes, and a way to smuggle money with limited material risks.
But similar to oil in the late 19th century, these applications are still in their infancy. Kerosene lamps were evidence of the concept; the real value of oil lies in its being an easily transportable energy storage that can be released densely. Similarly, Bitcoin's current utility is limited; its true value lies in allowing money to move at internet speed and enabling it to be stored independently.
Investors buying Bitcoin today are betting that future uses based on these core capabilities will be greater than Bitcoin's current market value.
For example, if Bitcoin significantly penetrates parts of external wealth markets, collateral, payments, remittances, or other markets, its potential would be much greater.
The 'greater fool theory' states that asset prices can rise simply because someone is willing to buy them at inflated prices in the hope of selling them later to a 'greater fool,' regardless of their true value. But this game ends once there are no 'fools' left willing to pay.
According to this theory, an investor ignores financial valuations, earnings reports, and all the fundamental metrics of investment, and instead relies on the hope of having a later buyer who will pay more. This is a highly risky approach, as it can eventually leave the investor with worthless assets when the market collapses.
How does the theory work?
Under this theory, an investor may buy securities of questionable value, hoping to sell them quickly to another, more optimistic investor. But it collapses with the burst of speculative bubbles, as happened in the mortgage crisis of 2008, when financial institutions could not dispose of worthless mortgage-backed securities.
Theory vs. Real Valuation
One of the key lessons from the financial crisis is the importance of fundamental valuation of assets. This includes analyzing the intrinsic value of the asset, studying earnings data, growth rates, cash flows, industry and competition analysis, as well as understanding ownership structure and management.
Are cryptocurrencies meant for fools?
In a talk with TechCrunch, Bill Gates stated that non-fungible tokens (NFTs) and cryptocurrencies "depend 100% on the 'greater fool theory.' Or as Warren Buffett said in 2020: 'Cryptocurrencies have no intrinsic value. You can’t do anything with them except sell them to someone else.'
The point Gates, Buffett, and many economists make is that cryptocurrencies do not provide any 'real' value. Thus, cryptocurrencies are simply a bubble through which people are trying to outdo each other. It is merely a scheme to make money by buying and selling at higher prices.
And when people realize this fact, cryptocurrencies will collapse. But how fair is this analysis of cryptocurrencies? While practical applications of cryptocurrencies are few, it is too early to assert that Bitcoin or other digital currencies are practically worthless. Today, people use cryptocurrencies to transfer money across borders and settle large transactions.
At least a few major retailers accept Bitcoin as if they were accepting paper currencies. Matt Hogan, a writer for Forbes magazine, compares Bitcoin to oil in the 1850s. At that time, oil was used only for lamps and lubricating machines. Of course, with combustion engines and technological advancements, oil became one of the most valuable commodities in the world. Perhaps something similar will happen with cryptocurrencies.
And when we think about it, we find that the 'greater fool theory' is how many markets operate. Prices and value are not always determined by practical factors like utility, but rather by supply and demand. If people believe that a Rothko painting is worth $80 million, then that is its value. If people are willing to pay a price, then that price is what determines value (at least economically). Of course, the problem is that humans are remarkably fickle. What we consider valuable today, we may consider worthless tomorrow. Therefore, cryptocurrencies are not a 'bubble' any more than any other market that often inflates, like art or jewelry#MerlinTradingCompetition #BinanceAlphaAlert #GENIUSAct #BinanceAlpha$1.7MReward $BTC
