Bitcoin and Other Forgotten Bubbles: What Happens After the Crash?

You may not have noticed, but a little cryptocurrency called bitcoin has increased nearly tenfold in price in the last two months, and the total value of all bitcoins in existence recently rose to more than $10 billion. It's not the only cryptocurrency -- i.e., a form of digital money created by decoding complex mathematical problems -- that has soared, either. There are now dozens of variants, from the second-place Litecoin (with nearly $1 billion in market capitalization) to a number of tiny alternatives denominated in fractions of a cent, and many are experiencing huge surges in value.

Source: Zach Copley via Flickr. .

This sort of rise, naturally, has prompted plenty of cries of "bubble, bubble!" The mania surrounding bitcoin has all the hallmarks of classic bubbles, including delusional proponents predicting an imminent rise to $1 million per bitcoin (remember "Dow 100,000" in the late '90s?) and a larger cadre of fierce defenders who simply don't seem to have learned much from the bubbles that have inflated so many times throughout history. It's true that some investments can increase at super-exponential rates, but none can do so forever; every bubble has to pop eventually.

What can history's craziest bubbles teach us about bitcoin's ultimate fate? Well, that depends on which example you feel most closely resembles the current craze. Is bitcoin like the railroads of the 19th century, which endured several bubbles and subsequent crashes while ultimately creating a new connected world and a more technologically driven society? Or is this latest mania more like the frenzy over Beanie Babies, which made the man behind the toys very rich but made everyone else who hoarded them a pitiful punchline for economic pundits?

We all know a little bit about Tulipmania (and if you'd like to learn more, click here for a detailed primer on the first great bubble in world history), but let's take a closer look at a few of history's lesser-known bubbles to see just how the madness of crowds can lead market participants to dream of great riches and ultimately succumb to lasting ruin.

The 1990s collectible craze
Beanie Babies were the signature craze of the 1990s, and prices of the little stuffed toys reached absurd levels at their peak. Some limited-edition Beanies fetched five figures on eBay, which acquired a reputation in its early years as a marketplace for collectibles of all sorts. The Beanie bubble blew apart in spectacular fashion as soon as its manufacturer announced that production would end in 1999. Suddenly, thousands of collectors found out that their rare tiger or toucan wasn't worth much if everyone else who had wanted one suddenly wanted to sell their collection at the same time.

Source: Dominique Godbout via Flickr..

But Beanies weren't the only thing that got overheated in the '90s -- all manner of collectibles, from trading cards to comic books to Pogs, all experienced bubbly fervor as millions of Americans suddenly found themselves with more money than common sense. Most petered out quickly, but the baseball card craze lasted for roughly a decade, in part because the fragmented nature of the market prevented collectors from discovering the true demand for their cards.

Baseball cards are a classic example of the irrational excitement surrounding collectibles that were far more common than they appeared and far less popular than they were ultimately purported to be. Card manufacturers churned out huge quantities of cards in the 1980s and 1990s, with all sorts of gimmicks offered to justify the soaring prices per pack, which could reach $10 or more for the shiniest and most "limited edition" issues. Media hype fed the frenzy, but the availability of new online marketplaces like eBay revealed the truly glutted state of the baseball-card market. Prices for the cards of most 1980s and 1990s stars peaked before the dot-com bubble did and have never recovered. Most collectors simply grew disheartened with their inability to find buyers for their shiny-foil, triple-embossed, real-leather, die-cut, autographed, rare-insert cards (baseball cards got pretty ridiculous in the '90s) and gave up the hobby, reducing the market's size to a level that could never sustain the prices promised by leading card-valuation guides.

Other trading cards, most notably Magic: the Gathering and other collectible-card games, became popular in the 1990s, but the Magic enthusiasts who continue to host tournaments to this day help sustain the prices of early-edition cards, although you're not likely to get rich from the deck you built in 1994. The lesson here, whether we're talking Beanies or baseball cards (or bitcoins), is that collectibles only increase in value so long as other collectors keep joining the community.

Precious-metals bubble of the 1970s
For nearly all of American history, the price of gold was fixed against the dollar. When President Richard Nixon ended gold convertibility in 1971, the precious metal was set on a soaring trajectory, as it became the pre-eminent inflation hedge during the worst inflationary period of the postwar era. The price of gold peaked in 1980, 2,400% higher than its convertible price and 800% higher even after adjusting for the era's rampant inflation. Silver, which had historically moved in tandem with gold despite not holding the same elite status as a monetary standard, went on an even more momentous surge following the Nixon shock, rising an inflation-adjusted 1,100% from 1971 to 1980.

Source: Mark Herpel via Flickr..

The end of the gold and silver bubble coincided with two key events: the interest rate ramp of the Federal Reserve under Chairman Paul Volcker, which is widely credited with ending stagflation, and the huge two-decade economic expansion that began in the early '80s. Suddenly, it made less sense to bet against the dollar; three decades later, those who did so in the summer of 1980 still haven't recovered their investment on an inflation-adjusted basis despite a second surge in gold and silver that began after the start of the new millennium. As bitcoin is often treated as a digital stand-in for gold (its design is deflationary by nature and thus emulates the limited supply of precious metals), the lesson is clear: The American economy and its leading policymakers might not always be strong, but you bet against them for the long term at your own peril.

The railroad bubbles in Britain (1840s) and America (1870s and 1890s)
Railroads were so important to the industrializing West that the two greatest stock markets endured not one, but three massive bubbles related to railroad shares.

Britain was the site of one of the earliest stock-market bubbles. The implosion of the South Sea Co. bubble in 1720 would leave scars on the British investor's psyche for a century. However, by the 1830s, the legacy of the South Sea bubble had faded, and fresh investing frenzies were ready to be whipped up by the exciting new technologies of the early Industrial Revolution. The combination of low interest rates, extreme leverage (some railroads allowed investors to buy shares on margins of just 10%, a level reminiscent of the Roaring '20s), aggressive promotion, and burgeoning wealth helped funnel British money into the explosion of railroad shares available by the mid-1840s. Railroads, like the Internet in the 1990s or radio in the 1920s, was the speculative technology investment of its time, and people believed the railroads could do no wrong despite their high capital costs and often dubious paths to profitability.

Source: Roger Wollstadt via Flickr..

Three decades later, American investors rushed into railroad shares following the completion of the Transcontinental Railroad. The vast and largely untamed American continent, only recently removed from a devastating Civil War, took longer to connect with railroads, but the boom more than doubled railroad track-miles in slightly more than a decade, from 1860 onward. More than 23,000 miles of track were laid in the four most frenetic years of the first American railroad bubble, causing a price spike in the necessary iron rails. As the railroads grew, so did their shares, and by the bubble's peak in 1873 some 364 railroads accounted for about 40% of the stock market's total capitalization. Despite the devastation wrought by the end of this bubble, American investors nevertheless blew another great bubble in railroad shares during the late 1880s and early 1890s.

Of course, none of this meant that railroads were bad for the economy or that the end of the railroad bubbles meant the end of the railroads. Railroad track-miles kept climbing past the American bubbles of the 1870s and 1890s, eventually peaking with 254,000 total track-miles in 1916, a level of development eight times greater than that seen at the beginning of the first bubble. The much smaller British Isle developed its rail network earlier but still experienced growth in track-miles following the end of its bubble in the 1840s. This is the bubbly end result bitcoin enthusiasts should most fervently hope for: Even if (or when) the bubble pops, it won't stop the growing adoption of an important new technology.

Bubbles, bubbles everywhere
What is bitcoin? Is it a digital collectible, a ward against the ravages of inflation, a transformative new technology, or some combination of the three? The end result of the present bitcoin bubble can probably be gleaned in these three overlooked bubbles of history, but even investors who have no interest in buying bitcoins can learn a bit about the long-term prospects of a potential investment by analyzing it along similar lines. Humans are often irrational creatures, which means that when it comes to investing, a price you see today may have little to do with fundamental value and much to do with how much higher everyone thinks the price may be tomorrow. If something has long-term value, this irrational enthusiasm will ultimately be replaced by sensible investment decisions and a better final price, but if a price is only as good as the next sucker to buy in, then you'd better leave it for the next sucker and look for something else to invest in.

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 Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more insight into markets, history, and technology.The Motley Fool recommends and owns shares of eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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