Scott Sumner On EMH And Bitcoin

While I disagree with his prediction, this was a spot on post by Scott Sumner.

How should Bitcoin be priced?  If there is a 95% chance that it will soon be worthless and a 5% chance that it will soon hit $1000, then $30 seems like a relatively fair price.  That allows for a substantial expected gain ($50 minus interest costs would be the risk-neutral price.)  But Bitcoin is very risky, so investors need to be compensated with an above average expected rate of return.

Now consider a point in time where the asset is selling at $30, and investors have not yet discovered whether it will eventually reach $1000.  Should you predict that the price is a bubble?  Yes and no.  It is likely to eventually look like it was a bubble at $30.  Indeed 95% of such assets will eventually see their price collapse.  That’s “statistically significant.”  It’s also significant in a sociological sense.  Those that call “bubble” when the price is at $30 will be right 95% of the time, and hence will be seen as having the “correct model” of bubbles by the vast majority of people.  Those who denied bubble will be wrong 95% of the time, and will be seen as being hopelessly naive by the average person.  And this is despite the fact that in all these cases there is no bubble, as by construction I assumed the EMH was exactly true.

This post is motivated by earlier predictions that suggested Bitcoins were a bubble at $30, and hinted it might be a bubble at $2.  I predict that eventually the price of Bitcoins will fall sharply (from some level of which I am not able to predict) and people will vaguely recall:

“Wasn’t Scott Sumner the guy who denied Bitcoins was a bubble?  What an idiot.”

Defending the EMH is a lonely crusade that can only end in tears and ridicule, unless you are Eugene Fama, in which case it ends in a Nobel Prize and ridicule.  And I’m not Fama.

I made a similar point several weeks ago although I didn’t tie it into the efficient market hypothesis. Basically the point Scott is making is that despite the rampant cries of “bubble”, Bitcoin is rationally priced at the moment. How so? First, you need to ignore his numbers since he basically pulled them from an older post. Suppose Bitcoin lives up to its potential, the price years from now would be $100,000, say. Now even if you think the probability of that happening is low, what would you pay right now for that chance? Surely $1,000 doesn’t seem irrational in that context. Yet, if/when the probabilities hold true and Bitcoin doesn’t pan out, the price will fall dramatically. When that happens all of the bubble predictors and behavioral economists will collectively say “we told you so”! But according to EMH, Bitcoin was rationally priced the entire time.

I don’t believe EMH holds true in all situations but I do think it is a good approximation for how markets work. Volatility aside, I think this is a great explanation for why Bitcoin is currently priced the way it is.

In this context I’ll mention that I think most people (including Sumner above) significantly underestimate the probability that Bitcoin will succeed. There are likely many reasons for this including an inability to see the potential in technology. I’m reminded of this famous Paul Krugman quote:

By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s

I think there’s a good probability we’ll look back on many Bitcoin predictions the same way.

12 thoughts on “Scott Sumner On EMH And Bitcoin

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