Bitcoin, the beautiful bubble machine

Whether you believe that Bitcoin will be highly successful or not, you should recognize that we are witnessing the birth of a potential currency in realtime. Regardless of which economic camp you call home, your theories will be put to the test. We can all learn something from watching the fledgling Bitcoin try to escape the nest and survive in a complex world.

People validly observe that the Bitcoin price denominated in fiat currencies is phenomenally volatile, and on occasion organizes itself into distinct run-ups that we call "bubbles." Personally, I prefer to call them "bubblettes," since if Bitcoin really really takes off, we're going to see price increases that will completely eclipse historical comparisons.  

I would argue that the prevalence of consecutive bubbles is actually a healthy and expected part of the growth phase in Bitcoin, and that they provide a potential counterargument to the supposition that Bitcoin will become irrelevant due to hoarding.

At any given time, the distribution of Bitcoin holdings looks about the same. You will see about 70% of wallets holding a small amount, 29% of wallets holding a medium-sized amount, and 1% of wallets holding a significant amount - depending on your subjective definitions.

Over time, this distribution will change, coincident with the amount of Bitcoins needed to qualify for the top 1%. The reason for this is because bubbles serve a very valuable purpose in prying Bitcons from the hands of large holders. It is the market's way of letting small and new players say: "We want those Bitcoins, and we're coming for you."

What ensues is a chase up a very steep hill, atop which the large Bitcoin holders eventually capitulate and sell their coins - then everybody walks (or tumbles) downhill on the other side.

Because of psychological reasons, the large holders will always be the majority of sellers in the last stages of a bubble. The reason being the asymmetrical value of a currency hedge to holders of different amounts. For instance, if you own 0.1 Bitcoins, and the price quadruples, you are much less likely to get trigger happy and sell than if you owned 10,000 Bitcoins. Surely, even the most stoic of Bitcoin believers would trim a little off the top of a stash that large if the price were $500. Not so for the small holders. In fact, they might be more likely to keep buying.

And so this process continues in a very fair way. New and small players chase around the big players as if they were in a game of American Football, trying to swat away Bitcoins and cause a fumble. On net, this sloughs off more and more coins from the top percentiles over time.

Just to give you an example, I would remind you of the frequent stories told by super early adopters when they would send around 10,000 or 20,000 BTC between one another just for fun. Some would sell 30,000 at $0.01 each, feeling very happy with the $20 profit that they turned.

Yet today, we lament that those days are long gone, and it's such a shame that we have to pay $100+ for a single Bitcoin!

But remember, that's what people thought when Bitcoins hit $1 apiece: "The days of mere pennies per Bitcoin are over!" Early on, 100 Bitcoins was chump change. Now those Bitcoins would be worth over $10,000. 

In conclusion, people only hoard Bitcoins until they don't. The market makes sure of that, and bubbles are an illustration of this activity, something to be marveled at and (depending on your sensibilities) even embraced. Some individuals believe that early adopters will hold too large a sway in the future because of their ability to smash the market with large sell orders. This argument is true, but only to a limited extent. Remember, when a large holder of Bitcoins loads the proverbial chamber and fires a slug at the exchange rate, they also deplete their ammo.

Unlike the purveyors of the world's fiat currencies, nobody has unlimited Bitcoins.