What Lies Behind the Rise of Crypto
Saint Paul once transformed himself from being a tax collector who persecuted early Christians into an apostle of the Church. BlackRock CEO Larry Fink has been following the same path lately. In 2017, he claimed that bitcoin was an “index of money laundering.” In 2023, he insisted that bitcoin “could revolutionize finance” with the world’s largest asset manager filing for a spot bitcoin exchange-traded fund (ETF) (see Picture 1 below). The ancient Romans would hardly have been surprised by describing this pattern of human behavior very well: “The times change, and we change with them.”
Furthermore, ARK Invest CEO Cathie Wood argues that crypto is now a U.S. election issue, which is why key documents for the proposed ether exchange-traded funds (ETF) were approved suddenly and unexpectedly in May (see Reference 1 below).
Politico agrees by declaring that “…it’s starting to have an outsize impact on U.S. politics and policy.” (see Reference 2 below). As a result, the U.S. House of Representatives passed a new bipartisan piece of legislation – the Financial Innovation and Technology for the 21st Century Act aka FIT21 – that would create a regulatory regime for the crypto and blockchain industry.
Why many members of the economic and political elite have been undergoing this sudden change of heart? Without going to the extremes expressed by crypto skeptics and crypto enthusiasts, impartial observers may conclude that the crypto asset phenomenon is a reaction to the following events:
1. A Loss of Confidence in Today’s Financial System. Why did crypto assets emerge in the first place? The term “bitcoin” was first mentioned in a white or concept paper released on October 31, 2008. I can remind you that the investment bank Lehman Brothers declared its bankruptcy on September 15, 2008. This was the time when the world’s major central banks were involved in extinguishing a raging high-intensity “fire” that threatened to engulf the entire financial system. Even the world’s largest commercial banks were experiencing a loss of mutual trust and confidence, while the interbank lending market was practically frozen. That is why one of the major reasons for the emergence of a crypto world was the crisis of confidence in today’s financial system.
2. Fiat (“Paper”) Money Debasement. How was this “fire” that was raging during the global financial crisis extinguished? It was extinguished by providing a huge amount of liquidity over the following years to maintain the solvency of commercial banks, real estate, and securities markets. As a result, too much fiat or “paper” money circulating in the financial system was chasing too few viable investment opportunities available in the economy at that time (see Picture 2 below).
More broadly, a loose monetary policy has been an integral part of the global economy since the final abandonment of the gold standard in the early 1970s, the launch of financialization in the 1980s (see Picture 3 below), and the “inflationalization” of our economic life (see Picture 4 below). In practical terms, this meant that in the period from 1971 to 2023, the US dollar lost 87% of its purchasing power.
3. In Search of Digital Gold. What are most crypto assets striving to achieve? Ideally, they are striving to achieve the status that gold and, to a certain degree, silver (the “poor man’s gold”) have historically occupied by becoming new safe-haven assets but at a more advanced technological level.
What are the historical characteristics of a safe-haven asset?
• Universal Acceptability of Value. The value of a safe-haven asset is universally accepted across all cultures and civilizations. For example, gold is recognized as a safe-haven asset in any culture and on any continent.
• Anonymity and Perpetuity. The ownership of a safe-haven asset is anonymous. It also has no maturity date unlike government debt securities. A safe-haven asset can be sold without anyone knowing who its previous owner was. In turn, fiat or “paper” money is a government-issued security where the rules of circulation are determined by the government itself.
• Limited or Controlled Supply. The supply of a safe-haven asset cannot be increased by pressing a button on the central bank’s computer keyboard. Its supply is either limited or it rises in a controlled manner without exerting a downward pressure on its value that may eventually lead to its devaluation and debasement.
• Stability and Independence of Demand. A safe-haven asset does not depend on the subjective will of controlling shareholders, issuers, or regulators. Its use can be banned. But, most likely, this will only result in the emergence of a booming black market.
• Durability. A safe-haven asset does not burn like buildings. It also does not depend on the benevolence of insurance companies and court decisions.
Crypto assets have been trying to achieve this status at a more advanced level in terms of technology. This implies that there is no need for physical storage of safe-haven assets, while their transfers and payments are on course to becoming almost instant and increasingly secure.
4. Speculative Frenzy. While there were the three objective factors that facilitated the emergence of crypto assets, a subjective speculative factor undoubtedly played an important role too. “Rags-to-riches” stories continue to motivate and inspire many novice crypto investors. However, due to a large mismatch between the amount of available liquidity and viable investment opportunities, you may as well find this speculative frenzy in real estate, high-tech stocks, high-yield bonds, special purpose acquisition companies (SPACs), or “peer-to-peer” lending platforms.
As McKinsey put it: “Net worth has tripled since 2000, but the increase mainly reflects valuation gains in real assets, especially real estate, rather than investment in productive assets that drive our economies.” (see Reference 3 below).
As a result, “…from 2000 to 2020, almost $2 of debt and $4 of liabilities were created for every $1 of net investment.” (see Picture 5 below).
We can apply the same logic to the use of anonymous crypto assets when conducting illicit activities or running Ponzi schemes and other investment scams. Criminals are equally interested in many other areas and industries: from finance to construction to gambling, etc. That is why the crypto world is certainly not unique in this regard.
What Is Money?
The textbook definition of money is anything that can serve as a
· medium of exchange, something that people can use to buy and sell from one another;
· unit of account, that is, provide a common base for prices;
· store of value, which means people can save it and use it later — smoothing their purchases over time
In general, most popular cryptocurrencies have technology to become a medium of exchange. They also have a good chance of becoming a store of value due to their anonymity, limited supply, technological durability (no physical storage is needed), and slowly rising acceptability.
If we study the history of bimetallic monetary systems, we can make a conclusion that, due to its lower value, silver was primarily used for transactional purposes, while gold was predominantly used for storing value.
For the time being the existing crypto assets are well equipped to become digital “gold” to store value, but they are not yet ready to become digital “silver” to be used for transactional purposes. What they are lacking right now is the stability of their prices.
A Decentralized Monetary System
What we need is a decentralized hybrid of the gold standard and the fiat monetary system where the supply of money is regulated AUTOMATICALLY without relying on any “independent” and “smart” decision makers. If an individual or a group of individuals is able to print paper money, electronic money, or digital money, sooner or later, he, she or they will exploit this possibility.
This could be achieved by automatically changing the current level of main monetary policy instruments (money supply and interest rates) after the publication of inflation data. This monetary regime can be called an “inflation board” similar to the “currency boards” used to maintain exchange rates of unstable currencies.
Low price volatility and stable purchasing power are the necessary prerequisites for any cryptocurrency to eventually become a medium of exchange and a unit of account. The underlying logic behind this approach is very simple, namely, the preservation of the purchasing power in terms of the “anti-inflationary cryptocurrency”. This approach also implies that the exchange rate of this cryptocurrency should be considerably less volatile compared to other crypto alternatives, whose main purpose is to achieve high investment returns.
One should not expect, however, that the existing monetary system can be reformed without political upheaval.
One of the possible options may be the emergence of competing blocs of countries, where one of the blocs will decide to create a “sound” monetary system as its competitive advantage. It is true that politicians may announce the launch of a new asset-backed currency. But the launch of an automatically regulated monetary system is very unlikely.
Therefore, the creation of a new monetary system is likely to follow the path of cryptocurrencies. In other words, it is likely to be developed in a decentralized way. Some ten years ago it might have seemed something improbable, implausible, and simply impossible. But the emergence of bitcoin, ethereum, and other cryptocurrencies has proved that the unrelenting depreciation of official money makes this path not only practically feasible, but also inevitable.
Undoubtedly, the governments of many countries will try to implement prohibitive and punitive policies aimed at any competing monetary system beyond their control. But these policies will eventually fail because most existing official monetary systems are fundamentally flawed. I am sure that the governments of many countries would be happy to ban the circulation of gold, but they know very well that this measure will only contribute to the emergence of a flourishing black market.
Consumption-Driven versus Innovation-Driven Economic Growth
One may argue that it is necessary to maintain some small level of inflation in order to stimulate consumption. This argument implies that consumption is the engine of economic development. This is fundamentally false. Economic progress is facilitated only by our human striving to create truly innovative, interesting, and useful things. The massive financialization of our economies over the last 40 to 50 years as well as debt-based consumption associated with it have proved it very well. Higher sustainable consumption is just a by-product of significant scientific advances and successful technological innovations.
The prevention of bank panics was one of the major reasons why the gold standard was abolished. Therefore, one may argue that monetary policy instruments are also needed in order to maintain the stability of the financial system. However, the events of recent decades have demonstrated that one-sided monetary policy can ultimately lead to financial bubbles too. If you want to prevent bank panics and financial instability or if you deal with the aftermath of a financial or banking crisis, you can use various macro- and micro-prudential policy and financial regulation instruments.
There are many other tools available to authorities in a crisis situation. You may recall that “liberal” Britain temporarily nationalized its largest banks during the Global financial crisis in 2008. You may also recall that “economically conservative” Switzerland essentially forced UBS to acquire the agonizing Credit Suisse, when a 50 billion Swiss franc ($54 billion) credit line with the country’s central bank had failed to stabilize its situation in March 2023. You may also recall that in March 2023 in the “strictly capitalist” United States J.P. Morgan, Wells Fargo, Citigroup, Bank of America and seven other banks deposited $5 billion apiece in uninsured deposits into First Republic Bank, a troubled U.S. regional bank, to shore up confidence in the industry. They even considered converting these deposits into equity. Extraordinary times call for extraordinary measures as they say.
The history of the last 50 years proves that money should not be viewed as the engine of growth. The role of any monetary system, first and foremost, is to facilitate the long-term stability of prices. Easy and unstable money destroys motivation, distorts reality, and fuels bubbles.
The most negative effect of the current monetary policy is that ordinary people, businesses, and governments alike behave like preschoolers who expect their “parents” — central banks — to help them in all situations rather than trying to invent some new technology or product, finding a new export market, or organizing the production cycle more efficiently.
The second negative effect is that many take on risky investments just to preserve the purchasing power of money, while risky investments should be only taken if you want to significantly improve your financial situation.
Today it is quite obvious that only rising growth rates of technological advancements and labor productivity are the sources of sustainable economic development.
Using mathematical terminology, stable money is a necessary but insufficient condition for achieving a major technological breakthrough. And what would be a sufficient condition for such a breakthrough? To be continued…
References:
1. “Cathie Wood Says Ether ETF Filings Were Approved Because Crypto Is an Election Issue”, Sam Reynolds, Bloomberg, May 29, 2024.
2. “Crypto’s ‘Huge Moment’ Scrambling US Politics”, Jasper Goodman and Eleanor Mueller, Politico, May 23, 2024.
3. “The Rise and Rise of the Global Balance Sheet: How Productively Are We Using Our Wealth?”, Lola Woetzel, Jan Mischke, Anu Madgavkar, Eckart Windhagen, Sven Smit, Michael Birshan, Szabolcs Kemeny, and Rebecca J. Anderson, McKinsey Global Institute, November 15, 2021.
