Cryptos may destabilise fiatNov 9, 2017·Alasdair Macleod
The assumption in some quarters is that crypto-currencies will replace gold as money, or at least challenge it. This is an error borne out of a misunderstanding of catallactics, or the theory of exchange. It also ignores the fact that beyond a few European countries and North America, gold is firmly money in the minds of ordinary people. I wrote an article on this subject, explaining why cryptocurrencies are not a new form of money, here.
Anyone reading this article may wish to read my original article first, to understand the true status of cryptocurrencies. I concluded that cryptocurrencies are the purest form of financial bubble in the history of speculation, and will be of great theoretical interest to future generations, just as the phenomena of the Mississippi, South Sea, and tulip bubbles are to us today. I also wrote that
“It’s worth noting that all crypto-currencies together are worth $120bn, with bitcoin $55bn of that total. This is only a very small fraction of cash and deposits worldwide. Therefore, the point where new money to fuel the craze runs out does not appear to have been reached, and could have much further to go.”
That was in August, when bitcoin was about $3,000 against today’s price of more than double that. In the short-term, all sorts of dubious promoters are sending unsolicited invitations to buy, promising price gains of thousands per cent. It’s a fair bet these promoters own cryptocurrencies themselves, and are puffing their own interest. A failure of the innocent to take the bait in sufficient numbers could easily lead to a sharp correction.
We must look beyond that. This article will examine more closely the dynamics driving bitcoin and other cryptocurrencies, and it concludes that rather than destabilise gold, if the craze continues it is far more likely to destabilise fiat currencies.
But first, we must understand the way bubbles form and progress. A word of caution: what follows is a theoretical description of how bubbles evolve and eventually implode, including the points that may be relevant to cryptocurrencies. Other factors are almost certain to impinge on how prices will progress, not least the underlying dynamics of the global credit cycle engineered by the banking system. On its own, the forthcoming credit crunch, independently from the crypto craze, threatens to be the most disruptive in our lifetime and could easily override the cryptocurrency bubble cycle. This article does not attempt to identify all the risks in this new asset class.
Dynamics of a financial bubble – the initial phase
Bubbles, like markets, tend to run through three distinct phases. The first is the initial move, driven by participants in the know, or by those close to the promotors that initiate a scheme. Sensible, experienced investors become aware early on that prices of a new venture, financial instrument or even a physical item are being inflated, irrationally they believe, so they do not participate. The wider public is generally unaware at this juncture, and many of those that might have taken an early punt will have fallen foul of sharp corrections, counterparty failure, or outright fraud. Consequently, prices are driven in the main by insiders, the earliest adopters, the creators of the new opportunity to make money.
In the case of cryptocurrencies, these are the geeks, and the tech-savvy entrepreneurs who have a good understanding of the dynamics driving values. This has been the cryptocurrency story so far. Bitcoin, the leader in a pack of about 1,000 different cryptocurrencies, has risen from nothing to over $7,000 at the time of writing, in less than a decade.
Already, this is a bubble of near-record inflation. Each bubble has its own characteristics, but this one is special. The invention of blockchain, the self-auditing process central to bitcoin, ensures payments are confirmed and property rights are unarguable. Blockchain on its own could turn out to be one of the greatest financial and technological legacies of our age. The mix of financial and technological elements is the background to cryptocurrencies, a powerful combination, compared with the single dimension bubbles of the past.
The limitation on new supply for individual cryptocurrencies is designed to ensure that increasing popularity drives prices higher. This contrasts with fiat currencies, which through the expansion of credit on an elastic base-money foundation, means the increase of their supply is virtually limitless. The difference between these two characteristics is likely to become increasingly important to future cryptocurrency prices, measured in fiat currencies.
The limitation on new demand has been significant so far, because it has had to overcome some disadvantages. Besides widespread dismissal of the phenomenon by the investment establishment, the market has also been unregulated, and therefore seen as dangerous for investment. Governments have closed bitcoin exchanges under the pretext that cryptocurrencies are being used to evade tax and launder the proceeds of crime. While the technology side of the phenomenon has been advanced and generally competent, financial aspects have been on a scale from amateurish to fraudulent. It has been a modern version of the wild-west, partly driven by anti-government libertarianism.
Governments have yet to decide their response, but apart from expressing interest in blockchain technology, they are mostly clueless and have been taken by surprise. Cryptocurrencies can undermine capital controls, important to China and many other countries trying to protect their own fiat currency values, and they arouse discomfort in those quarters accordingly.
However, we are now passing from the early stages of development, when cryptocurrencies were mainly the preserve of technophiles and starry-eyed libertarians. The transition may not be plain sailing. Nearly all the movers and shakers are fully invested themselves, so a significant downturn could lead to problems for them. A nasty wake-up call of this nature, after such enormous initial gains, should not be lightly dismissed.
With or without such a price correction, exchanges and other service providers are beginning to realise that dealing with strangers on a no-questions-asked basis is impractical, when governments insist on being able to track all transactions. Businesses making it into Phase 2 will work on improving their reputation, and are likely to embrace regulation. This brings us to the second phase.
Phase 2 – acceptance in the investment mainstream
The interest generated by the initial phase of the bubble has now caught the attention of professional investors, particularly the more adventurous hedge funds and some other quasi-institutional dealers. They note that conventional investments appear fully valued, so alternatives are being actively considered. After all, if interest rates are now going to rise from here, bonds and therefore equities are likely to fall in value. There are options, such as playing the commodity cycle, and perhaps gold, for those that understand it. However, the vast bulk of investments are in regulated assets which probably have little or no upside remaining.
These professional speculators will be monitoring closely government policy on cryptocurrencies. Cryptocurrencies are not regulated, which is a serious impediment to investing institutions. Therefore, the CME’s recent announcement that they will introduce a bitcoin future by the year-end is a mile-stone development. Futures are regulated investments, and will permit the managed money category on Comex to speculate in the bitcoin price. The proposed contract will be cash settled, based on a bitcoin reference rate, which means delivery cannot be demanded. It seems ironic that the first regulated investment medium in bitcoin uses the same mechanism that links betting to a horserace, but at least the futures contract is divorced from unregulated counterparties.
Assuming the CME goes ahead with this contract, other regulated exchanges around the world are likely to follow suit, and demand for futures covering other credible cryptocurrencies will arise. Before very long, wealthy clients will be asking their money managers about their investment policy towards cryptocurrencies, and it will no longer be possible to dismiss them as irrelevant. That is why the CME contract is such an important development. While it will deflect some of the second phase demand from buying true bitcoins through the creation of a parallel betting market, it legitimises investment in the underlying product.
Central banks and their governments will then face a huge challenge. This is a new phenomenon, and they know it is not money, but worry it could become money. Frankly, government economists lack the theoretical knowledge to deal with the issue convincingly. Some, like the Chinese, might continue to clamp down where they can, because of the threat to their capital controls. Other governments are likely to take the opposite view, on the basis that if the cryptocurrency service providers are regulated, or at least conform to financial regulation, then the enormous profits being made are a welcome additional source of tax revenue.
Tax is the carrot and could become an important key to the future acceptance of cryptocurrencies. And if governments permit cryptocurrencies to become mainstream, it will be a very bold fund manager who still refuses to get involved. It will be momentum investing versus value all over again, and a new paradigm, just like the tech bubble in the late nineties.
The division between the end of Phase 2 and the beginning of Phase 3 is unlikely to be clear-cut. When investing institutions get involved in a bubble, the public is bound to begin to do so as well. Our theoretical distinctions are just that, but in practice there is likely to be an elision between the second and third phases. The second phase, as it progresses, could see an enormous weight of money seeking to enter this market, and this is where we begin the third and final phase, the true madness of crowds.
Phase 3 – driven by public greed
Who knows how high bitcoin and the others will go in Phase 2. One thing is for certain, at the end of it you will have to be a true financial hermit not to know that the most sure-fire way of making money, more money than you can possibly make doing anything else, is to buy cryptocurrencies. Doubtless, by then bitcoin won’t have a price in the tens, or hundreds of thousands, because they will be split down, one thousand or even ten thousand to one. All a public greedy for profits will want to know is that the price is low, affordable and can only go up. It is the same with every bubble in history, but this one is potentially far larger. To enjoy the thrill of the Mississippi and South Sea bubbles, you had to be in communicable distance of Paris and London respectively. If you lived outside these capitals, you would probably risk the highwaymen, take a stage-coach with your gold and seek lodgings to be close to the brokers. Bubble hysteria probably infected no more than a few tens of thousands. These were the wealthy, when there was barely an independent middle class.
At the time of those bubbles, money was mostly sound. In other words, speculative purchases had to be paid for with real money, diverted from other uses. The result was an inflation of prices in Paris and London, reflecting the quantity of money that flowed to those centres. At the same time, prices in the provinces nearby would have been depressed due to lack of circulating money. Those that banked profits did so with real money, gold and silver.
Richard Cantillon, who was John Law’s banker in Paris, loaned real money (his own and his depositors’ gold) for the Parisian nobility to buy into John Law’s paper scheme. He took in Mississippi stock as collateral, and secretly sold it for gold. Cantillon withdrew to Italy to await developments, and Law’s Mississippi bubble duly collapsed.
The deflation of a bubble usually reflects an adjustment of values and expectations more than actual selling. Sufficient money had been sucked out of Paris, thanks mostly to a few savvy punters like Cantillon, to ensure the bubble imploded. Wealth simply disappeared, leaving everyone, including those who hadn’t bought stock, impoverished.
One cannot say there was no credit behind the bubble, but before the days of fractional reserve banking, issuing unbacked credit was very risky for a bank, being fraudulent to boot. Today, cryptocurrencies are not so hampered. Their purchase is entirely paid for by expanded bank credit and unbacked fiat money, both created out of thin air. Modern banking practice could in time allow cryptocurrencies to be accepted as collateral, and bankers will only know that prices are rising and it is a profitable loan business.
Not only will the fiat money be available, but you no longer need to be within a day’s coach ride from the action. Anyone with a bank account and a mobile ‘phone will be able to join in; not just the Paris or London aristocracy, but billions around the world. Supply, in the form of new currencies and yet to be invented investment media will likely not keep up with the increase in public demand, at least for a while. Methods of channelling the public’s money into cryptocurrencies will be regulated properly, giving them public respectability.
Just when the public knows only one thing, and that is cryptocurrencies are a financial miracle and a failsafe way to make money, they will be ready to collapse, if the history of bubbles is any guide. The last question we need to address is how this may come about.
The collapse of a bubble occurs when the increase in supply catches up with demand, or alternatively demand fails to keep pace with supply. Before fractional reserve banking was sanctioned by the state, the limitation on demand was the availability of money, which as stated above, meant that money had to be diverted from other activities to feed the bubble. Nowadays, the expansion of bank credit, in theory at least, permits bubbles to be extended both in terms of duration and extent.
In practice, supply in a bubble is always restrained, if by nothing else, the desire of individual promoters to see rising prices for their schemes. But the South Sea bubble showed that one successful promotion leads to a plethora of imitations, and so it is proving already with cryptocurrencies. Very few of them have gained market traction so far, but future cryptocurrencies could be more credible, increasing the available media. So, while the bitcoins of this world individually have supply constraints, the overall market has not.
Associated derivatives and developments are likely to evolve out of the market, and they will doubtless be more sophisticated and acceptable. Funds that invite public subscription and invest in cryptocurrency futures could be given official approval by becoming regulated through stock market listings. Their listings will organise extra demand, but there is bound to come a point where that extra demand will be fully absorbed. In theory, at least, that time is some way off.
Given the ability of banks to create the credit to inflate the bubble, it is hard to visualise that there will be an end to the madness by looking at cryptocurrencies on their own. We must therefore consider the prospects for the fiat currencies that are sold to buy cryptocurrencies, and how the expansion of the cryptocurrency bubble will affect fiat. For it is from that angle the end is likely to occur.
Measured in fiat currencies, any bubble is an inflation of prices. Exclusion of relevant assets from government inflation statistics means that the effect on consumer prices will be a second order event.
For the purposes of illustration and assuming all other things being equal, let us assume that at the height of the bubble, five per cent of the world’s population is dealing in cryptocurrencies. This is quite possible given the ubiquity of mobile ‘phones and other electronic devices. The paper wealth being created by some 350 million people enjoying the bubble, as well as a small portion of the enormous quantity of money under professional management, will then be in the trillions, possibly in the tens of trillions. That wealth will spread out into spending on goods and services, raising consumer prices everywhere. The effect is likely to be more pronounced in the advanced economies, where very few people are unbanked, and their successful speculation is likely to feed more directly into spending.
This is where the commonly accepted narrative, that cryptocurrencies are the eventual replacement for state currencies, becomes a dangerous illusion. It will not take long for central banks to realise that widespread public gains in cryptocurrencies are undermining the purchasing power of unbacked government currencies. They will then have no option but to raise interest rates sufficiently to choke off demand for them. And when demand is curtailed, there will almost certainly be a swift collapse.
In the absence of other factors, there can be little doubt that this is how the bubble should play out. It has the makings of being the purest bubble in the history of money, following the three impulse moves traditionally associated with bull markets. There is no defining difference between a bull market and a bubble except of degree, just as there is no one point where inflation becomes hyperinflation, and socialism becomes communism.
The underlying credit cycle and its affects
The progress of this phenomenon is likely to be affected or curtailed by other factors, notably the existing credit cycle. The industrial revolution throughout Asia, being masterminded by China and Russia, will almost certainly have a profound impact on the world-wide prices of goods and services over the next year or two. Not only can commodity prices be expected to rise, but funds will flow from conventional investments into capital projects, raising demand for skilled workers and increasing their wages.
Rising prices and production shortages will force nominal interest rates to rise anyway, whether the central banks wish it or not. Any expansion of bank credit to back cryptocurrency speculation will be in addition to these end-of-cycle factors. Therefore, it appears likely that interest rates will rise sufficiently to trigger a credit crisis before the cryptocurrency bubble has time to run its full theoretical course.
Assuming the commercial banks are rescued following the next credit crunch, it may be possible for the interrupted cryptocurrency bubble to continue, after a bad wobble perhaps. Bank deposits will still be intact, with depositors as a whole already possessing considerably more fiat currency than they need. Central banks will almost certainly force interest rates back to zero, or into negative territory, making cryptocurrencies a more attractive alternative to bank deposits.
This must lead towards one conclusion, and that is if it continues, the cryptocurrency bubble will play a major part in undermining the purchasing power of fiat currencies, potentially in dramatic fashion. If the public’s involvement in the final phase of the bubble occurs before the next credit crisis, it could bring forward and magnify the credit crisis itself. If it is still running its course after the credit crisis, it could undermine fiat currencies’ purchasing power in its wake, in a way we did not see after the Lehman crisis.
Will the price of gold be adversely affected? Obviously, some members of the public, particularly in Europe and North America, will think so, and sell or delay gold purchases to invest in cryptocurrencies. But gold is real money, and has survived episodes such as this before. The eventual victim in this bubble will be unbacked state-issued money. Gold will remain sound money long after the cryptocurrency bubble is recorded in history books as the most convincing and purest evidence of the madness and delusions of crowds.
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