The Specter of Cryptocurrencies

Douglas Adams’ "The Restaurant at the End of the Universe" pokes fun at our often flawed conception of money:

"How can you have money", demanded Ford, if none of you actually produces anything? It doesn't grow on trees you know."
If you would allow me to continue.
Ford nodded dejectedly.
“Thank you. Since we decided a few weeks ago to adopt the leaf as legal tender, we have, of course, all become immensely rich.”
Ford stared in disbelief at the crowd who were murmuring appreciatively at this and greedily fingering the wads of leaves with which their tracksuits were stuffed.
“But we have also,” continued the management consultant, “run into a small inflation problem on account of the high level of leaf availability, which means that, I gather, the current going rate has something like three deciduous forests buying one ship’s peanut."
Murmurs of alarm came from the crowd. The management consultant waved them down.
“So in order to obviate this problem,” he continued, “and effectively revalue the leaf, we are about to embark on a massive defoliation campaign, and ...er, burn down all the forests. I think you'll all agree that's a sensible move under the circumstances."
The crowd seemed a little uncertain about this for a second or two until someone pointed out how much this would increase the value of the leaves in their pockets whereupon they let out whoops of delight and gave the management consultant a standing ovation. The accountants among them looked forward to a profitable autumn aloft and it got an appreciative round from the crowd.”

This is a post about the worst case scenario. If you are looking for a more likely outcome for cryptocoins, see this for example. In short, it's more likely that crypto money eventually becomes some kind of digital gold, a volatile asset with poor performance as an investment (though there might be money to be made until it reaches its steady state).

It's worth mentioning the worst case scenario however, because of the potential magnitude of the devastation it entails.

First, let's talk about what causes recessions and depressions. In economics, recessions are usually described in terms of low aggregate demand.

I find aggregate demand is a poor way to convey the idea because it's not that people suddenly don't want stuff, it's that they prefer to hold cash. You can describe what is happening in terms of too high demand for currency. As usual, Nick Rowe explains it best for laypeople like myself:

"We buy newly-produced goods with money. A Keynesian recession is an excess supply of newly-produced goods, and a deficiency of Aggregate Demand. In a monetary exchange economy, a deficiency of Aggregate Demand, and an excess supply of goods, is an excess demand for money. Money is what we demand goods with."

So people on an economy wide scale suddenly prefer to hold government-managed cash. During recessions, people (and businesses and banks) also don't want to invest their savings in businesses, again, relative to how much they prefer to hold government pieces of paper (it doesn't help that these busineses sell less since potential customers prefer to hold currency, but even if they maintained sales, preference for cash would make them less attractive to own).

The point is that it's the fact that governments have made available paper money, an artificial alternative to private investment that causes people to withdraw from the real economy at the first sign of trouble in the markets.

People hoard fiat when economic conditions turn sour. Money's real returns are often fixed at -2%. Returns in private markets, on the other hand, can sometimes go further negative (especially on a risk-adjusted, liquidity-adjusted basis). Plus if there is disinflation or outright deflation, money's real returns go higher and these returns further compete with assets on the private markets. This can turn into a vicious cycle. Hording money causes money's value to increase which in turn causes people to further want to hoard and so on.

The failure of government paper to follow the private markets into sufficiently negative returns can turn into a massive economic distortion. It crowds out private investment on an economy wide scale. See this post about the Great Recession for elaborations on the mechanics and on the sometimes counter-intuitive negative returns.

The Great Depression of the 1930s was a particularly bad case of this. It can be seen as the demand for money crowding out private investment on a global scale. The effect was amplified by the deflationary pressures of tying currencies to gold, which limited cash supplies and made it seem even more valuable.

The world ended up in a state where few wanted to invest in businesses to produce stuff because they preferred to hold non-productive, gold-tied, government-stabilized tokens. Combine insufficiently inflationary currencies with the effects of sticky wages and markets just couldn't adjust to resolve the problem.

The Great Depression destabilized Europe, especially Weimar Germany which was particularly afflicted by deflation. You already know how that story ends.

Now, this all begs the question, could cryptocoins, as more and more people hoard them, crowd out private markets globally like gold tied currencies did in the 1930s?

Well, cryptocurrencies have a few things going for them that might prevent this. First, not much is priced in units of cryptocoins and crypto token prices tend to float freely compared to government currencies. This is what makes them more like gold (here I mean plain gold when there is no attempt at tying it to government currency). Gold's scarcity naturally causes it to have high volatility and this volatility keeps it from interfering with wider markets. On a risk adjusted, liquidity adjusted basis, it's often not super attractive compared to assets with more predicatable returns, even sometimes when those returns are lower. Free markets automatically tend towards this returns-volatility trade-off.

There is no free lunch. You can't beat the trade-off by stabilizing the price of non productive tokens. Trying to stabilize deflationary tokens, if you are a government with formidable enough means to do so, causes the tokens to be hoarded to a point where the instability gets pushed to the rest of the economy. Investment in productive endeavors gets displaced by currency hoarding which leads to recessions or depressions.

If there wasn't a trade-off between volatility and returns, it would be possible with no downsides, to do like in the story about the tree leaves and build wealth by declaring something currency and making it scarce. Unfortunatly, for people to be able to consume more, production has to increase. Scarce, artificially stabilized tokens work against this.

By the way, this also means that contrary to popular belief, gold (and cryptocoins) are a terrible "inflation hedge". The price of gold goes up when people are looking for more "inflation hedging" and goes down when they no longer want it, which means the average inflation hedger is buying high and selling low. This is a component of the volatility that prevents gold from crowding out other markets. The one case when gold might be useful as an investment is when you know your spending needs are counter cyclical to the majority's spending needs. If you are following the herd you are likely incuring this buy-high-sell-low loss.

The necessary volatility also has the down side of making it impractical to conduct day to day transactions and negotiation of contracts with deflationary tokens.

Some people might say that the free floating nature of cryptocoins solves the sticky wages issue. It might help but I don't think it fixes the problem. While wages are not sticky in terms of crypto prices, if they are negotiated using an inflation targeted currency, in real term, they are still sticky. Real wages being sticky means they can't sidestep the effects of the real returns of cryptocoins.

Despite all this, left to themselves, cryptocoins are mostly harmless. I'm ignoring the other concerns that usually come up such as energy consumption, fraud etc. For the purpose of this argument, assume these are solvable as the technology matures.

But what if, like gold in the 1930s, cryptocoins are not left to themselves?

While speculators have essentially no chance of affecting the greater economy, if large organisations and institutions catch the crypto fever, the effects can spread. This definitely gives me pause.

Note that this is not even specific to cryptocoins. If Tesla was amassing billions in gold or another metal and this started a trend with other large organisations, I would also worry that we were setting ourselves up for a repeat of the 1930s. At least gold has been studied so much by macroeconomists that the threat would likely be recognized and neutralized very fast.

Now even if lots of organisations choose to hoard tokens instead of investing in the real economy, in theory, central banks can compensate and keep the economy cruising. They can stay stimulative enough in phases of greater crypto hoarding that there is plenty of monetary flows to fuel both the real economy and the high prices of tokens.

The goal would be for cryptocoins to reach their steady state, a price high enough that they can go down again and resume natural volatility as soon as possible. I'm sure cryptocoins holders will be glad to hear that the "To The Moon" strategy is actually a possible solution here.

As long as central banks don't flinch at the sight of what may look like high volatility and crypto bubbles, we might be ok. Central banks have been known to flinch in the past but they've been doing a comparatively good job keeping the economy going during the extreme challenge of the covid 19 crisis so maybe they can get us through crypto induced storms.

But what if there is a slow trend of more and more organisations adding crypto to their balance sheet, which slowly pushes crypto prices up over a long period of time. Everybody gets used to inflated returns on crypto which makes more and more organisations buy them which further fuels their upward trend. Eventually even financial institutions get in on the fun and overload their balance sheet with cryptocoins and get addicted to the easy returns. This makes crypto coin prices overshoot their safe level at the same time as they are becoming systemically important.

We get to 2029 and we have lots of organisations that have political power and incentives to keep prices rising and stable and they also now have arguments that cryptocoins are new fundamental technological part of the financial system and it's dangerous to let them become too unstable.

I can see it right now, there would be news articles saying how these coins are now an integral part of the financial infrastructure, an evolution of technology and governments and central banks should play a role in insuring their stability. If a consensus forms around these ideas, smarter voices could be drowned out.

So central banks cave, and against expert advice, in order to save too big to fail institutions overloaded with cryptocoins, try to stabilize and prop up cryptocoins, maybe partially tying monetary policy to cryptocoin movements. In doing so, they severely destabilize the rest of the economy, just as they had done with gold a hundred years prior.

After seeing how quickly the comparatively mild recent global financial crisis boosted right wing populism worldwide, reading from wikipedia's Weimar Republic page doesn't inspire confidence.

From 1930 onwards, President Paul von Hindenburg used emergency powers to back Chancellors Heinrich Brüning, Franz von Papen and General Kurt von Schleicher. The Great Depression, exacerbated by Brüning's policy of deflation, led to a surge in unemployment.[8] On 30 January 1933, Hindenburg appointed Hitler as Chancellor at the head of a coalition government

WWIII, sticks and stones and all that, is not outside of the realm of possibilities.

What makes a trend like this particularly insidious is the bad equilibria of the group decision.

Even I, knowing the potential for destroying the world, am tempted to hop on the crypto bandwagon.

The problem is that in the mean time, before the destruction, the earlier you hop on, the more you stand to gain even if in the end it causes everybody to lose.

That is, if the world is going to incur a high risk anyways because of herd behaviour, I might as well profit from it while the going's good, even though this will cause me to contribute to the likelyhood of the terrible outcome. Maybe I should even promote crypto so that the good run last longer and goes higher, even though that makes the final outcome even worse.

It's a prisoner's dilemma. It's Moloch. I am painfully aware that I am potentially losing by not participating and that my individual decision will likely do little to save the world from itself anyways.

If this stays contained to individuals, the risk of catastrophe is low. But large institutions also benefit from joining the fray early on.

These types of inadequiate equilibria where it's advantageous for individuals to do things that can lead to collective demise down the road when done by too many people, tend to inflict the worst kinds of pains on civilization.

On top of all this, it's possible that the danger is higher with crypto than with gold. Gold caused worse problems when its deflationary issues manifested in a financial system that was getting more globally connected than before. Communication technologies were maturing fast in the 20th century.

We've now gone a long way in that direction. The potentially stronger network and memetic effects of cryptocoins, along with the amplification factor from markets being synchronized through instant global networks nowadays might make them dangerous to the economy with less central bank involvement. We saw how much people got hypnotized during the Gamestop episode.

What if governments are being lobbied right now for greater integrations of crypto tokens in the financial and monetary systems? Coinbase and Tesla likely have lobbyists. They might not succeed but would you bet the world on it?

Now there are a lot of if's in the above scenarios which thankfully means a lot of off ramps from the path to the worst case scenario. But the 1930s and 1940s did happen so it's not unimaginable.

When Douglas Adams wrote "to embark on a massive defoliation campaign, and ...er, burn down all the forests" in 1980, I don't know if he was being extraorinarily prescient about the impact of future tokens on the environment or more likely 'defoliation' was a metaphor for deflation crises of the 20th century and how readily people will agree to burn it all down in an attempt to boost the worth of their tokens (Note that people are now literally burning down art for NFTs).