Good Riddance to Crypto, or How Everything is Related to Everything Else
In his latest blog post, Francis Fukuyama looks at crypto wunderkind Sam Bankman-Fried and how monetary expansion has fueled the rise of cryptocurrencies.
It has been hard to read the innumerable accounts of the fall of Sam Bankman-Fried and the bankruptcy of his FTX cryptocurrency exchange this past week without a strong sense of Schadenfreude. SBF, as Bankman-Fried was known, was lauded as a different kind of crypto advocate, one who invited regulation, contributed to liberal causes, and claimed to be the voice of responsibility in a Wild West sector. It turns out that he may have been running one of the world’s largest ponzi schemes, in which investor money was used to shore up a related exchange, Alameda Research, which in turn invested in FTX’s own cryptocurrency FFT. As many as a million creditors may be out their money, leading to many further bankruptcies and collapses throughout the sector.
Cryptocurrencies were always a solution looking for a problem. Running on top of a blockchain, they were supposedly a currency that was not manipulable by governments and whose value was therefore more secure. As Nouriel Rubini and many others have explained, however, since the beginning of Bitcoin a decade ago they have never functioned as a meaningful form of money and have always had the character of a Ponzi scheme.___STEADY_PAYWALL___
Currencies have three main functions: as a mechanism of exchange, a measure of value, and a store of wealth. Cryptocurrencies have fallen short in each category. Only a minuscule fraction of the world’s trillions of dollars of daily transactions are carried out in cryptocurrencies. Bitcoin sharply limits the number of bitcoins in circulation, and uses an unconscionable amount of energy to verify each transaction. The usage of bitcoin has therefore hardly budged since its introduction; other crypto coins circulate more widely but are mostly used to buy other cryptocurrencies.
Given the wildly fluctuating prices of cryptocurrencies, they hardly perform the second function as a reliable measure of value. (Bitcoins were worth $4,000 at the end of 2019 but soared to $69,000 in November 2021, and are currently at about $16,000 today.) How many times have you seen a house or car priced in Bitcoin or Ethereum? It is only as a store of wealth that crypto potentially has a use, since by design cryptocurrencies are limited in supply and cannot be readily counterfeited. But unlike gold—another store of wealth sometimes used as a currency—crypto tokens have no intrinsic value, and while any given cryptocurrency cannot be artificially replicated, anyone can create a new currency. Unlike gold, you can’t use tokens to make jewelry or fill teeth; they are valuable only as long as there is another sucker to come along and buy them.
The only places where cryptocurrencies make sense are those like Argentina, which have a history of persistent inflation. And indeed, Argentines are per capita among the largest buyers of crypto. They would however have been better off buying U.S. dollars instead, were they allowed to. In the U.S., cryptocurrency prices have declined rather than increased as inflation has returned—the exact opposite of what they were supposed to do.
The rise of cryptocurrencies and related phenomena like NFTs (non-fungible tokens) and meme-stock trading (e.g., the pumping and dumping of GameStop and other penny stocks) in 2020-21 are related to the same underlying phenomenon, which was the monetary expansion that took place over the past two decades, and particularly after the 2008 financial crisis. The U.S. and other countries suffered numerous shocks in this period, from 9/11 to financial crises to the Covid pandemic, and monetary policy was used in each case to stabilize financial systems. Year after year, however, this pumping up of the money supply by central banks in developed countries through ultra-low (if not negative) interest rates and quantitative easing (purchases of financial assets by central banks) did not have the effect predicted by monetary purists of stoking inflation. Indeed, the failure of central banks to generate consumer price inflation despite the monetary expansion they produced led to things like Modern Monetary Theory (MMT) that argued that money could be endlessly printed with no adverse economic consequences.
The fact was, however, that while consumer prices stayed largely flat throughout this period, money was flowing into other sectors and lifting the value of other assets from stocks and bonds to houses to paintings and antique cars. Monetary expansion encouraged the explosion of cryptocurrency prices, which after 2019 were also driven by the pandemic as Americans stayed away from stores and restaurants and cashed in their Covid support checks to trade in crypto assets. Ultra-low interest rates also encouraged the use of leverage to pump up capital gains.
In the U.S., there was a generational component to the crypto movement. My first exposure to financial markets came when I was an undergraduate at Cornell. I was a member of Telluride Association, a student-run organization established by a robber baron named L. L. Nunn who founded Utah Power and Light. As students we managed everything about the organization, including the Association’s endowment. While a junior in college, I became chairman of the endowment’s investment board. Under my leadership, the value of the endowment went from $4 million to $3 million, having gotten caught up in the 1974 bear market. Hence my first experience with the stock market was that it usually went down.
Subsequent generations, however, have experienced nothing but rising markets. Once U.S. inflation was tamed in the early 1980s, the U.S. economy charged ahead over the next couple of decades. Technological developments kept driving down the cost of transportation and tied the world together in unprecedented ways. There were periodic setbacks like the 1987 stock market crash, the collapse of the dot-com bubble, or the 2008 financial crisis. But better monetary policy and underlying deflationary trends caused both by technology and globalization meant that those problems would only be temporary. Anyone with financial assets in this period could look like a genius. Gen-Z investors came regard crypto as a secret that their generation had uncovered, and they looked down upon anyone who tried to cast doubt on the fundamentals of the enterprise.
In retrospect, it seems pretty clear that this unusual period of ultra-low inflation and interest rates was being driven by a one-off phenomenon, which was the entry of China and a handful of other developing countries into the global trading system. This was particularly the case after China’s entry into the World Trade Organization in 2001. As hundreds of millions of new low-wage workers were added to the global labor supply, jobs and manufacturing along with their supply chains moved from the U.S. and Europe to East Asia, depressing rich country wages and keeping down the prices of goods and services.
This period is now over. Wages in China have been rising steadily in recent years, and the flow of new entrants into the global labor market has slowed. Immigration became politically controversial in Europe and America, and barriers to the movement of people have gone up. The pandemic again exaggerated this slowdown in trade by disrupting supply chains and blocking cross-border movements of people. MMT now looks pretty silly in retrospect, as consumer price inflation has taken off in virtually every corner of the world. As interest rates rise, all the leveraged bets on asset prices have gone into a sickening reversal and financial failures have cascaded on one another. Younger investors probably need to dust off used copies of Graham and Dodd and relearn the fundamentals of market investing.
The fall of SBF and FTX will probably increase calls to regulate the crypto world. A recent article in the Financial Times however suggested that this market be allowed to destroy itself through fraud and abuse, provided it was walled off from the rest of the economy by, for example, prohibiting fiduciaries to hold crypto assets. If libertarians want to live within their own government-free world, let them do so. It is hard to imagine that this would have a negative effect on the rest of us, since cryptocurrencies weren’t performing any useful social function in the first place. The safest financial asset remains, in the end, the U.S. dollar.
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