AMAC Exclusive by Daniel Roman
For much of the past year, the hottest story in financial markets has been the staggering rise of so-called “cryptocurrencies” such as Bitcoin–but for many Americans, even those who fancy themselves, savvy investors, the topic remains baffling and opaque. Are these cryptocurrencies the wave of the future, or are they a bubble ready to pop? The answer, as it turns out, is that they may be both.
If you have been wondering what all the fuss is about, here is your primer, along with some context for the current crypto-mania that is taking the financial world by storm.
Cryptocurrencies, of which Bitcoin is only the most prominent, are in reality a series of numbers produced through an encryption system that theoretically creates a unique ID number for each “coin” that cannot be duplicated. This is supposed to solve the greatest problem with fiat currency, namely the ability of governments to print money at will, thereby undermining the value and causing inflation. As a consequence, cryptocurrencies have become popular among those concerned with inflation, who previously might have been attracted to gold. Furthermore, the ease of trading without supervision has made them popular for international purchases.
Yet while cryptocurrencies possess extensive promise, the market for cryptocurrencies has expanded dramatically over the last decade before exploding with the COVID-19 pandemic. The result has been concern about whether a bubble exists and the dangers posed by the potential instability of crypto markets as they come to represent an ever greater part of the global financial system. With memories of the 2000 Dot Com bubble and the 2008 Sub-Prime mortgage crisis in mind, many politicians from both parties have called for greater regulation in the United States. Abroad, China has moved to crack down on the market as a whole.
The technology behind crypto has the potential to transform the financial system and restore fiscal conservatism to governmental spending around the world while empowering individuals against governments. Yet, the cryptocurrency market in its current form is far from the stable, new gold standard that advocates have promised. The proliferation of a vast number of distinct cryptocurrencies, many of them efforts at market manipulation, means that the cryptocurrency market as it currently exists bears more than a passing resemblance to the pre-2009 financial markets, with investors looking for “get rich quick” schemes pouring their stimulus money into dubious cryptocurrencies whose major selling point is their price volatility.
What is Cryptocurrency?
Cryptocurrency is a term used to describe a whole set of data packages that are currently being bought and sold on international exchanges. These packages come in a variety of forms and are created in different ways. Computer processors produce some, others utilize hard drive space, while the vast majority use graphics processors. The commonality between them all is that they are unique, they cost time, energy, and processing power to produce, and the difficulty of producing new “coins” increases exponentially with supply.
Why would a random packet of data with a series of numbers have economic value? Well, to answer that question, it is necessary to ask yourself why gold, silver, or diamonds have value. You cannot eat them, nor can you use them to generate heat or grow food. They are valuable because they are rare, and supply is limited. While more precious metals can be “mined”, doing so requires labor and time, and the more that is recovered from the ground, the higher the cost goes because, the scarcer the remaining supply becomes. As such, anyone who owns them can be reasonably certain that the value will be relatively steady.
Cryptocurrency functions in a similar fashion to precious metals, at least in theory. Each “coin” is unique, and more can and will be created, which ensures that unlike, say, sports trading cards or famous paintings, people are willing to “spend” their crypto rather than simply hold them forever. While cards and paintings can be highly valuable, of course, the supply is steadily shrinking. No new classic sports cards or Da Vinci paintings are being created while existing ones are damaged or lost with time. This makes them valuable as investments but useless as currencies. If an item is only going to increase in value over time, then the best move is for the owners to hoard it rather than trade it. This is historically why deflation has been as damaging to societies as inflation. The number of Roman coins found in the ground is a testament to that. When the Roman government reduced the gold content of its coins, rather than trading older coins, individuals concluded that the existing coins would only go up in value and promptly buried them, causing a further currency shortage.
The above concern also illustrates the limitation of fiat money. People have long found it inconvenient to carry around precious metal. It is heavy and tends to make one a target for bandits or other ne’er do wells. The creation of fiat currency, especially paper money, simplified transactions, but governments long ago abandoned convertibility to gold. Since the 1970s, fiat currencies have been convertible against each other, and gold has merely been priced into them. In theory, governments are restricted by collective restraint. If one government prints infinite paper money, its currency will fall against all others. Since the 1990s, however, governments have figured out that they can get around this limitation as long as everyone else is printing money also. When the United States racked up a massive deficit on its own, it risked the position of the dollar. When the United States, the European Union, and dozens of other countries all print money with abandon, the illusion is created that no inflation is taking place.
Cryptocurrency is attractive because it offers the advantages of gold, silver, or other fixed assets, while also being tradable digitally in the way dollars or euros are. As a consequence, its rapid rise is no surprise to anyone who has watched the price of gold over the last decade. It is not so much that gold has increased in value as it is that paper money has decreased. Anyone above a certain age has witnessed the impacts of this “stealth inflation” on the prices of goods and services over the last three decades.
The Promise of Anonymity
Cryptocurrencies, especially Bitcoin, have, however, risen in value vastly more rapidly than gold. Therefore, it is not merely the fall in the value of paper money that is driving the increase, nor even speculative fears about the consequences of future deficit spending under Biden in America. Cryptocurrency offers other attractions, especially outside the United States.
Transactions in government-backed currencies are subject to numerous restrictions. Not only are they taxed, but anyone who has purchased products abroad has found themselves subject to numerous “conversion fees”. Furthermore, they are tracked. By contrast, cryptocurrency is generally not regulated by banks or governments. This has negative aspects. It has become highly popular on the “Dark Web” for transactions involving drug and human trafficking. Yet, one of the things that most irritates Xi Jinping and the Chinese government is the way in which Bitcoin and other cryptocurrencies have undermined centralized government controls. China’s RMB is a controlled currency. China does not allow it to flow freely and makes it hard for anyone to exchange RMB for other currencies. As such, it is difficult for Chinese citizens to get their money out of China. China also uses this to force Western companies operating in China to reinvest their profits locally rather than repatriate them to the United States or Europe.
Cryptocurrencies undermine this control. They allow Chinese citizens to purchase foreign goods while bypassing China’s protectionist policies. As such, they are proving as great a threat to China’s trade practices as anything foreign governments have done. That is one reason the Chinese government is cracking down.
This ideological element of crypto is actually part of the appeal, as the very concept of cryptocurrency is associated with freedom. Cryptocurrencies are potentially more democratic than gold or other precious metals. With Cryptocurrency, in theory, anyone with a computer can “mine” for “coins.” And millions have chosen to do just that. While this is by no means democratic in practice, insofar as the ability to mine is limited by the costs of equipment and electricity, it is easy to see why it is more appealing to a younger, libertarian generation that wishes to see a free market currency for a truly global economy.
A Currency or Commodity?
Nonetheless, the increase in the value of cryptocurrencies goes far beyond what is strictly justified by what they are and what they can do. A large portion of their increasing value has to do with a transformation of cryptocurrencies into something they explicitly were designed not to be. As noted, the difference between, say, gold and a Mona Lisa is that supply of the former can increase, but due to costs will only increase at a rate below inflation. By contrast, the supply of the latter cannot increase, and as a consequence, the result will be that the “money” supply will shrink, and deflation will result.
Cryptocurrency was designed to be a currency, not a collector’s item or commodity. But its rapid rise has led to investors, some of them opportunistic such as Elon Musk or hedge funds, others driven by media attention or online memes, to treat it as a collector’s item. Tens of millions of people are pouring their savings into Bitcoin and other cryptocurrencies not because of what those currencies can do or be used for but because they believe the value will increase.
This investment has on its own distorted the cryptocurrency market in the same way the Roman Empire’s policies led people to bury their physical coins. The purpose of crypto was to allow people to safely use a currency without worry about inflation or deflation. Instead, the rapid rise in prices means it would be madness to use Bitcoin to buy anything else, except perhaps another cryptocurrency, or as a speculative bet on Bitcoin’s future price volatility. Cryptocurrency has become too valuable as a commodity to be used effectively as a currency.
For all the talk about “what is crypto backed by?” or “what is its real value?” the most dangerous dynamic currently operating is that the boom has caused cryptocurrency to cease functioning as a currency.
There are other concerns with cryptocurrency. The first is claims that it uses vast amounts of electricity, an annoyance to the Chinese government to be sure, but along with the impact on the supply of global microchips, one that the market can easily solve.
A bigger, and more specific problem, has been how the proliferation of different cryptocurrencies has undermined the basic premise of the currency as an inflation hedge. While it is true that the supply of any individual “coin” is limited, the number of different currencies that can be created is infinite. Many enterprising individuals have discovered this, and there is a booming market in launching new currencies and using the current hysteria to inflate their value several thousand times over. Dogecoin, which started as a satire, is perhaps the most prominent example, but there is reason to believe that figures like Musk may be using their megaphone to promote new cryptocurrencies they have invested in while driving down the prices of existing ones such as Bitcoin by say, announcing that they will no longer accept payments in it due to environmental concerns. Only to then turn around and reverse himself, having caused tens of billions of dollars worth of price volatility.
This is a serious problem for the current market and is likely to contribute to a forthcoming crash. Crypto is turning into a bit of a casino, and the thing about casinos is that while players can occasionally make money off fellow players, the house always wins. In this case, the “house” being Musk and others with the megaphone to influence market behavior and the resources to profit from that manipulation.
Ultimately, this is the greatest problem facing this new financial frontier. As a technology and a concept, cryptocurrency has the potential to transform global economics and society, finally bridging the gap between the gold standard and fiat currencies by creating a currency with the stability and trust of gold but which is as agile and easy to use as (digital) paper. But the current market boom is not a boom for a currency, but rather for the coins as collectors items which people expect to skyrocket in value. Tens of millions of people have effectively decided to invest in high-tech coin collecting, spending vast sums of money to, in effect, hoard digital coins under their beds. That behavior has never worked out well in history–yet any crash which may hit the market should not cause people to dismiss out of hand the long-term potential of cryptocurrencies. They will almost certainly become a mainstream form of exchange for decades to come.
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