The recent collapse in cryptocurrency markets may be a sign that these supposedly innovative technologies just aren't that useful after all.
It has been a terrible year for crypto. Prices of bitcoin and Ether have collapsed, the terra/luna project cratered, runs on stablecoins are semi-normal events, and Celsius, Voyager Digital, and Three Arrows Capital are either bankrupt or have filed for bankruptcy. The year has been so bad, in fact, that even the crypto faithful have had to acknowledge how very bad it’s been. But if you think they are cashing out their bets, closing ventures, and moving on with their lives, you haven’t been paying attention.
Regular folks may turn lemons into lemonade, but crypto bros — male and female alike — attempt to spin straw into gold. Incapable of being chastened or called to account, the industry has fashioned a counter-narrative in which its manifest failures are merely growing pains — necessary ones — rather than signs that the product itself is a pointless, redundant gewgaw beloved by, well, let’s just say people who are not, perhaps, the financial world’s most respectable players. Indeed, the bros claim that 2022’s failures have ushered in a “crypto winter” from which only the best cryptocurrencies will emerge, presumably stronger than ever.
As Yogi Berra reminded us, “It’s tough to make predictions, especially about the future.” But an endgame in which even bitcoin, the most credible of the cryptocurrencies, emerges as a fully fledged currency simply makes no sense. And if there is no path for crypto out of its winter, a potential next step is to plod along as a curiosity in the evolutionary history of money.
Let us suppose bitcoin is used as a unit of account and a medium of exchange, while its claim to being a store of value rests, as ever, on the supply of bitcoin being capped. In this scenario, the supply of bitcoin would be used to buy goods and services for a large swath of the economy.
As productivity improves and that swath of the economy grows, the supply of bitcoin remains fixed. After one year at, say, a 5 percent growth rate, whatever amount of bitcoin was needed to buy 100 apples now buys 105 apples. A world with a fixed supply of bitcoin is deflationary. Prices fall. So, people can purchase more apples with the same number of bitcoin.
People hesitate to write contracts in bitcoin. The workers who contracted with the farmer for 10 apples an hour at the beginning of the year are paid 10.5 apples an hour at year’s end. The debtor who borrowed 100 apples’ worth of bitcoin at five percent owes 110 apples’ worth in one year — a real interest rate of 10 percent. Deflation means that even though these liabilities are fixed in nominal terms, they become more costly in terms of the purchasing power surrendered in the future to pay them off.
Deflation creates an incentive for people to hold on to their bitcoin, circulating the smallest balances necessary for economic life to go on. The lack of circulation is self-reinforcing: reducing the circulating supply accelerates deflation.
The conclusion, inevitably, would be that the world needs more bitcoin, or at least claims on bitcoin: a monetary expansion must be engineered. Perhaps the coders managing Bitcoin reset the supply to some larger number. Perhaps bank-like entities extend loans and create deposits settled in a fractional reserve of bitcoin. Whether the decisions are made centrally or distributed among actors, unless they are exactly and felicitously calibrated to the growth of the economy, inflation or deflation results.
The system begins to fork. Different bitcoin varieties try to solve the problem by other means (various changes to the supply, fractional reserve requirements, etc.). Soon competing bitcoin-like standards proliferate. The world comes full circle — now, alongside national currencies issued by over 150 central banks, we have cryptocurrencies issued by many anonymous consortia and used on their platforms. Power has not been decentralized so much as recentralized in the consortia (which may not be very big after all), and money hasn’t become better.
Whether money is a tangible thing or an entry in a bank’s ledger or an address in a blockchain, the problems of aligning money with economic activity will always exist, and those problems will always have to be solved with governance and competence. To claim that any cryptocurrency will be better governed than a major fiat currency, or more competently administered as money than the major fiat currencies, is no more than a pure article of faith.
Whatever faith there was that crypto would do a better job with governance and competence in money ought to have been shaken to its core by the destruction of value, suspensions of redemption, and bankruptcies that have rocked this area this year. Billions of dollars have gone unaccounted for, gotten lost, or simply been gambled away. And these are merely the problems we know about in a secretive, aggressively opaque sector. Lacking any other means of accountability or recourse, holders of crypto can only run for the exits — and if they find their way barred, hope that bankruptcy courts and prosecutors will help them recover value.
In fact, one possible reading of the current situation is to say that the scenario above is exactly what has played out so far this year. Because so little “good” crypto was in circulation, many actors rushed in to create claims on crypto according to various standards. This experiment in unregulated fractional-reserve banking unwound quickly and unceremoniously with a series of runs on the would-be banks — perhaps with more to come. Demand for claims on crypto has been driven mostly by speculation, rather than real economic needs. Given the pain we have witnessed among claim holders in this speculative frenzy, why would anyone want to tie the economic demand for money more closely to such flimsy standards?
When presented with forecasts of a crypto winter and the implication that a few diseased beasts are being culled for the good of the herd, practical people should respond: “Don’t pee on my leg and tell me it’s raining.” Lawmakers, for their part, should know when to distinguish invasive species from endangered ones and take action accordingly.
Steve H. Hanke is a professor of applied economics at Johns Hopkins University. He is a senior fellow and the director of the Troubled Currencies Project at the Cato Institute. Matt Sekerke is a fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise.