The amount of central bank warnings about the rise in private cryptocurrencies – and the potential impact on central banks’ ability to conduct monetary policy – has become deafening. This criticism only serves to convince libertarians that reducing the power of central banks and governments is desirable. Certainly, the hostility of the Chinese authorities towards private cryptocurrencies can serve as evidence that they are viewed by the state as a defense against intrusive social control. But whether that view is correct or, when it comes to monetary control, not social control, is dangerously naive, there is another undeniably serious problem with cryptocurrencies. It’s a problem only hinted at by central banks, but that is what libertarians should be most concerned about. The problem is bubbles.
There are many bubbles in the world now, but they differ in their nature and their consequences. A stock bubble can be rational. The price of stocks can go up indefinitely, provided that “real” (inflation-adjusted) interest rates do not and will not go up. Assuming a growing world population, the range of “bigger fools” to sell to at a higher price is theoretically endless. The idea of a “bond bubble” is harder to rationalize. Unlike stocks, virtually all bonds have an end date – their maturity date. If you buy a bond with a negative interest rate (a negative “yield”), you know for sure that if you still own it when it matures, you will be suffering a nominal loss (the loss will get worse in real terms). So if you are concerned that other assets are overvalued and could crash, why not just hold cash?
Still, many professional investors currently own bonds that trade with negative yields. This only makes sense if you expect even more negative interest rates that lead to a capital gain (bond prices and bond yields move in opposite directions). But even then, the price of the bond must at some point return to face value (its “face value”), inflicting a capital loss on whoever bought it at a price above par. So implicitly, the ultimate “bigger fool” is expected to be the central banks, which are not motivated by returns and can expect recapitalization by their governments – albeit at a significant cost to their independence – should capital losses lose their solvency.
Alan Greenspan’s big mistake
Bubbles in both bonds and stocks are symptoms of a deeply ingrained imbalance in today’s developed world. The downtrend in long-term real interest rates, which persisted through this millennium and was only exacerbated by the pandemic, fueled the bubbles necessary to restore and maintain full employment and to stave off deflation. Why is that happend?
Interest rates are “intertemporal” price signals – they balance the supply and demand for money over time. When these signals go wrong, it leads to a misallocation of resources across the economy. Our current imbalance dates back to the second half of the 1990s. The then Chairman of the Federal Reserve, Alan Greenspan, failed to allow real long-term interest rates to rise at the right time in response to the very buoyant business expectations in the internet-driven “new economy”.
As a result, not enough consumer spending was deferred during this period. In fact, the dot-com-era equity bubble boosted spending even further. When an additional “New Economy” offering was put online, there was no “pent-up” demand from previously deferred spending (ie savings) to absorb. This mistake, combined with the far less harmless catastrophe of the monetary union in Europe, ensured that intertemporal price signals – that is, interest rates – went badly wrong and have been wrong ever since. A secular trend towards lower and lower interest rates and bigger and bigger bubbles has started.
An illusion of wealth
The equity bubble in particular has created the illusion of wealth. It is illusory – for the economies as a whole – because it is not based on a greatly increased future potential output (if at all, estimates of this potential have been persistently lowered). The political implications of the resulting wealth inequalities are worrying, but so far they have not caused serious problems. That’s because they haven’t caused the economy to overheat: the extra spending created by this illusory wealth accumulation has offset the resistance of the intertemporal imbalance (in which past bringing forward spending from the future leaves a demand hole while the future the gift).
But when dangerously high public “capital expenditures” lead to inflation – feared by many in the UK and particularly in the US – some equity “wealth” holders may feel they should spend more of that wealth before it reaches its true value reaches falls. But the only way to do this without starting an inflationary spiral is for everyone else’s spending to fall. Distribution problems would then really become a major political issue.
An even riskier mania
Yet another, even more dangerous, bubble has developed in recent years. This is one that, if not controlled, will inevitably lead to catastrophic changes in the distribution of wealth. This bubble is in private cryptocurrencies. As with stocks, cryptocurrencies do not have an end date. So a bubble can be rational in the same way. However, when looking at the macroeconomic context, it becomes clear that the bubble has to burst.
Why? For example, the market price of Bitcoin can either become infinite or not. If this is not possible, at some point the only possible change in the market price of Bitcoin is negative. At that point, all holders would want to sell (unless the central banks – as with bonds – would support the Bitcoin price indefinitely!).
If instead price can and does move towards infinity, then using a tiny amount of a single person’s Bitcoin wealth would deplete the world’s productive potential; that is, every owner could have all of the world’s resources by being the first to sell and spend. The rise in the general price level towards infinity as Bitcoin holders competed for resources would impoverish everyone else.
It is clear that many governments – especially the US government – now want to produce huge wealth transfers. Whether they are right or wrong is a matter of dispute. The key questions are: How do you differentiate in practice between what I have termed “acceptable” wealth (wealth that is owned that does not diminish lifelong consumption opportunities for everyone else) and “unacceptable” bladder wealth, the possession of which affects consumption possibilities Lifetime reduced? for all others?; and how to eliminate unacceptable wealth without crashing the economy.
But whatever your view, the wealth transfer that Bitcoin is threatening to produce is definitely not what the US government or others want to produce. When the bubble grows, it does not create additional wealth in the form of future production potential for an economy as a whole. It simply transfers assets from everyone else to existing Bitcoin holders. This creates pressure on everyone else to participate.
Governments need to burst the crypto bubble
To avoid serious social and political discontent that leads to civil unrest and ultimately sociopolitical collapse, authorities need to burst the Bitcoin bubble before its macroeconomic impact becomes much greater. The similarity to bank runs is pretty clear. If none of Lehman Brothers’ ten largest liquidity providers had withdrawn funding, in all likelihood no one else would have done so. If those ten withdrew their funding, they would likely all do the same. The greater the “illusory wealth to potential income” ratio in the economy, the greater the temptation for someone to get off the ship and be the first to use their wealth to acquire real resources.
Indeed, the reverse of this “illusory wealth-to-potential-income” ratio can be viewed as the equivalent of a bank’s equity ratio during a financial crisis. This ratio is moving in the wrong direction as the illusory nature of many of the bank’s assets becomes apparent. Conversely, the incentive for his debtors to withdraw is growing. It is deeply ironic – and tragic – that while central banks and regulators reacted to the financial crisis (they created themselves) and insisted on higher capital ratios for banks, monetary policy worked and continues to work to increase the economy’s “capital ratio”. Aside from a radical change in the policy framework, the likely outcome will be a devastating economic, financial, social and political crisis far worse than anything the 2007-09 financial crisis could have produced. Marxists could be happy about such a prediction. Libertarians should be careful to keep it from coming true.
The longer central banks wait before taking action to prevent cryptocurrency bubbles from swelling, the more difficult it will be for them to do their job. Bank of England Governor Andrew Bailey has warned Bitcoin “investors” that they risk losing all of their money. But if the bubble gets much bigger first, its bursting will have a significant macroeconomic impact as the expenses funded by borrowing against Bitcoin’s “wealth” will disappear. Worse still, devastating losses are being inflicted on speculators, including an increasing number of ordinary households. The fact that they have been warned will not prevent potential seismic reactions.
Central banks and regulators, therefore, now have an unenviable choice. Presumably they don’t want to be blamed by crypto “investors” for a burst bubble. So they can hope that it will subside by itself and then regulate it out of existence. But if the bubble continues to grow, they will have to grab the nettle and cause losses now or face a future scramble to convert crypto holdings into goods and services that will create hyperinflation and destroy society.