Crypto Mania, Financial Contagion and the “Goldilocks Zone”
Tuesday 03 May 2022 09:36
From the gold fever of the 1840s and 1850s and the bicycle bubbles of the 1890s to the bowling craze of the 1960s and the dot-com boom of the 1990s and early 2000s, our animal spirits are always at the search for greener pastures.
In recent times, the financial herd has been rushing into the cryptocurrency arena.
A study published by the Financial Conduct Authority last year estimated that 2.3 million adults now own crypto-assets in the UK (up from 1.9 million the previous year). Six percent of US respondents said they had bought or traded cryptocurrencies in the past 12 months, according to a Statista Global Consumer Survey last year. Respondents in Peru, Turkey, the Philippines, and Vietnam had entered the crypto market at much higher rates, from 16% to 21%.
In Central America, El Salvador has made bitcoin legal tender and plans to develop “Bitcoin City” at the foot of the Conchagua Volcano. The International Monetary Fund (IMF) has warned El Salvador against this course.
Digital currency has gained remarkable legitimacy in the minds of the masses, media, and markets. But not everyone is buying “technobabble,” as Nobel Prize-winning economist Paul Krugman calls it. “Cryptocurrencies play almost no role in normal economic activity,” he writes. And investors such as Charlie Munger – Warren Buffett’s 98-year-old business partner at Berkshire Hathaway – have been rather fierce in their criticism.
Perceived value is contagious
A key element of behavioral finance that we need to appreciate, however, is that perceived value is contagious. I may not believe in the aesthetic appeal of diamonds, for example, but I cannot ignore its psychic value in the imagination of others.
Admittedly, crypto ostensibly has some economic value. The promise of blockchain technology – security, transparency, efficiency, traceability and automation – has been discussed at length.
For this reason, non-crypto believers should beware of what former Intel chief executive Andy Grove calls the first version trap. Think, for example, of Apple’s Newton portable devices in the early 1990s. There were legions of naysayers, and it became kind of a mess. But that was not the end of the portable digital device. Sometimes it takes generations for technology to realize its first promises and transform the landscape.
Crypto devotees, on the other hand, should be wary of the siren song of speculation. Irrational exuberance and fear of missing out (FOMO) can lead to a lot of recklessness. Just as it can take generations for a truly transformative technology to reach critical mass, bad investments and outright scams can survive for decades before bottoming out.
Moreover, bad behavior tends to worsen where capital is freest. A study found that around one in four bitcoin users and 46% of bitcoin transactions are associated with illegal activity. This represents $76bn (around £58.5bn) in shady dealings.
Risks to our interconnected financial world
Equally salient are the risks of financial contagion. Prior to the global financial crisis in 2006, US subprime mortgage issuance totaled $600 billion (less than a quarter of the US mortgage market). Few people imagined that this failure was possible, or that such a failure would threaten the entire financial order.
As Ben S Bernanke, Timothy M Geithner and Henry M Paulson Jr write in Firefighting: the financial crisis and its lessons, experts underestimated the dangers of an interconnected, overleveraged system and the potential for an E. coli effect: the financial equivalent of a case of food poisoning at a local burger restaurant leading to a national aversion to fast food. Indeed, the crisis of confidence was so visceral that even well-capitalized titans like Berkshire Hathaway, in the words of Warren Buffett, were staring “into the abyss”.
Similar risks may apply today in the crypto world. At the time of writing, the global cryptocurrency market capitalization is north of $1.7 trillion. The market capitalization of gold, by comparison, is around $12.5 trillion. Crypto market capitalization is not an insignificant sum.
A cocktail of real estate debt, speculative assets, prolonged economic shock and contagious panic could generate the perfect storm. We should not think of speculative markets in a reductionist way and isolated from the real economy.
Crypto will have to prove itself
Those tail risks, however, won’t stop the music. Today, many households entrust their hard-earned savings to digital coins. JPMorgan Chase, for example, is increasing its customers’ access to crypto funds, even as chief executive Jamie Dimon describes bitcoin as “worthless.”
New instruments such as bitcoin bonds and crypto exchange-traded funds (ETFs) are making the rounds. And if the internet and subprime bubbles are any guide, we can expect opaque, complex, and leveraged innovations and financial engineering to follow. Animal spirits paved the way for both rational speculation and teeming incompetence.
Similarly, investor and philanthropist George Soros describes how fallibility, reflexivity and positive feedback loops can push valuations into territory away from equilibrium. Stories, expectations and prices will, of course, adjust as confirming and disproving evidence comes to light. Crypto will also have to face this test. At some point, it will have to prove its economic worth.
Until then, there seems to be a “Goldilocks Zone” of trust and expectation. We don’t want to fall into the trap of the first version and dismiss any valid risk that comes along. But we must also avoid the dangers of unbridled speculation. We forget that even temporary failures in inflated markets can spread and endanger the whole system.
Of course, governments and institutions will play some role in temperature stability and control. But financial history tells us – whether it’s because of bureaucracy, inertia, libertarian ideals, or some combination of these – that they’re likely to be late in the game.
Either way, crypto will serve as a fascinating case study in the annals of financial history, whether it ends up being the 21st century equivalent of tulip mania or a truly lucrative, game-changing innovation. coming.
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By Tobie Sebastien Limeconomist working in competitive strategy and technology investing and co-founder of Athenarium.com.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Mesut Ugurlu