It has been five years since I last wrote about crypto currencies. So far they have not become worthless, so they are holding up better than I thought. Time to revisit the argument for and against them. I can see three ways crypto currencies can fail, at least one of which is likely. I can only see one way in which they can succeed.
The first way they can fail is if it turns out that the technology is flawed. It could be hackable, either because the code is faulty or because we will see new technology that allows the hacking of code that was previously not hackable. This would be a black swan event that is difficult to predict.
I am not a technology guy. Therefore, it is difficult for me to judge the soundness of blockchain technology myself. I can only conclude that so far, after almost 15 years of being tested by the combined intelligence of the worldwide technology community, blockchain technology seems to hold up pretty well. Therefore, I would give crypto currencies a low probability to fail on this front.
The real problem I have always had with crypto currencies is that they don’t work economically. That is because investment psychology is not on their side. As far as I can tell, investment psychology is like a law of nature. It will always prevail on a free market.
How does investment psychology work? Warren Buffet famously said “In the short term the market is a popularity contest; in the long term it is a weighing machine.” In other words, in the short term markets move because of psychology, but in the long run fundamentals matter.
Humans like inductive reasoning, meaning they project past trends into the future. We cannot help it, it is fundamentally how our brain is wired. If we see something going up in price, we expect that trend to continue into the future. Conversely, if we see something going down in price, we expect it to go down further.
The masses are deeply in the hands of this psychology. From personal experience, I know it is impossible to teach most people to go against that instinct. When most people see someone else making money in something that is rapidly going up, they want to be part of it. They think that this past trend of upwards trending prices is certainly going to continue into the future. Therefore, they too will make a lot of money if they invest now.
This drives prices to go beyond the actual value of an investment. People are not buying because they think that something is fundamentally undervalued compared to its intrinsic value. Instead, they are buying solely for the reason that their brain projects the past upward trend into the future. In other words, because of that past trend, they think they will soon find someone that will buy their investment for an even higher price.
That psychology also works in reverse. Once something is going down, the masses start to think that there is only one direction the price will go in the future, and that is further down. They therefore do not buy more and instead sell if they are still invested.
Prices are determined by supply and demand. When demand goes down, prices go down, and when demand goes up, prices go up, assuming that supply is unchanged. Usually, however, when demand for something goes up supply also increases, since capitalists are trying to profit from the trend and increase production. This then eventually leads to supply exceeding demand, at which point prices top out and start to go down.
The big selling point of crypto currencies is that the supply is more or less fixed. That means, within a single crypto currency, supply cannot be increased to match demand. Therefore prices can go up for a long time once an upward trend is in motion.
However, even in this case the upward trend will not go on forever. That is because there is a natural limit to demand. At some point everyone who has a budget to invest in crypto has fully invested that budget. At that point there are more sellers than buyers and therefore prices are starting to go down. As I explained earlier, this new trend then feeds on itself.
If this was not the case, everyone could become rich by investing in crypto. But it should be clear to everyone that that is impossible. Cryptos are a zero sum game. For every winner there must be an equal amount of losers. That means that only the early investors, who sell before most others do, can make money. That is a mathematical certainty.
Because of this investment psychology, markets go in cycles of bull and bear markets. These follow each other like night follows day. While there are big players, like governments, who can prolong or shorten these cycles, nothing can stop them. History has shown that markets eventually always win.
So far so good. In order for crypto currencies to become real currencies they need to have a somewhat stable value. Only then it is possible for businesses to use them for planning. People also won’t hold a currency if it is not stable. Usually, it is already a big deal if a currency looses or wins a few percent of value in a full year. Compare that to crypto currencies where even the most stable digital tokens frequently move multiple percent in a single day. They are therefore not useful as a currency or a store of value.
How can crypto currencies get to the point where they have a stable enough value to function as a currency? It is not necessarily a problem that some people use a real currency as an investment vehicle for capital gains. Every major currency in the world, like the US Dollar or the Euro, is traded every day by an army of traders seeking capital gains.
The big difference between those currencies and crypto currencies is that most people use the US Dollar not as a speculative investment vehicle. All major currencies are mainly used for daily transactions. Instead of seeing these currencies as an investment, most people see them as a store of value, an anchor that is a tool to value everything else.
Usually, in order for something to become a currency on a free market, it first needs to have a stable value and it needs to be traded on a liquid market. Only then do people trust it enough to use it as a store for their hard earned capital. In order to have a stable value there needs to be a large market for it outside of its use as a currency.
For example, cigarettes are often used as a currency in prisons. There is a large and stable market for cigarettes, because they provide direct utility to their users. This market guarantees that one will always find a buyer for a cigarette. The safety that there will always be a buyer makes them potential good money in a situation where supply is scarce, like in a prison.
There does not appear to be a market for crypto currencies outside of being an investment. If that is true, then how can the price stabilise without such a market? I cannot see any market force that could do that.
Investment vehicles, like stocks, are usually more volatile. What potentially somewhat stabilises the price of an investment is its intrinsic value. An intrinsic value is the use value of the investment, in other words the utility some people can get out of it other than speculating on capital gains.
For example, if I buy stocks in a company, that company has some real use value. It owns useful assets that could be sold, and it earns money by providing some kind of utility to its customers. If I am an owner of such a company, even if I just own a small part of it in the form of commonly traded shares, I have a claim on those real values of the company.
Most bull and bear markets in investments tend to fluctuate around the intrinsic value. The price goes beyond that intrinsic value in a bull market and goes below it in a bear market. But it always eventually comes back to that intrinsic value. That is because, there are always investors who are able to overwrite their investment psychology instinct. Instead of projecting trends into the future, they are trying to figure out what an investment is really worth on the market outside the investment market.
These value investors, like Warren Buffet, start selling when an investment gets too expensive and start buying when an investment gets too cheap. Value investors are the main reason why investments do not go to zero. With pure investment psychology, it is likely that in the long run everyone sells, as everyone would project the downtrend indefinitely into the future. As a result, eventually there would be no investors left.
Value investors, who are looking towards the intrinsic value instead of the trend, come in at the bottom of bear markets and reverse the trend upwards. They are saving the price from going to zero.
The point that I am trying to make with all of this is, what is the intrinsic value of a crypto currency, and how can I determine it? If it does not have one, then it is in the hands of investment psychology. This would mean they will likely eventually go to zero, as no value investors will come to rescue them.
Some people argue that crypto currencies do have an intrinsic value. Blockchain technology is an incredibly valuable technology, and in particularly the Bitcoin network is very useful. I don’t disagree with that. However, I cannot see how that translates to a real intrinsic use value.
I am old enough to remember the dot com bubble at the end of the 1990th. Back then, a similar argument was made. The narrative was that the internet is a revolutionary new technology that will disrupt everything. Now, a quarter century later, it is hard to argue that this prediction was false. If anything, most people underestimated how much of a disrupter the internet was going to become.
But that did not prevent a lot of the dot com companies to go to zero. The mistake in the narrative back then was to think that by owning a dot com address one owns a part of the internet. The internet, however, cannot be owned by anyone. It is a network which is in the hands of a large amount of players.
An internet address is just an application that is using the internet. Investors eventually figured out that the value of a dot com company does not come from being a part of the internet. Instead, it comes from how much utility that company can provide for its customers. In other words, what mattered was the intrinsic value of the dot com company. And many of these companies did not have any such value. As a consequence, the shares of those companies went to zero. There were no value investors stepping in to safe them from becoming worthless.
The same appears to be true for blockchain technology. Just like the internet, no one owns this technology. It is open source. One can own an application using blockchain technology, but this application ultimately is only worth as much as its intrinsic value. How much utility does one bitcoin have? Not the bitcoin network; not the blockchain technology, but one bitcoin. Single bitcoin units are the only thing one can actually own. And I cannot see any utility that these tokens provide. The only reason anyone buys crypto currencies is to speculate on their capital gains.
I have never heard anyone saying, I need to buy some bitcoin to eat them with my steak; or I need a bitcoin to start my car etc. Bitcoins don’t have any utility, they are merely a book keeping entry. That is all. Yes, the book they are entered in might be valuable, but one only owns the entry not the book. And the entry does not point to anything else with real value.
If I hold something as a currency I would like to have a guarantee that there will be someone who will buy it from me. Gold for example is an extremely useful metal. There are all kinds of applications for it. That gives me the guarantee that if I own a bit of gold in the form of a gold coin, I will always find a buyer for it, even if it is not accepted as a currency. Gold is an extremely liquid commodity.
Some will say that the utility of crypto currencies is that I own something outside the banking system. I can transfer a bitcoin wherever I want in the world without a government being able to stop me. That certainly sounds like a very valuable use value to me. But again, I don’t understand how that translates to an intrinsic value.
On net, there does not seems to be any demand increase from this for bitcoin. In fact, for this to work, bitcoin always needs to have a value before the transaction takes place. The value therefore cannot come from the transaction itself. In order to transfer money from a to b via bitcoin, I need to buy bitcoin in place a and sell them in place b. That means there is just as much selling involved as there is buying. How does this translate to a net demand for bitcoin that would put a floor into its price?
And what would that price be? How can I calculate it? It seems any price will do to facilitate that function. Some might now argue that I don’t have to sell them, why not just keep them? The reason why one might not keep them is because they are very volatile. And as long as they are volatile they cannot function as a store of value.
I can of course speculate on higher prices, but then we are back to square one. We have come full circle. We are looking for an intrinsic value so that we can beat investment psychology in which everyone is speculating on higher prices, and now the intrinsic value is suppose to be that one should speculate on higher prices. That does not work.
Again, it is totally possible that I am missing something, but it seems to me that the only reason why someone might hold any crypto currency is to speculate on higher prices. There does not seem to be anything else. And of course, I don’t mind people speculating on higher prices. I am just saying know what you are getting yourself into. You are essentially invested in a ponzi. Sure, some people get rich in ponzi schemes, but some people also loose everything. At the end, there needs to be an equal amount of losers than winners, as the gains have to come from someone.
If crypto currencies cannot beat investment psychology, they cannot become currencies or a store of value. In that case, the best case scenario is that some of them, with a large enough network effect, will remain a highly volatile investment for speculators. The more realistic scenario, however, is that eventually, too many people will have been burned trading them that the market implodes and goes to zero. However, maybe greed is a powerful enough force to keep enough people pouring into these currencies in the long run. I mean, there is no shortage of demand for lottery tickets, even though most people get burned by them every time. We will see.
To be clear. I like the idea of an anarchic currency that is not controlled by a government. I therefore have a natural sympathy for what these currencies are trying to do. But I cannot see how digital tokens without an intrinsic value can become a currency or a store of value on a free market. Paradoxically, the only way I could see them becoming a currency and/or a store of value is, if they stop being anarchic.
The only way these digital currencies really could get there is if a major government player were to back them. Governments could fix the price of one of these tokens and then force everyone to use them. That could get these currencies out of the hands of speculators and into the hands of daily users, just like any other currency.
But only a government, which is a player that can forcefully extract a lot of resources out of the economy, and therefore does not need to worry too much about profitability, could realistically achieve this. Once a crypto currency is widely accepted for commercial transactions and business accounting, and they become stable enough to be a store of value, then it could continue to be a currency, even after the government withdraws its support for it.
After all, current government fiat currencies are also just book keeping entries without any intrinsic value. And major fiat currencies like the US Dollar are accepted in many places where they are not legal tender.
However, my third reason why these currencies could fail is that governments do not have an interest to have a currency that they cannot control. They will not abolish the US Dollar or the Euro and replace it with a decentralised crypto currency. They will want to do the opposite.
Let us say I am wrong about the economics of these currencies and one of these currencies really becomes stable and widely accepted on the market, in that case governments would most likely stop them, not support them. While they cannot un-invent the technology they can certainly criminalise their use. It would be very naive to think that that would not stop these currencies.
If they were criminalised, one would not be able to get their crypto money into the normal banking system. That means owners would be stuck to buy things on the black market only, and would risk being prosecuted for it. That is unattractive to most people.
Some will say that El Salvador supported bitcoin, so there is hope. That is not quite what happened though. Yes, it is true that bitcoin was made a legal currency next to the local Colon and the US Dollar. But it looks like the motivation behind that was that the president of El Salvador wanted to speculate on the price of bitcoin to rescue his bankrupt finances. And like all inexperienced investors in the hands of investment psychology, he ended up buying near the top.
However, El Salvador is a good indication that my analysis is correct. The country allowed bitcoin to freely compete with the Colon and the US Dollar, but the price for bitcoin was not fixed. It is too small a country to be able to do that, and the whole purpose of the exercise was to speculate on capital gains anyway. Bitcoin does not seem to do well in the competition. By and large, other than a few idealists, it is not used, the US Dollar is still king, because the value of bitcoin is way too volatile to be a usable currency. These currencies do not work on a free market, because they lack an intrinsic value.
That being said, there is some hope. It more and more looks like these currencies could be of interest to governments in another way which could make some governments start to support at least one of them. Similar to gold, which governments hate to introduce into the monetary system, they might not have a choice.
Gold is still trusted as a valuable and scarce metal. If currencies loose trust, some form of gold backing might be able to restore trust in a currency. If the only alternative is hyperinflation, governments might prefer to introduce a gold backing, not because they like gold, but because they have no choice.
Crypto currencies could play a similar role. While these currencies do not enjoy the millennia old trust that gold has, they might be useful in geopolitics. Governments don’t trust each other. There are no friends in geopolitics only interests. In the last few decades, most governments at least trusted the US government enough to use the US Dollar in global commerce. In recent years however, the US government has made very clear that it cannot be trusted. It has kicked countries like Iran and Russia out of the swift system and even confiscated the foreign reserves from Russia.
Again, states will have no choice to move away from the US Dollar. The only alternative is to lose their independence. A lot of effort is being made to find an alternative. To replace the US Dollar, gold and other commodities could be monetised. That way governments don’t have to trust each other, they just have to trust the gold. Crypto currencies, however, could be an attractive book keeping system to facilitate transactions. The number of units is limited by an algorithm, no trust needed. And unlike commodities, the logistics of using crypto currencies are very simple.
Instead of leaving the price of a crypto token to the market, governments could fix the price by backing them with commodities. That way all government players could trust this currency.
Such a currency would only strictly be used for international trade. Domestically, governments would still use their fiat currencies so that they do not need to give up control over the money supply. The latter would cost them a lot of power if they were to lose it.
Another way crypto currencies are useful for state players is that they can use them to defraud people of their money. These unregulated speculations are easy to manipulate for big players. That way, highly organised criminal organisations, like the democratic party in the US, can use them to make a lot of money. That is exactly what happened with FTX, but there are other such schemes, tether for example. Therefore, all these inexperienced crypto investors can be used to finance the deep state.
The influence of large criminal organisation is probably the main reason why crypto has not gone to zero yet. And it might be the main reason why they will keep going for a while. State actors will certainly use blockchain technology to enhance their independence. This might eventually make first movers like Bitcoin some form of trusted reserve asset. Although it is more likely that these state actors will come up with their own currencies. After all, the technology is not owned by anyone, so anyone can use it.
There are even signs that this was the plan all along. It is still not clear who invented blockchain technology. There is clear evidence that bitcoin originated in the US deep state. By making it look like this is some kind of anarchic revolution, they were able to get the combined intelligence of the developer community to test and improve the technology for free. Once the technology is ripe, it can then be used by the state.
Another function is to get people used to digital money. Cash is the real enemy of government control. While it might be possible to construct a digital book keeping system that comes close to the anonymity and simplicity of cash, it will unlikely be able to ever match it. Even if they did, states won’t pick those currencies if they chose to support any. Bitcoin in particular is not anonymous at all.
Either way, crypto currencies are a fascinating experiment. They certainly have made some people question the monopoly of money by the state. That is a very good thing. I, however, remain convinced that in order for something to become a currency on a free market it has to have some kind of intrinsic use value. Short of that, the only way something can become a currency is by the force of the government. But contrary to what I believed a few years ago to be unlikely, we might actually going to see that happening in some form.