How a bitcoin bubble could lead to hyperinflation

The volume of warnings from central banks about the rise of private cryptocurrencies – and the potential impact on the ability of central banks to conduct monetary policy – has become mind-boggling. This criticism only serves to convince libertarians that it is desirable to reduce the power of central banks and governments. Certainly, the hostility of the Chinese authorities towards private cryptocurrencies can be presented as proof that they are seen by the state as a defense against intrusive social control. But whether that view is correct or – when it concerns monetary control rather than social control – dangerously naive, there is another undeniably serious problem with cryptocurrencies. This is an issue so far only mentioned by central banks, but one that libertarians should be most worried about. The problem is the bubbles.

Today there are many bubbles in the world but they differ in their nature and their consequences. A stock market bubble can be perfectly rational. The price of stocks can continue to rise endlessly, assuming that “real” (inflation-adjusted) interest rates do not rise and remain high. Assuming a growing world population, the supply of “bigger fools” to sell at a higher price is theoretically endless. The idea of ​​a “bond bubble” is more difficult to rationalize. Unlike stocks, virtually all bonds have a maturity date – their maturity date. If you buy a bond with a negative interest rate (a negative “yield”), you know for sure that you will suffer a nominal loss if you still own it at maturity (the loss will be even worse in real terms). So if you are worried that other assets are overvalued and could collapse, why not just hold some cash?

Yet many professional investors currently hold bonds traded at negative yields. This only makes sense if they expect rates to become even more negative, producing a capital gain (bond prices and yields move in reverse of each other). But even then, the bond’s price must eventually revert to par (its “face value”), inflicting a capital loss on whoever bought it at a price above par. Implicitly, therefore, the ‘biggest fool’ is expected to be central banks, which are not yield-driven and can be expected to be recapitalized by their governments – albeit at considerable cost to them. independence – if capital losses threaten their solvency.

Alan Greenspan’s big mistake

Bubbles in both bonds and stocks are symptoms of a deep-rooted imbalance in today’s advanced economies. The downward trend in long-term real interest rates that continued throughout this millennium and was only accentuated by the pandemic, fueled the bubbles that were necessary to regain and maintain full employment and fight deflation. Why did this happen?

Interest rates are “intertemporal” price signals – they balance the supply of and demand for money over time. When these signals go wrong, the result is a misallocation of resources in the economy. Our current imbalance dates back to the second half of the 1990s. Then Federal Reserve Chairman Alan Greenspan did not allow real long-term interest rates to rise at the right time in response to expectations. very dynamic entrepreneurial organizations of the Internet-based “new economy”.

As a result, consumer spending has not been sufficiently postponed during this period. Indeed, the dotcom-era equity bubble has further boosted spending. Therefore, when the additional supply of the “new economy” was brought online, there had been no “pent-up” demand from previously deferred spending (i.e. savings) for the ‘absorb. This mistake, combined with the much less innocent catastrophe of monetary union in Europe, caused intertemporal price signals – that is, interest rates – to have gone wrong and always wrong. since. A secular trend of ever lower rates and ever larger bubbles has taken hold.

An illusion of wealth

The stock bubble, in particular, has created the illusion of wealth. This is illusory – for the economies as a whole – because it is not based on a considerably increased future productive potential (where applicable, the estimates of this potential have been constantly revised downwards). The political implications of the resulting wealth inequalities are worrying, but so far have not caused serious problems. Indeed, they did not cause the economy to overheat: the additional spending generated by this illusory increase in wealth compensated for the drag of the intertemporal imbalance (where the past postponement of future spending leaves a hole in demand while the future becomes the present).

But if dangerously high levels of ‘investment’ government spending produce inflation – as many fear in the UK and, in particular, the US – some ‘rich’ equity holders might think that they should spend more of that wealth before its real value. falls. But the only way they can do it without producing an ever-increasing spiral of inflation is if everyone else’s spending were to go down. Distribution problems would then really become a major political issue.

An even riskier mania

Yet there is another even more dangerous bubble that has developed in recent years. It is a problem which, if left unchecked, is likely to produce cataclysmic changes in the distribution of wealth. This bubble is in private cryptocurrencies. As with stocks, cryptocurrencies do not have an end date. A bubble can therefore be rational in the same way. However, once the macroeconomic context is taken into account, it becomes clear that the bubble must burst.

Why? Either the market price of bitcoin, for example, can become infinite or it cannot. If not, at some point the only possible change in the market price of bitcoin is negative. At this point, all holders would want to sell (unless central banks – like with bonds – are supposed to support the price of bitcoin indefinitely!).

If, on the contrary, the price can and does move towards infinity, then the use of an infinitesimal amount of a single person’s bitcoin wealth would exhaust all the productive potential of the world; that is, each holder could control all the resources in the world by being the first to sell and spend. Rising the general price level to infinity as bitcoin holders compete for resources would impoverish everyone.

It is clear that many governments – and most notably the US government – now want to generate huge transfers of wealth. Whether they are right or wrong is a matter of debate. The key questions are: how to distinguish in practice between what I have called “acceptable” wealth (wealth which possession does not result in reduced possibilities of lifetime consumption for everyone) and wealth ” unacceptable “bubble, the possession of which reduces the possibilities of lifetime consumption for everyone? ; and how to eliminate unacceptable wealth without crushing the economy.

But whatever your perspective, the transfer of wealth that bitcoin threatens to produce is certainly not the one that the US government or anyone else wants to produce. When the bubble grows, it does not create additional wealth in the form of future productive potential for an economy as a whole. It simply transfers the wealth to everyone’s existing bitcoin holders. This creates pressure on everyone else to join them.

Governments will need to burst the crypto bubble

To avoid serious social and political discontent, leading to unrest and ultimately socio-political collapse, authorities will need to burst the bitcoin bubble before its macroeconomic importance becomes much greater. The similarity with bank runs is quite clear. If none of the top ten liquidity providers to Lehman Brothers had withdrawn their funding, in all likelihood no one else would have. If those ten people withdrew their funding, in all likelihood everyone would do the same. Likewise, as the ratio of “illusory wealth to potential income” in the economy increases more and more, the temptation for someone to get off the ship and be the first to use their assets to acquire real resources. gets bigger and bigger.

Indeed, we can consider the reverse of this “illusory wealth to potential income” ratio as the equivalent of a bank’s equity ratio in a period of financial crisis. This ratio goes in the wrong direction as the illusory nature of many of the bank’s assets becomes apparent. In turn, the incentive for its debt holders to pull out is growing. It is deeply ironic – and tragic – that as the reaction of central banks and regulators to the financial crisis (which they themselves created) was to insist on higher capital ratios for banks , monetary policies have operated, and continue to operate, to weaken the “capital ratio” of the economy. Unless there is a radical change in the political framework, the likely result will be a devastating economic, financial, social and political crisis far worse than anything that could have been produced by the financial crisis of 2007-2009. Marxists might rejoice at such a prediction. Libertarians should be concerned to prevent it from happening.

The longer central banks wait before taking action to prevent cryptocurrency bubbles from swelling, the harder they will make their job. Bank of England Governor Andrew Bailey has warned bitcoin “investors” that they risk losing all of their money. But if the bubble grows first, its bursting will have significant macroeconomic effects, as spending financed by borrowing against bitcoin’s “wealth” disappears. Worse, devastating losses will be inflicted on speculators, among whom more and more ordinary households will be found. The fact that they have been warned will not prevent potentially seismic reactions.

Central banks and regulators therefore now have an unenviable choice. Presumably, they won’t want to be blamed by crypto “investors” for a burst bubble. Thus, they can hope that it calms down on its own, and then regulate it out of existence. But if the bubble continues to grow, they must grab the nettle and inflict losses now, or face a future scramble to convert crypto holdings into goods and services, which will produce hyperinflation and destroy society.