Can Government Tolerate the Crypto Explosion?

Cryptocurrencies as they are called, are a relatively new asset class. They were virtually unknown until they made their first appearance about 10 years ago and it is only in the last few years that they have gained wider acceptance. Whether they actually have the characteristics of currency (a medium of exchange, a store of value, a unit of account) is debatable.

Whatever they are, they have become a true phenomenon.

On December 6, 2021, the Wall Street Journal reports investment clubs have now formed around these investments for education and promotion to the public.

By early November of 2021, the total market capitalization of all cryptos reached $3 trillion. According to CoinMarket.com, there are now more than 6,000 of these “things”. They will either prove to be one of the great financial innovations of the age, or perhaps the greatest speculative bubble ever produced by mankind.

Martin Pring, the senior technical writer for Stockcharts.com, points out this market cap is about 13% of the $23 Trillion Gross Domestic Product of the United States.  It is about the same size as the total GDP of England. It is huge and growing.

Bitcoin, perhaps the earliest and most successful, went from a low of $164 as recently as 2016, and recently hit a high of $68,000 before backing off somewhat.

This is an astounding performance for something that does not generate a cash flow, pay dividends, or can be consumed by industry.  Its technology has not as yet spun off major industries, other than supporting itself.

The motivation to purchase seems to be privacy, hedging against the potential of a weakening dollar, and just plain profit potential. At least for Bitcoin, the argument is blockchain technology provides confidentiality and limits supply.

We will admit some sympathy with the motivation. If the government was producing a stable monetary unit and did not tax production so voraciously, there would not be an elevated desire to find alternatives.

Much of this depends on the proposition that cryptos will be superior to government money. Limitation on issuance remains the key. That might be true for Bitcoin, but if more Initial Coin Offerings are provided, there is no limit to the total amount of cryptocurrency that can be created. If that were not true, there could not be 6,000 and counting growing varieties.

Maintaining Bitcoin’s unique blockchain technology does not come cheap. It is estimated the “mining of Bitcoin” consumes about as much electrical power as the entire nation of Sweden. So-called Bitcoin mining may consume substantially more energy than conventional mining for gold, silver, copper, and other metals and materials. That is a considerable expense just to maintain a monetary alternative.

As cryptocurrencies become more accepted, we can expect Wall Street to offer new financial instruments denominated in them. However, given their extreme volatility, it would be difficult to use in bonds, mortgages, loans, and other financial instruments over intermediate to longer periods of time. However, it is highly likely you will see more cryptos and more investment vehicles that use them. Right now, a number of credit card companies allow them to be used to settle payments.

The extreme volatility on the other hand will likely lead to futures markets, options markets, leveraged ETFs, and all manner of leveraged and geared investments to cater to speculators, large and small.

It is worth mentioning that under the gold standard since money was stable, there were no foreign exchange futures markets or bond futures. Those markets developed after the final break with gold in 1971 and we went to “floating currencies.” Today, these areas of financial speculation dwarf traditional commodity speculation

Cryptos seem to introduce even more financial volatility, rather than less.

We will not enter the torrid debate between advocates and critics, as we have other things to discuss. Clearly, cryptos are here and are reshaping the financial landscape. One casualty of this shift might be precious metals. Gold and silver have traditionally been the only accepted “non-government issued money”. At one time, they were the very basis for money. But with this new form of privately issued money, it is likely crypto growth has drained away at least some money that likely would have gone into precious metals, given the excessive government spending, FED monetization of debt, and long period of negative interest rates.

Last time we checked, Bitcoin was up over 60% year to date, while gold bullion was down about 6%.

Money is a remarkable social convention, a product of spontaneous order much like language.  Many things have been money at some point or another.   The process by which society decides what is money, and what is valuable, is organic. Typically, they have been metals, such as copper, silver, or gold. The Chinese were early innovators in paper money. But in some societies, it can be seashells, beads, cattle, grain, and among some ancient Pacific societies, large stones, which made payment transfer comically difficult in rough seas.

Money has always been associated with the power of government, the sovereign. Often, money was issued by the king and in later years, the nation-state. The government would enforce its will by requiring payment in taxes to be made in a currency they controlled and they also used the power of law to see that private debt, public and private, be settled in the government’s money. All these things, the payment of taxes, and legal tender laws guarantee a market for the government’s money, and more importantly, the debt floated by the government denominated in that money. Such a constant demand for government money is thus important for the government to fund itself.

For many years, money was little more than a warehouse receipt for precious metals. Look closely at the wording on the picture above of the dollar bill. It says the note certifies there is on deposit silver in the US treasury, payable on demand by the holder of the note. The money supply could only grow slowly, along with the supply of gold and silver. In addition, there were circulating gold and silver coins.

Although the appearance of the note today is quite similar, today’s money is not backed by metals on demand. Rather, it is held up by law or fiat. Hence, the term fiat currency.

On a few rare occasions, there could be some inflation within a precious metal system, such as when the Spanish made huge discoveries of gold and silver in the “new world” of today’s South America. But for the most part, the gold standard created centuries of price stability where the money would maintain its value over long periods of time. This helped to develop long-term credit markets where governments or capital-intensive industries such as railroads, could borrow money for periods of 50 and even 100 years.

However, the gold standard put the government in a monetary straight jacket. It really was difficult to grow the government because what the government could print was restricted and so was the amount they could borrow. A simple voluntary mechanism helped hold the government in check. If citizens felt the government was becoming profligate, they could turn in their paper money for the gold and silver behind it. Likewise, foreign holders of money could turn their paper in for the real thing, at any time, on-demand. As gold left the treasury, the money supply was forced to contract. Government spending was kept on a short leash.

The history of fiat money is quite different. No fiat paper money has held its value over time. There are no exceptions. And, you know why. Government cannot restrain itself. It requires external constraints such as a written Constitution and external constraints such as a gold standard.

As Progressives desired to get out of the realm of limited government into the realm of big government socialism, they broke down both the Constitutional and monetary obstacles put in place by the Founders. They wanted a fiat currency controlled by the government or the government’s central bank.

In the case of gold-backed money, it was made illegal by FDR in 1933, when gold was removed from money and gold clauses were outlawed. Silver was removed from money in 1965 because of the excessive budget deficits to fight the Viet Nam War and fund the Great Society. By 1971, the ability of foreigners to get the gold behind the dollars they held, was unilaterally canceled by President Nixon. We have been on fiat money since.

Thus, the control of money is the control of political power. Having an unbacked fiat currency that can be printed at will, gives the government much greater power to spend and borrow.

Now comes along cryptocurrencies, supposedly private money that can keep transactions and taxes hidden from the government. Their “limited” supply is supposed to offer an alternative to the constantly depreciating money issued by the government.

The government needs to force the creation of demand for its own money and its bonds. This is particularly the case when the government spends way beyond its means. While there is talk of governmental fiat money that is digital, you could argue it already exists. The amount of currency that circulates in physical terms is a small percentage of the total. Overwhelmingly, the bulk of fiat money is simply electronically transferred around the system, and hence digital.

An electronic or digital currency need not be limited in supply. In fact, it can be created by the keystroke of a computer and does not even require the printing of physical notes.

Again, without entering the contentious debate between crypto advocates and critics, we would simply like to point out that government, in the end, cannot tolerate the widespread use of privately issued money with a limited supply. They have spent the past century wriggling out of the restrictions imposed by the gold standard and it is highly unlikely they will yield the tremendous advantages given to the government by its monopoly on money, just for the profit of private actors.

This is more than just our historical observation. Last September, the Chinese government, arguably the first or second largest GDP, made cryptos illegal.

The government of India is now also anticipating banning cryptos with laws expected early next year.  However, the law is ambiguous and may create more confusion than order.

The US government is starting to regulate trading in cryptos, in part because of substantial fraud in the space. But also, the government is concerned about people evading taxes, engaging in illegal activities, and frankly, the development of a competing currency to that issued by the government. The most recent “infrastructure bill” has a provision subjecting cryptos to the $10,000 reporting requirement that exists for cash transactions. If so, the advantage of anonymity could go out the window.

As the reader may sense, our view is the government, in the end, cannot tolerate private money that allows citizens to hide their transactions, beat the tax system, and compete against the government-issued money.

As the government moves against cryptos, what happens to the $3 trillion in this investment space?

That is a subject reserved for another day. But given the size and level of speculation, anything that reduces the utility and value of cryptos has the potential to be a very destabilizing event.

Problems for cryptos will not occur in a vacuum. They will occur with key markets already juiced to historically high valuation levels by huge injections of monetary liquidity by both the Congress (fiscal stimulus) and the Fed (monetary policy). Negative interest rates, that is a rate below inflation, have driven money out of bonds and bank deposits and into equities.

For a sense of magnitude, flows into the US stock market this year are more than the flows over the past 12 years combined!  Thus, the present price level of equities reflects this torrential flow of money, which is not guaranteed to continue.

Cryptos are simply another parallel bubble being blown up by government policy.

The potential for economic destabilization is high, as is the risk of a policy error by the FED. Oblivious to all of this, the government keeps its foot on the monetary gas pedal, the fiscal gas pedal, no doubt hoping everything will look good for the mid-term Congressional elections.

As they say, hope is not always the best plan.

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Neland D. Nobel is Editor-at-Large of The Prickly Pear and a retired portfolio manager and Certified Financial Planner.