The same way a trainer feeds a pit bull special foods to keep its aggression up in the dogfighting ring, the Fed keeps the crypto markets volatile by holding back and letting loose liquidity.
Forget what you’ve been told about cryptocurrencies for a minute and consider that despite being compared to everything from a pet rock to rat poison, they’re still a US$2 trillion market (at time of writing, check regularly to avoid disappointment).
Because cryptocurrencies aren’t “backed” by the familiar, for instance the promises of a sovereign government, it’s no surprise then that so many investors continue to question their value as a reliable investment.
Yet throughout the course of their existence, and especially since the advent of the Covid-19 pandemic, cryptocurrencies, led by bitcoin, have been steadily appreciating against major sovereign currencies (you need to swap them dollars for bitcoin ) and even being touted as an inflation hedge akin to gold.
Part of the reason of course is that fiat currencies (those fat stacks you have in your stash house) are, just like cryptocurrencies, faith-based, with their values highly dependent on the investing public’s belief in sovereign authority and a central bank’s commitment to preserve their value.
Yet almost all major central banks have very publicly committed to monetary policies that undermine the value of their national currencies through a process called “debasement.”
Take the U.S. Federal Reserve for instance, which has a stated goal of achieving a 2% target annual inflation — so if your buck buys you only 98 cents of stuff at the end of the year — mission accomplished and champagne all around at the central bank.
But wait, there’s more.
In the aftermath of the 2008 Financial Crisis, the Fed embarked on a quantitative easing program that significantly increased its liabilities, composed primarily of cash and bank reserves, from less than US$1 trillion to somewhere closer to US$9 trillion at the time of writing — a phenomenal increase in money-creating capacity.
By some estimates, one out of every four greenbacks in circulation today was willed into existence (it was really keystrokes) over the last eighteen months.
But perhaps (and somewhat insidiously), that money-creating process of the Fed isn’t governed by any rule (as opposed to bitcoin), but by a bunch of overwhelmingly white men (there is one African American and three white women) in a 12-member Federal Open Market Committee (FOMC).
The FOMC is not bound by rules or constraints, subjecting U.S. monetary policy, and by extension the global economy, to the slings and arrows of outrageous FOMCing.
By some measure, the Fed’s independence was intended to counteract several evils, including personal profit, politics and prejudice, but in practice, the central bank is far more beholden to its political masters than it would like to admit (and its members alleged to make some profit on the side too).
That the Fed (just like all man) is susceptible to bias (and profiteering) has been revealed in the unprecedented growth of its balance sheet in the decade and a bit since the 2008 Financial Crisis, a pattern of behavior being replicated by central banks across the globe, from Brussels to Tokyo.
Until fairly recently, the Fed’s balance sheet growth, hoovering up U.S. Treasuries and mortgage-backed securities, did little to spark general price inflation, but increases in everything else from real estate to cryptocurrencies.
Holding money just isn’t as gainful an allocation of resources as it once was and so to hedge against negative real yields, investors are buying almost anything else.
And while any one or all of these asset classes could be in a potential bubble, with the Fed greatly expanding America’s monetary base and with the dollar the global reserve currency, asset inflation isn’t so much a reflection of “irrational exuberance” but rather the consequence of rational choices.
In contrast to fiat currencies which can be willed into existence, cryptocurrencies have no sovereign sponsor and no buyer of last resort.
But also unlike fiat currencies, cryptocurrencies largely play by a firm set of rules that more systematically constrains their ability to arbitrarily expand in volume.
Because the blockchain is transparent, a new cryptocurrency that hoards copious amounts in a handful of wallets would be suspect, and those which unilaterally flood the market with a seemingly infinite number of tokens will soon find themselves undermining the very value of that which they seek to capitalize on.
That transparent cost-benefit analysis and the inherent Game Theory that makes it more profitable for genuine cryptocurrency creators to want to preserve the value of their digital assets stands in stark contrast to the fiat currency system.
For now though, cryptocurrencies are not widely used as a medium of exchange and that makes absolute sense, especially for digital assets like bitcoin, which has a deflationary emission schedule and akin to a store of value — why would anyone spend bitcoin if they expect its worth to only go up?
So while cryptocurrencies are in some ways like fiat currency — they aren’t really “backed” by anything — their rules-based supply and potential future utility as a form of money (there are many flavors of cryptocurrencies) have made them a preferred intangible asset among investors and speculators alike.
And despite being criticized as having all the hallmarks of an asset bubble, doomed to collapse, cryptocurrencies nevertheless remain a favored investment among savvy allocators given their controlled growth, expected long-run appreciation and their ability to act as a frictionless medium of exchange.
Least Risky Among the Riskiest
To be sure, cryptocurrencies may not even be the riskiest asset out there.
Compared to the copious amounts of leverage against other assets and the explosive growth in derivatives and synthetic derivatives, cryptocurrencies may appear comparatively benign.
While there is leverage in the cryptocurrency markets, in some cases, inordinately elevated levels, it’s nothing compared with traditional financial instruments, barely a rounding error.
That cryptocurrencies appear to keep growing despite the interim volatility isn’t happening for no reason.
The world’s major central banks have been dramatically expanding the money base for over a decade and appear intent on continuing that pattern.
With over one in four dollars in circulation created since the start of the pandemic, the problem is only just beginning.
And inching up interest rates or paring back the U.S. Federal Reserve’s balance sheet is the equivalent of putting a band-aid over a bullet wound.
While markets may be roiled by the prospect of major central banks increasing interest rates, incrementally raising borrowing costs only helps to slow the future debasement of fiat currency, but doesn’t deal with the problem accumulated over the past decade and a bit.
To put things in perspective, the U.S. Federal Reserve’s balance sheet went from around US$1 trillion before the 2008 Financial Crisis, to around US$7 trillion at the height of the pandemic and now sits around US$9 trillion.