Crypto is an Unproductive Bubble

This post sparked a great conversation on Hacker News! See the comments here.
Another update: Scott Alexander just (12/8/22) wrote the best counterpoint to this that I’ve read – see it here

“The four most expensive words in investing are: ‘This time it’s different.'”

John Templeton

I’m writing this essay not so much to convince anyone of my point of view as to outline my current thinking around cryptocurrencies and the mania surrounding them. Because this is a controversial subject over which smart people disagree, I’m making these claims in public so that I might be proven either right or wrong later.

If you disagree with any of my claims here, or have more to add, I’d appreciate you leaving a comment with your thoughts, both for my benefit and for that of other readers.

Claim 1: Crypto is a Bubble (Confidence: High)

The hallmark of a bubble is people buying an asset primarily in the hopes of future appreciation driven by other buyers, rather than because of any notion of its long-term value. Cryptocurrencies have satisfied this criterion starting a number of years ago, and from what I’ve seen continue to do so. The trouble with bubbles is that once the supply of hopeful buyers runs out, prices stop rising and start falling as fear replaces greed. I predict that this will happen to all cryptocurrencies, including Bitcoin and Ethereum, within a decade. This goes doubly for double-bubble assets like NFTs.

Crypto boosters claim that cryptocurrency has long-term value as a digital currency, but I disagree for the reasons outlined in Claim 3.

Claim 2: Blockchain technology has no non-monetary applications (Confidence: High)

While this mania seems to have calmed down as of late, I’ve seen a number of claims that blockchain technology – i.e. the ability for a network of people to maintain a distributed ledger without trusting a central authority or authorities – unlocks non-monetary uses, e.g. supply chain transparency. However, any use of blockchain technology in which the ledger is not self-contained, but is instead tied to the physical world, has the fatal flaw that there can be no trust-free link between the ledger and the physical world. If you don’t trust anybody to enter a delivery of wheat into your ledger, then your supply-chain ledger will be empty, but if you do trust certain people, then you are relying on the honesty of specific people or on other safeguards outside the ledger itself, undermining the purpose of a distributed ledger.

Claim 3: Future monetary use of blockchain technology will be minor (Confidence: Medium)

This is where it gets more tricky. Blockchain technology does unlock an interesting use case, which is the ability of participants in a network to maintain a ledger, or record of holdings, without trusting a central authority. In theory, this approach could replace fiat currency, which is controlled and tracked by trusted authorities like banks. However, I see two major roadblocks to the widespread adoption of cryptocurrencies:

1. Inefficiency – Requiring every participant in a network to interact with a distributed ledger imposes substantial transaction costs which make cryptocurrency transactions more expensive than transactions in fiat currency, where the network is supported by trusted central authorities like banks and the government. To my knowledge, nobody has yet found a way to correct this flaw and it’s likely a feature of the way distributed ledgers work. If that’s the case, then cryptocurrency adoption will be limited to marginal use cases where fiat currency is impractical, e.g. online black-market transactions, since people prefer paying lower rather than higher transaction fees.
2. Control of monetary policy – When the world was on the gold standard and central banks had limited ability to control the money supply, extreme and frequent booms and busts were a major feature of the economy and a constant detriment to people’s lives and livelihoods. Fiat currencies administered by competent central bankers have the attractive feature that their governance can be used as a tool to cool excesses and calm panics when the credit cycle goes through its inevitable revolutions. Cryptocurrencies, to my understanding, dispense with this notion of central control on purpose, and their adoption as the primary currency in an economy would subject that economy to pre-fiat-era booms and busts or worse.

Unless both of these factors are somehow addressed, I predict that cryptocurrencies will play a marginal role in the future, if they exist at all. Even if they continue to grow in value as more speculators pile in, their usage as currency will be limited unless the inefficiency problem is solved. If that does somehow happen as well, we may see widespread use of cryptocurrencies in at least some countries, until a reckoning with the subsequent booms-and-bust dynamics, which may take decades, forces a return to fiat currency or its equivalent. (This could take the form of something which is a cryptocurrency in name only, with a “ledger” maintained by the government and banks.)

I also believe that it’s unlikely we’ll get even that far, as governments will not be keen to lose control over monetary policy. Authoritarian governments are likely to restrict or ban cryptocurrencies if they get much bigger than they are now, and even democratic governments will have to weigh voters’ enthusiasm for cryptocurrencies with the importance of being able to control monetary policy.

Some bubbles are caused by over-enthusiasm over genuinely innovative and productive assets, like the Railway Mania of the 1840s or the Internet Bubble of the 1990s. When those bubbles pop, they leave behind large amounts of investment in assets like rail and software that can be used for productive purposes later. (For more on this, see Carlota Perez’s Technological Innovations and Financial Capital, or a summary.) Other bubbles are triggered by enthusiasm over assets which have much less enduring value, like Tulip Mania, the South Sea Bubble, and Beanie Babies. It’s my prediction that the cryptocurrency bubble will turn out to have been another one of those unproductive bubbles, fueled by low interest rates and speculative enthusiasm from a wide base of retail investors rather than by a genuine advance in financial technology.