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After Crypto’s Cold Winter, Expect Springtime for Web 3.0

Niall Ferguson

By Niall Ferguson

First the economy overheats, then winter comes to Wall Street. January was especially horrible for the cutting-edge investor, and February might be even worse. At the end of last month, big tech stocks were down nearly 8%, according to the New York Stock Exchange’s FANG+ index — and that was before shares of Meta Platforms Inc. (the company formerly known as Facebook) fell off a cliff last week.

The crypto winter has been even colder. Since the start of the year, Bitcoin (BTC or XBT if you prefer the official ticker) has fallen by 12.5%; despite a rally on Friday, it is still down 40% from its all-time high of $67,734 in November 2021. If you bought Ethereum at the top ($4,799 on Nov. 9), you are down 38.5%. Only meme stocks such as GameStop Corp. (down 31% since the year began) and Robinhood Markets Inc. (down 78% over six months) have been hit as hard. Oh, and let’s not forget Facebook — down 34% over six months.

Past Their Peak? DeFi vs. Digital Gold

Source: Bloomberg

By contrast, it’s been a rip-roaring start to the year for retro investors. Oil (Brent Crude) was up in January (+19%) more than Bitcoin was down. Long coal was one of the trades of 2021: If you bought America’s biggest coal company, Peabody Energy Corp. (BTU), a year ago, you’re up 252%. So much for COP26 and the Green New Deal. The winning trade of the post-pandemic era would seem to be long the past, short the future.

You can tell it’s a bear market for crypto because the usual suspects have been tweeting about it. (They’re always mum on the way up.) It doesn’t get better than Nouriel Roubini tweeting a Business Insider story with the headline: “Economist Paul Krugman says there are ‘uncomfortable parallels’ between the recent crypto slump and the subprime mortgage crisis.” Sorry, this doesn’t seem like the relevant historical analogy.

That’s not to say the crypto winter can’t deliver a bigger chill, if not the polar vortex or bomb cyclone of Roubini and Krugman’s imaginings. How much lower could Bitcoin go? It is worth recalling that, after the price of Bitcoin peaked during its first bubble — at $1,137 on Nov. 29, 2013 — it dropped by 84% to $183 just over a year later, on Jan. 14, 2015.

This pattern was repeated four years later, when the price peaked at $19,041 on Dec. 17, 2017, and bottomed out a year later at $3,204 — a cumulative drop of 83%. Were this historical pattern to repeat itself exactly, the price would fall to a low of $11,515 this November, 83% below its peak in November of last year.

However, such a plunge seems unlikely for two reasons. First, Bitcoin is a much larger asset than in the 2010s, with its market cap peaking at just shy of a trillion dollars last year. The process of adoption by individuals and institutions, which I forecast in the updated edition of “Ascent of Money” in 2018, continues apace. First came the hedge funds. Then came the banks. Now the sovereign wealth funds, the pension funds and the big endowments are sniffing around. Sooner or later, a respectable central bank will admit that it has some Bitcoin in its reserves, and the financial journalists will pay less attention to El Salvador’s eccentric experiment to make Bitcoin legal tender, alongside the U.S. dollar.

Second, while Bitcoin remains a highly speculative investment, it is less speculative than it was a decade ago, based on measures of 30-day volatility and institutional adoption. Some institutional investors — such as the pension funds that have become limited partners in crypto hedge funds or venture funds — have long time-horizons, measured in years. The crypto newbies who bought at the top of the market will no doubt retreat to lick their wounds. But more sophisticated players will want to buy the dip.

Crypto’s Smoother Ride

Source: Bloomberg

What is going on here? Clearly this is more than just a crypto winter. Part of the metanarrative (sorry, couldn’t resist) would seem to be pandemic-related. After two years of Covid restrictions, people are eager for a return to the real world: real ballgames, real shopping, real travel, real gyms. There was no way companies such as DoorDash Inc. (-45% over six months), Zoom (-64%) or Peloton Interactive Inc. (-80%) could expect demand for their services not to decline as stir-crazy Americans adjusted their behavior from pandemic to endemic conditions.

At the same time, the tight U.S. labor market has presumably driven up costs for tech companies more than for most. Good luck hiring a top engineer in Silicon Valley these days. Rumor has it that practically every graduating computer science major at Stanford already has an offer from Meta. Finally, there’s a chance that people just aren’t that into the metaverse as envisioned by Mark Zuckerberg — or feel they already have it (it’s called the internet).

At the time the Facebook founder unveiled it, many thought it was a genius move to extricate his business from the approaching army of antitrust hipsters and aggrieved politicians. But I don’t think his plan was to ward off antitrust actions by ceasing to be profitable. No rebranding alters the reality that Facebook is passe (ask any teenager), TikTok has eaten its lunch on viral video content, and the days of the Facebook-Google online ads duopoly are over.

Look a little closer, however, and you see that Wall Street’s winter has barely touched other big tech companies. Microsoft Corp. is up 6.8% compared with August last year, Alphabet Inc. 6.0%, Apple Inc. a mighty 17.3% — yes, it’s Springtime for Tim Cook in Cupertino. So this is a lot more complicated than a general rotation from “growth” to “value,” or from tech to the real world.

Clearly, the dominant force in financial markets today is the tightening of monetary conditions by central banks. In some cases, such as the U.K., interest rates have already gone up. In others, notably the U.S. and the euro area, rate hikes are a near certainty in the coming year. The stated reason for these hikes is that (as previewed here last March) inflation has surged over the past year, as a result of massive fiscal and monetary expansion in response to the pandemic, combined with supply-chain and labor-market disruptions that caused shortages of goods and workers.

Jay Powell, chairman of the Federal Reserve, was not the only central banker to underestimate the inflation risk, but his are the words future historians will quote. “Frankly we welcome slightly higher … inflation,” he told the Financial Times a year ago. “The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”

We have gone from “What, me worry?” to “Five rate hikes priced in” in 12 short months. Not to mention a much more rapid taper of asset purchases than in the period after the global financial crisis, and the real possibility of quantitative tightening, i.e. a reduction in the size of the Fed balance sheet.

Powell’s metamorphosis from Alfred E. Neuman to Paul Volcker is the main reason for the decline in the price of Bitcoin. That is because Bitcoin was highly appealing when the Fed appeared set on a recklessly inflationary course: Remember, it soared from  $4,904 on March 16, 2020 — when Wall Street belatedly woke up the scale of the disaster Covid would inflict — to a level nearly 14 times higher in November last year. (That must also have been peak FOMO for the professional crypto-haters in economics departments across the country.)  Now that the Fed has turned hawkish on inflation, the long-Bitcoin trade is less seductive.

Bitcoin today is seen primarily as “digital gold” (or, to be more accurate, an option on digital gold, as it could conceivably go to zero if the entire era of digital finance were brought to an end by rampant cyberwarfare or China winning “the quantum supremacy”). As my Hoover Institution colleague Manny Rincon-Cruz argued in a brilliant essay last month, “Bitcoin’s core value proposition, and technological innovation, is digital scarcity via a public, decentralized ledger that tracks a fixed supply of 21 million bitcoins.” It’s that scarcity that investors like, compared with — as the pandemic made clear — the potentially unlimited supply of fiat currencies.

Rincon-Cruz suggests that Bitcoin in our time is playing the role gold played in the 1970s. In the inflationary 1970s, the price of gold surged nearly tenfold from its 1970 low ($256) to peak at $2,348 in February 1980. However, following the appointment of Paul Volcker as Fed chairman in August 1979 and the rate hikes he imposed to fight inflation (the Fed funds target rate went from 10.5% when Volcker took over to 20% seven months later), gold plummeted. By January 1985, the price was back down below $800.

Of course, Jerome Powell is no Paul Volcker. The markets have already seen him blink once in the face of a stock market selloff, at the end of 2018. Nevertheless, the Fed seems far more constrained than it was back in January 2019, when Powell essentially abandoned the attempt to normalize monetary policy. Inflation was nowhere to be seen at that time, whereas the last CPI print (7%) was the highest since 1982, the year Volcker’s “regime change” succeeded and inflation expectations subsided.

Yet that doesn’t mean rates are heading back to 20%. This is partly for the obvious reason that inflation seems unlikely to reach the eye-watering levels it reached in the second quarter of 1980, when it exceeded 14%. But there is another, more profound reason. In his recent, pathbreaking work on the long-run history of interest rates, Yale economic historian Paul Schmelzing has argued for “suprasecular stagnation” — a multicentury tendency for interest rates to fall.

According to Schmelzing, recent arguments about “secular stagnation” as an explanation of falling nominal and real interest rates have focused too much on the recent past — to be precise, on the period since Volcker’s war on inflation. Schmelzing’s reconstruction of public and private interest rates since the 14th century shows a much longer-term trend for rates to decline.

“Global real interest rates,” Schmelzing writes, “have … followed a ‘gentle,’ persistent trend decline, at a level of 1-2 basis points per annum over [five] centuries.” Since the Renaissance, he argues, periods of negative real interest rates have been far from unusual. “Global real interest rates at the zero lower bound are fully consistent with deep historical trends — seen in the long context, interest rates over the past four decades have in fact [reverted] back to trend after reaching unusually elevated levels in the context of the oil shocks.”

Seven Centuries of Real Interest Rates

Inflation-adjusted yields, leading sovereign borrower

Source: Paul Schmelzing

A key point Schmelzing makes is that, over half a millennium, whichever government was seen as providing the safest asset — typically a bond paying a fixed annual amount — could pay relatively low nominal rates and quite often negative real rates.

I infer from Schmelzing’s research that Americans should not expect real rates to rise as high as they did in the early 1980s, when the 10-year rate, adjusted for inflation, went as high as 7%. Indeed, rates will likely remain negative through this year, even after five 25-basis-point Fed hikes. It would take a much larger calamity than a mishandled pandemic to destroy the U.S. government’s reputation as the issuer of the safest financial asset, in a world awash with savings in search of a guaranteed return. (The accumulation and abundance of capital is the principal force driving down rates, in Schmelzing’s account, with destructive events such as major wars only temporarily pushing them upward.)

Of course, the crypto selloff is about more than just inflation expectations. An important point is that, as so often in the history of bubbles, the most speculative investors have been buying on margin, utilizing leverage in the hope of maximizing gains. As of Feb. 2, the three largest margin-lending crypto protocols — Maker, Compound and Aave — had margin loans outstanding of $9.3 billion, $3.5 billion and $4.5 billion, respectively, for a total of $17.3 billion. This is down 24% from the $22.7 billion peak in early December 2021, but still up more than 370% from a year ago.

Margin buying works wonders on the way up. It can wreak havoc on the way down, which typically begins when interest rates rise and credit conditions tighten. The crypto market correction in January triggered margin calls and collateral liquidations, leading Maker’s founder and others to debate on Twitter how to notify a user called “7Siblings” that about $650 million worth of Ethereum was about to be liquidated if he, she or they didn’t post some new collateral fast. Another user tracked down 7Siblings’ wallet on Aave and noted that it had $75 million in stablecoins available. 7Siblings finally woke up (or sobered up) and managed to salvage most of the situation.

This is a classic crypto bro story, you might think. However, it relates not to Bitcoin but to Ethereum. As Rincon-Cruz points out, the two should no longer be conflated under the anachronistic label “cryptocurrency.” If Bitcoin is fundamentally an inflation-hedging asset, because of its guaranteed finite supply, Ethereum and its imitators (e.g., Solana) offer something different: the possibility of re-engineering the financial system on the basis of “smart contracts.” As Rincon-Cruz explains:

Ethereum was launched in 2015 as a “world computer” capable of executing code across a decentralized network of machines. Until 2019, however, smart contract protocols and their tokens had yet to bear fruit. All crypto assets had to offer was digital scarcity, and so their price mimicked Bitcoin’s. And while non-fungible tokens (NFTs) and meme coins are technically built and launched on top of smart contracts, their value proposition remains digital scarcity as digital collectibles or more volatile versions of Bitcoin.

Much more important than NFTs are the various open protocols known as decentralized finance, or DeFi: not only margin lending (see above) but also on-chain markets and automated investment strategies.

Rincon-Cruz draws an analogy between “Web 3” (the fashionable new name for crypto) and “Web 2,” the commercialization phase of the internet. The dot-com bust of 2000 seemed to vindicate everyone who had been skeptical about e-commerce during the 1990s bubble, just as the latest crypto selloff has vindicated those who have dismissed the last few years as another tulip mania.

True, a lot of the early experiments in DeFi were little more than initial coin offerings (ICOs) backed up with shoddy white papers. A number were blatant scams or mere jokes. However, just as the skeptics missed the beginnings of Big Tech in the wake of the dot-com bust, so today’s crypto haters are missing the beginnings of a major disruption of the financial system in the form of DeFi. The example Rincon-Cruz cites is Uniswap, the largest on-chain decentralized exchange protocol.

I am sympathetic to this argument for two reasons. First, the existing global and national financial systems really are ripe for disruption. Intermediaries such as banks, credit card companies and money-transfer companies collect sometimes extortionate fees from both consumers and merchants. (I speak with the bitterness of one who has to send monthly sums to family members in East Africa, far too big a cut of which goes to Western Union. But I could give many more examples, such as the usurious interest rates on credit card debt or the overdraft charges slapped on by banks.)

Secondly, DeFi looks like a bona fide financial revolution, taking advantage of new technological possibilities to reduce transaction costs in exciting ways. Skeptics love to insist that Ethereum isn’t money in the textbook sense (a store of value, a unit of account, a means of payment). This is to miss the point entirely. Let’s turn again to financial history.

After the Black Death of the mid-14th century, severe labor shortages eroded the system of feudalism whereby peasants worked the land as serfs and paid rent “in kind,” with shares of what they grew. In England and in northern Italy, there was a shift to a more monetized economy, in which an increasingly mobile workforce was able to insist on payment in cash. The problem that beset the medieval and early-modern economy of Europe was an insufficiency of good-quality coinage.

For merchants seeking to conduct trade over land or sea, the defective monetary system of the time was especially problematic. They got around it by developing the revolutionary financial innovation known as the bill of exchange — a simple piece of paper which extended credit from one merchant to another, typically for a period of several months, corresponding to the time it took for an item to be transported from port A to port B: in effect, an IOU. (An example from 1398 can be seen here.) Over time, bills of exchange came to be negotiable — that is they could be sold to third parties. Merchants’ signatures were the basis for this credit system.

Notice that bills of exchange were not money in the textbook sense. Yet they constituted a form of peer-to-peer credit that proved crucial to the development of European commerce from the late-medieval period down to the 19th century.  Notice, too, that there was no need for third-party institutions to verify or process transactions: Specialist banks known as discount houses evolved much later. In other words, the system of late-medieval trade finance was the nearest thing to decentralized finance that was possible in a time when cheap paper was the revolutionary information technology.

Economists have generally been unreceptive to cryptocurrency, if not downright hostile to it. I suspect this is because their discipline implicitly prefers the structures of financial intermediation to remain static, to avoid overcomplicating the mathematical models they are so fond of. Financial history, by contrast, enables one to discern both long-term trends in prices and revolutionary changes in markets. That is why I am so proud to have taught some of the most promising financial historians of the next generation, among them the two scholars whose work I cited above.

Applying financial history to the future, I expect this crypto winter soon to pass. It will be followed by a spring in which Bitcoin continues its steady advance toward being not just a volatile option on digital gold, but dependable digital gold itself; and DeFi defies the skeptics to unleash a financial revolution as transformative as the e-commerce revolution of Web 2.0.

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