Almost 70 years ago, John Kenneth Galbraith explained that during a bull market there comes a period when the embezzler enjoys his ill-gotten gains, but the victim does not yet realize that he has lost.
Think of the wealthy Europeans who invested with Bernie Madoff and spent their summers in St. Tropez and winters in St. Moritz, trusting that Madoff was growing their assets at a steady 12% annual return.
While the “boom” was going on, the economies of Saint Moritz and Saint Tropez prospered and the world seemed a better place. During this period, there were two engines of “unsound” economic activity: Madoff bought watches, yachts and vacation homes, while the investors he defrauded spent money as if their balance sheets were still strong.
I come back to this idea because of the $2.5 trillion cryptocurrency market capitalization that essentially came out of nowhere five years ago. The resurgence in cryptocurrency prices once again raises the question: what exactly is its “value proposition,” or in other words, what function does it serve?
Most industries make money because they make our lives better. Microsoft makes money because it helps us manage information; Netflix makes money because it entertains us; McDonald’s makes money because it feeds us; Starbucks makes a dime because it gives us our morning caffeine boost.
You can’t eat bitcoin
In the absence of a social function, it is difficult to understand why an industry should make a lot of money over a long period of time. We need shelter, food, clothing, transportation and entertainment, and we will pay those who adequately satisfy us. So what value do cryptocurrencies bring to society?
The answer doesn’t seem to be that they make transactions easier and cheaper. More than a decade after the introduction of Bitcoin, cryptocurrencies are still very far from becoming a medium of exchange. Rather, their main purpose appears to be to become a “store of value,” even if it is volatile.
Indeed, talk to any cryptocurrency enthusiast and the main argument is that Bitcoin, Ethereum and others will help protect capital in the face of looming currency depreciation; All this brings me back to Galbraith’s delirium.
Who is deceiving whom?
If, as many crypto enthusiasts believe, Western democracies are on the verge of massive currency depreciation to preserve their welfare states, the estimated $100 trillion or so held in global government bonds is worth only a fraction of that amount in real terms. .
But if this scenario turns out to be wrong, then $2.5 trillion in crypto money would be today’s profit. So consider the fairly simple decision tree shown below.
The chart clearly illustrates why it is difficult to find investors who are interested in both government bonds and cryptocurrencies. Most bond bulls are crypto bears and vice versa. Sometimes you can meet an investor who is both a bond bear and a crypto bear; such people tend to be goldbugs.
Now calling government bonds a profit can be seen as gross sensationalism. No one assumes that the bonds will not be repaid. Most Western issuers of sovereign debt are neither Argentina nor Greece, and almost all bonds will be redeemed at par.
The question is what the purchasing power of the denomination will be. And as the cryptocurrency gained traction, bond yields got worse and worse. Treasuries investors (as measured by the BAML US Treasuries All Maturity Index) have suffered losses in purchasing power in real terms for all of the past three years and are on track for a fourth.
Worse, over the past 20 years, U.S. Treasury investors have seen essentially no real return. This represents genuine euthanasia of the rentier.
So what?
The reason this is important is that bonds and cryptocurrencies are usually not owned by the same people. Without wishing to be stereotyped, bonds are typically owned – directly or indirectly – by older people who have either already retired or are about to retire. In contrast, cryptocurrencies are typically the domain of younger investors who have years ahead of them to recoup any losses incurred.
Right now, the market is suggesting that bonds issued by Western governments will remain poor stores of value. Considering the current political settings (record budget deficits in the USA, France, Great Britain, Japan), this is understandable.
Indeed, as many investors view OECD fiscal policy as unsustainable – thereby issuing bond forfeiture certificates – they are likely to continue to seek alternative stores of value. Note the current rise in gold, silver, high-yield energy stocks and the broader equity markets. Such trends are likely to continue until we see significant changes in fiscal policy throughout the developed world.
This leaves us with the question: what happens if the bulk of most pension fund portfolios end up delivering negative real returns of -5%, not just this year, but in the coming years?
Possible answers include:
- Older people will have to delay retirement and stay in work longer. This is possible in some professions, but is more difficult for those in physically demanding roles, such as police and fire services.
- Older people will have to adjust to reduced pension payments, at least in real terms. Will this impact residential real estate as such people look to downgrade along with healthcare, travel and entertainment expenses?
- Taxes on pension benefits will have to rise to offset the real bond losses.
In the meantime, alternative savings will continue to thrive.
PS
A few thoughts in response to a reader’s comment on this article:
I think history shows that financial regulators tend to be asleep at the wheel until a crash occurs. And then they wake up and, as soon as the horses run out of the stables, they close the barn doors (sorry for the confusion of metaphors).
So far, cryptocurrency volatility hasn’t caused any major financial players to fall (Silvergate Bank and Silicon Valley Bank may have been a warning shot, but those banks mostly imploded due to Treasury maturing mismatches), so I think the regulators haven’t sensed the need to interfere too much.
Perhaps this will change now that listed ETFs are absorbing more of the general public’s investment? But even so, would a 50% Bitcoin ETF collapse threaten financial stability? Probably no.
Usually, financial stability is threatened by an invisible lever. And this is where regulators come into play.
But there is an inherent contradiction to cryptocurrency, namely that in order for it to deliver on its promise, it must essentially replace fiat currencies.
And it is very difficult to imagine governments giving up the right to pay off their debts in a currency they can print without a serious fight.
Louis Gave – Founding Partner and CEO Gavekal. This article was originally published by Gavekal and republished with permission.
Special offer from Gavekal
Gavekal invites Citywire readers to a one-month free trial of Gavekal Global Macro Research and Gavekal Dragonomics (China Macro Research), distributed through daily and weekly newsletters. This will allow you to evaluate whether the Gavekal team can add value to your workflow. Click Here to access the free trial.
Any opinions expressed by Citywire, its employees or columnists do not constitute a personal recommendation to you to buy, sell, guarantee or subscribe to any particular investment and should not be relied upon in making (or refraining from making) any investment decisions . In particular, the information and opinions provided by Citywire do not take into account individuals’ personal circumstances, objectives and risk perceptions.