CEPR's Danielsson: The beginning of the end for cryptocurrencies

30 November 2022

While crypto currencies are not much of a public concern, they will leave a fine legacy by forcing much-needed reform on the financial system.

Cryptocurrencies have enjoyed a remarkable run from obscurity to a trillion dollar valuation in just over a decade. This column argues, however, that they have now reached the beginning of the end as the factors fuelling their success have come to a standstill.

Cryptocurrencies have enjoyed a remarkable run from obscurity to a trillion dollar valuation in just over a decade. They are praised and condemned in equal measure by world leaders and have even become legal tender in some countries.

Crypto has had two stages in its short life: rapid price growth and elevation from obscurity, followed by a prolonged phase of global recognition, controversy and volatile prices fluctuating but with no long-term price increases. The signs now point to crypto commencing its final, terminal phase. Cryptocurrencies will leave a fine legacy even if they have not lived up to the crypto evangelists' promises.

The reasons why crypto has entered its final phase have much to do with why it has been successful and what it promises and fails to deliver (Bindseil et al. 2022, Didisheim et al. 2022). It is all down to politics, speculation, and efficiency.

Politics is fundamental to crypto. Its foundation myth is a world where technology replaces corrupt human beings and their organisations. Instead of fiat money abused by governments with their extra-low interest rates and repeated quantitative easing, we get digital money created and governed by an algorithm programmed to be fair.

Such a crypto financial system promises to be much more efficient than the setup we have today, with modern algorithms, programming languages, and systems replacing a costly, error-prone, corrupt banking system – one with centuries of legacy practices and more than half a century of incremental changes to its IT systems, with much still based on Cobol written half a century ago, running on IBM mainframes.

The third plank of the crypto mission is speculation, since the number of people buying into crypto's political and efficiency aspects is tiny – much too small to leave much mark on the world. While the true believers are essential for shaping the crypto narrative, success and failure come predominantly from speculators fuelled by Bitcoin's spectacular price rise from four cents to $16,000 today.

The foundation myth is essential for crypto's success. Not only because otherwise there is no need to replace the existing financial order, but even more importantly, it is why crypto is not a Ponzi scheme.

While crypto has become visible and made many speculators wealthy, it hasn't enjoyed the success promised by the foundation myth (Danielsson and Macrae 2022). They might not even make sense (Danielsson 2018).  After all, the financial system is still almost entirely based on old school fiat money financial institutions. And that is a problem because the high price of crypto is based on speculators betting on success. For that to happen, the promises of the foundation myth will have to be seen as within reach. Otherwise, speculators will likely lose heart and abandon crypto. Which can then become a vicious downward spiral.

Both politics and speculation have been tested recently...

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