Crypto Mania, Financial Contagion, and the “Goldilocks Zone”

From the gold rushes of the 1840s and 1850s and the bicycle bubbles of the 1890s to the bowling craze of the 1960s and the dot-com boom of the 1990s and early 2000s, our animal spirits they are forever looking for greener pastures.

In recent times, the financial herd has entered the cryptocurrency field.

At the beginning of last year, 6% of US respondents said they had bought or traded cryptocurrencies in the previous 12 months, according to a global consumer survey by Statista. Respondents from Peru, Turkey, the Philippines, and Vietnam had entered the crypto market at much higher rates, from 16% to 21%.

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In Central America, El Salvador has made bitcoin legal tender and plans to develop “Bitcoin City” at the base of the Conchagua volcano. The International Monetary Fund (IMF) has warned El Salvador of this course.

The digital currency has achieved remarkable legitimacy in the minds of the masses, the media and the markets. But not everyone buys the “technobabble,” as Paul Krugman calls it. “Cryptocurrencies play almost no role in normal economic activity,” he writes. And investors like Charlie Munger have been quite vocal in their criticism.

A key element of behavioral finance that we must appreciate, however, is that perceived value is contagious. I may not believe in the aesthetic appeal of diamonds, for example, but I cannot ignore their psychic value in the imagination of others.

It is true that cryptography apparently has some economic value. The promise of blockchain technology – security, transparency, efficiency, traceability and automation – has been discussed at length.

For this reason, crypto-nonbelievers should beware of what former Intel CEO Andy Grove calls the first version trap. Consider, for example, Apple’s handheld Newton devices in the early 1990s. There were legions of naysayers, and it became something of a boondoggle. But it wasn’t the end of the handheld digital device. Sometimes it can take generations for technology to fulfill its initial promise and transform the landscape.

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Crypto faithful, on the other hand, must beware of the siren song of speculation. Irrational exuberance, natural Ponzi schemes, and fear of missing out (FOMO) can lead to a lot of recklessness. Just as it can take generations for a truly transformative technology to reach critical mass, poor investments and outright scams can survive for decades before the bottom falls out. Just look at Bernie Madoff.

Moreover, bad behavior tends to emerge where capital is more unrestricted. A study found that around one in four bitcoin users and 46% of bitcoin transactions are associated with illegal activities. That adds up to $76 billion in shady transactions.

Equally prominent are the risks of financial contagion. Before the global financial crisis (GFC), in 2006, subprime originations in the US totaled $600 billion, or less than a quarter of the US mortgage market. Few imagined that such failure was possible or that such failure would threaten the entire financial order.

As Ben S. Bernanke, Timothy M. Geithner, and Henry M. Paulson, Jr. write. a Firefighting: the financial crisis and its lessons, experts underestimated the dangers of an interconnected and overleveraged system, and the potential for an E. coli effect—the financial equivalent of a case of food poisoning at a local burger joint leading to a nationwide aversion country for fast food. Indeed, the crisis of confidence was so visceral that even well-capitalized titans like Berkshire Hathaway, in Warren Buffett’s words, stared “into the abyss.”

Similar risks can apply today in the crypto world. At the time of writing, the global cryptocurrency market capitalization is north of $1.7 trillion. Gold’s market cap, by comparison, is about $12.5 trillion. Crypto market cap is not an insignificant sum. A cocktail of housing debt, speculative assets, prolonged economic shock and contagious panic could create the perfect storm. We should not think of speculative markets reductively and in isolation from the real economy.

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These tail risks, however, will not stop the music. Today, many households trust their hard-earned savings to digital currencies. JPMorgan Chase, for example, is increasing its clients’ access to crypto funds, even as CEO Jamie Dimon describes bitcoin as “not worth it.”

New instruments like bitcoin bonds and crypto exchange-traded funds (ETFs) are making the rounds. And if the dot com and subprime bubbles are any guide, we can expect opaque, complex, and leveraged financial engineering and innovation to follow. Animal spirits set the stage for both rational speculation and incompetence.

Similarly, George Soros describes how fallibility, reflexivity, and positive feedback loops can drive valuations into far-from-equilibrium territory. Narratives, expectations and prices will of course adjust as confirming and disconfirming evidence comes to light. Crypto will also face this test. At some point, it will have to prove its economic value.

Until then, there seems to be a “golden zone” of confidence and expectation. We don’t want to fall into the first release trap and reject all the risks that are worth taking. But we must also avoid the dangers of unbridled speculation. We forget that even temporary failures in inflated markets can spread and endanger the larger system.

Of course, governments and institutions will play some role in temperature stability and control. But financial history tells us, whether due to bureaucracy, inertia, libertarian ideals, or some combination thereof, they will probably be late to the dance.

Either way, crypto will make a fascinating case study in the annals of financial history, whether it ends up being the 21st century equivalent of the tulip craze or a truly lucrative, future-defining innovation.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

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Tobias Sebastian Lim

Tobias Sebastian Lim is an economist working on competition strategy and technology investment. His interests are economic development, financial markets and complexity sciences. Co-founder of, Lim is also a regular contributor.

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