4 min read.Updated: 26 Jan 2022, 11:33 PM ISTAaron Brown
The views of contrarians, technophiles and sceptics matter more
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Bitcoin has fallen 50% since November. This is not unusual for a cryptocurrency; it did the same from April to July 2021, and quickly rebounded. From a statistical viewpoint, Bitcoin looks like a very high volatility asset without strong medium- or long-term tendencies to trend or revert. It’s not a perfect random walk with its future direction independent of past price movements, but it’s closer to one than most major assets. This background is important for evaluating a tweet by Nassim Nicholas Taleb of Black Swan fame that generated considerable attention: “For a contagion-driven asset with no economic anchor such as #BTC, a falling price does not make it ‘cheaper’ and more attractive. A falling price makes it less desirable [and], paradoxically, more [expensive]. Why? Because price is its only information."
This is not true empirically over Bitcoin’s short history. In the past, buying Bitcoin when the price was falling has been equally attractive as buying it when its was rising. But Taleb made an economic claim, not a statistical one.
The first thing to note is that there are lots of other “contagion-driven" assets without an “economic anchor." Art, diamonds, gold and many other things have value only because other people value them, not from any direct economic use. A particularly important contagion-driven asset lacking an economic anchor is the US dollar. Unlike Bitcoin, it has a strong tendency to trend. If the dollar’s value is falling due to inflation, it’s likely to continue to fall. No one buys the greenback because it’s cheap during inflation or sells because it’s expensive during depressions. The opposite happens.
The dollar has something that Bitcoin doesn’t, which is a government and banking system that sometimes acts to stabilize its value. But it’s not an anchor, and the US Federal Reserve does not try to return the dollar to pre-inflation values. Rather, it’s an engine to keep the ship from drifting too fast. If the dollar is losing value rapidly, the Fed would generate forces that may slow the decline, but not reverse it to bring it back to its previous value.
The world’s primary reserve currency gave up any economic anchor in 1971 when President Richard Nixon ended the gold standard—and that was only a loose anchor to gold, which itself lacks an anchor—and after a decade of mismanagement established a rough faith that its value would not erode too quickly, to make it useful for transactions and savings. That faith was shaken in the 2007-09 financial crisis, but due to fears of institutional collapse and not inflation. Another major currency, the euro, went through an even deeper crisis from 2009 through 2014, driven mainly by fear of government and central bank defaults.
This is the world in which Bitcoin was born and gained trust among technophiles, financially-repressed people and those sceptical of government and banks. Bitcoin was a lifeboat for people thrown overboard by the government ship, and for everyone in case the traditional financial system’s lack of an anchor caused it to flounder. Lifeboats don’t need anchors.
However, as Bitcoin’s value and acceptance grew, it acquired an initial economic anchor in the form of faith that some official currencies and financial institutions would be unattractive enough to many for significant demand to exist for Bitcoin transactions and savings. Later, as crypto projects delivered real services to willing customers, the value anchor for Bitcoin became faith that it would be a major store of value for the crypto-economy and a main exchange currency with the traditional financial system.
Over the last two years, progress in the crypto-economy has been roughly about as expected, without major breakthroughs or setbacks. It is the traditional financial system that has been upended by the pandemic, lockdowns, supply chain issues, aggressive fiscal and loose monetary policies, political dysfunction and threats of war. Therefore, it seems to me that volatility in the number of dollars people will pay for Bitcoin has more to do with uncertainty about the long-term value of dollars than reappraisals of the prospects for the crypto-economic sector. When Bitcoin’s price falls in terms of dollars, it doesn’t say much about whether Bitcoin is cheap or expensive, but it does suggest people are placing more faith in dollars, perhaps due to anticipated Fed monetary policy tightening, reduced expectations of government spending and also declining pandemic and war fears.
Mainstream financial markets give their opinions on such things via interest rates, equity volatility, exchange rates and inflation break-even rates. These are good indicators of median views. Bitcoin and crypto markets help us understand the opinions of, say, a 5% tail of contrarians, sceptics, technology experts and also those who are financially repressed. Wise investors would listen to both voices.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of ‘The Poker Face of Wall Street’.