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Thursday, June 23, 2022

Crypto And The Real Economy

The following tweet by Jon Sindreu set off a debate on Twitter, which I got tangentially involved in. This is a subject that I touched on some time ago (I believe), but I think I can succinctly cover my views now.

Explaining Feudalism from the Perspective of a Peasant

I will start with an analogy. Although most people at the time were peasants, it would be a mistake to explain all feudal institutions from the perspective of whether they benefit peasants. Instead, many institutions are there because they benefit the elites. These institutions are that way because the elites set the rules.

The developed economies are best described as industrial capitalism (with welfare state institutions of varying strength). As the names suggests, the economic elites in industrial capitalism are capitalists. “Money” is an economic institution, and so we should expect it to conform to the needs of the elites.

What do capitalists need?

Capitalism: A Short Definition

The core activity of capitalists is that they hire workers and raise finance to amass positions in capital (including inventories) and resources so that the workers can produce output that can be sold at a profit. More briefly, capitalists exploit labour, capital, and resources to make a profit — although Marxism and the reaction to Marxism has made “exploit” a dirty word.

We can immediately see that a form of “money” is useful to capitalists if (and only if) it allows them to:

  1. pay workers’ wages;

  2. raise financing to allow real investment. The best form of financing is other people’s money, also known as debt.

I do not claim to be a crypto expert, but I believe it is safe to say that the entire crypto complex has fallen flat on its face when it comes to meeting these two needs.

If one disagrees, one would need to enumerate:

  1. When converted into USD, how many billions of annual wages are denominated in crypto?

  2. How many USD-equivalent billions of financing has been raised for capital investment (as opposed to monkey jpegs or whatever)?

Even if the above numbers are not zero, scale them by the nominal GDP of the United States (about 24 trillion USD) — which is an overstatement, since crypto is global, and so it should be compared to global GDP. My guess is that if you rounded to the nearest percent. the numbers you are looking at are both 0% of GDP.

The Uses of Crypto

The three main use cases of crypto so far have been the following.

  1. Online gambling. Video games and online gambling are large industries, and the gambling component of crypto is just another video game. Admittedly, I would estimate that at least 99% of “traditional” securities market activity is similarly gambling. However, the 1% residual of traditional finance that serves other economic purposes keeps the other 99% going.

  2. Evading laws. Crypto was a godsend for the ransomware industry.

  3. Payment system. Given that I can already send Canadian dollars to other Canadians by email or text message via my bank, I am not seeing a huge opportunity set here.

No matter how useful the above are, they are useful for the peasants. Let’s look at this from the perspective of capitalists.

  1. Unless you are somehow paying workers to gamble with your capital, online gambling does not fit. And even if you do that, you are in the financial industry, and not the industrial side of industrial capitalism.

  2. Evading laws is definitely not what most industrial firms want to do (other than some intermediary firms that operate in the shadows of capitalism). Firms are enmeshed in a web of contracts — all of which are enforced by courts, who need the ability to seize assets to enforce contract law. If you have a factory for which you are openly hiring workers, it is normally difficult to hide it from a semi-competent government. (Admittedly, organised criminals can do things like have hidden drug factories, but they usually do not post “Help Wanted” ads in most jurisdictions.)

  3. Cheaper payments might be nice, but industrial firms need to work with banks. Furthermore, the payments need to be in the currency in which the firm wants to operate.

What’s the Fundamental Problem for Capitalists?

To the extent that crypto assets are denominated in their own “currency” (e.g., BTC), they have not been useful for industrial capitalists. The reasoning is straightforward: look at the multi-year price chart, and the behavioural patterns of crypto enthusiasts (“hodl”).

  1. It is impossible to come up with a plausible business case for a factory financed with a 20-year BTC-denominated bond. The volatility of the market value of the liability dwarfs the potential profit of the factory.

  2. Nobody who owns a lot of BTC is willing to pay workers in BTC (since that is not a “hodl”), and it is unclear what kind of work force would be willing to take BTC. Could you hire workers near minimum wage and have a BTC-denominated long-term contract?

(I will discuss the potential for “price stability” later.)

One could point to things like so-called “stable coins” that are pegged to currencies like the USD, which might be used in finance. However, to the extent that they work within a USD-denominated world, they are just a variant of unregulated shadow banking. Shadow banking has long been part of “traditional finance” (a bond is non-bank finance), and so any developments are not particularly novel, as the tech people involved will run into exactly the same economic forces that shadow banks have already adapted to.

Contract Law is Enforced by Courts

The belief that “code is law” is fairly hilarious from the perspective of anyone with experience with software projects. Although some stable code is occasionally produced, those are more the exception than the rule. Firms want contracts enforced by courts, and that implies the ability of “the gummint” seizing assets.

Transparency is for Retail

The crypto ecosystem appears to have absorbed the belief that financial markets ought to be based on transparent, screen-based trading. Retail investors unquestioning believe that markets ought to be transparent. However, large lenders and borrowers have no interest in transparency. This belief also makes its way into academic finance and economics, as screen-based trading is set out as the ideal methods for transactions.

A loan is a bilateral contract, and both sides have risk exposures to the other. This mutual risk creates a mutual desire to keep the exact nature of the risk under wraps. Unless the lender can speculate against the other party elsewhere (or wants to seize assets), it has an economic incentive to not highlight the financial fragility of its borrower. Meanwhile, a borrower wants as much opacity about its funding sources as possible so that it can hint to lenders (and potential lenders) that it can get funding elsewhere.

As such, anything on a blockchain is toxic for wholesale lending.

Can Crypto Currency Prices Be “Stabilised”?

Although inflation is a well-known issue, one can describe fiat currency prices as being “stable” in the sense that firms, workers, and lenders are willing to enter into long-term contracts denominated in those currencies. (Once inflation is seen as a major concern, indexation clauses start to appear.)

From the perspective of a capitalist, it is easy to see why this “stability” happens: for large classes of workers, there is a relatively well-known “prevailing wage” in the market. As such, firms are able to hire workers at around that wage, and since wages are one of the largest input costs for firms in aggregate, prices set by mark up over costs end up being at least loosely tied to those prevailing wages. Furthermore, since wages end up financing the bulk of final demand, output price growth cannot get too far away from wage growth.

Crypto currencies face the “chicken and egg problem” of input costs not being priced in crypto, so it is hard for tangible output prices to be denominated in crypto. (Items with effectively no marginal cost of production — e.g., digital assets — can be priced in crypto.) Would it be possible that crypto “exchange rates” stabilise enough to eventually allow a non-digital crypto economy to take hold? (This particular question was posed to me yesterday by “@CosmoCrixter” on Twitter, but it is an old debate.)

Bitcoin advocates have long argued that BTC prices will be stable using the following logic.

  1. BTC trading volumes get very large due to adoption.

  2. BTC prices end up “stable” versus the real economy. (Since BTC issuance is capped, goods prices would be stable/fall, and of course, fiat currencies will whither way due to inflation.)

(My apologies to South Park’s Underpants Gnomes.) The problem with the logic (so far) is that the “adoption” of BTC mainly involved financial market trading, and so the BTC price is as stable as any other other financial asset with no firm valuation method like an internet start up in 1999 (spoiler: it is not stable).

(We see many hucksters attempt to link proof-of-work coin prices to energy costs. However, this is a tragic misunderstanding even from the perspective of someone who allergic to reading anything about BTC. In the case of BTC, the computational difficulty scales with the computational effort expended, and so the energy cost link is just a guideline for miners as to whether mining is profitable right now. However, if prices keep going up, the tendency would be to bring more miners on line, and so energy cost similarly rise. Conversely, if we run the history of BTC backwards, a downward trend in prices would coincide with less mining activity and hence energy costs.)

In order to get “stable” prices, a crypto token would need to “peg” its value to something stable. This could include a commodity, a real world currency, or even a construction like the CPI of a particular country (expressed in the local currency).

Thing is, “pegs” do not magically happen. You either need a formal pegging mechanism or an informal one.

A formal peg is more straightforward, although the crypto community is re-discovering that the only way a peg without a lender-of-last-resort is stable is via requiring 100% collateralisation. In which case the token is a claim on a financial asset (or possibly a physical commodity), and we in fact just have a shadow banking institution with a mound of technobabble dumped over top of it. Furthermore, the token would have to be built around this peg, which something like BTC is not.

An informal peg is hypothetically possible. A group of large holders (“whales”) could decide to keep the price around some target level, and intervene if it gets too far away. This faces two problems.

  1. Individuals with large stakes tend to be evangelists who want to “hodl” and get price appreciation. Pegging would require them to dump their holdings in response to a jump in price. Do that enough, and they are no longer “whales.”

  2. The “whales” need deep pockets in other liquid assets to be able to absorb rapid falls in price. Given the genius decision to have crypto markets trading 24/7, that requires more liquidity provisions than even traditional market makers.

Someone who cares about game theory (I ran into it during grad school, and it was hate at first sight) might be able to decide whether such a cartel of price-fixing whales is stable. My uneducated guess is that stability would require a fairly low total market cap, where a few rich people can keep the token price stable as a hobby. However, if traders are significant (e.g., hedge funds, proprietary traders), the cartel would likely be shredded in the most painful way (for the whales) as possible.

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(c) Brian Romanchuk 2022


  1. This inspired me to write a post

    I think that legitimate commercial applications of "crypto", or rather some of the ideas, like public ledgers(but not necessarily decentralized), censorship resistance, and micropayments, can take hold.

    But these applications will revolve around what Joel Spolsky called "commodifying the complement".

    Crypto can persist indefinitely as a religion. To most outsiders, religions appear irrational, and yet the often offer something to there adherents either that or they exercise misinformation and control. Most of crypto has and will followed this path, with very narrow and specific legitimate commercial applications(notably for social media and video games)

  2. Call me naive, but I think this post is a bit one-sided from the perspective of the Developed Economies which currently dominate the economic landscape. There are many errors here, but I would like to focus on the "uses of cryptocurrency". Quote:
    The three main use cases of crypto so far have been the following.

    Online gambling. Video games and online gambling are large industries, and the gambling component of crypto is just another video game. Admittedly, I would estimate that at least 99% of "traditional" securities market activity is similarly gambling. However, the 1% residual of traditional finance that serves other economic purposes keeps the other 99% going.

    Evading laws. Crypto was a godsend for the ransomware industry.

    Payment system. Given that I can already send Canadian dollars to other Canadians by email or text message via my bank, I am not seeing a huge opportunity set here.

    No matter how useful the above are, they are useful for the peasants. Let's look at this from the perspective of capitalists.

    It seems you were sleeping all this 2022 and did not notice that the national reserves of the Bank of Russia were frozen in what they call the "biggest theft in history". Something similar happened to the gold reserves of Venezuela or the National Bank of Afghanistan. I am sure the author entirely agrees with the legalities of these actions (as I said, the author writes only from the point of view of the Holy Alliance of Western Countries), but I would argue that all the respective countries will be happier if they retained their wealth. That would have happened if traded was done through Bitcoin because it allows trade without counterparty risk. Interestingly, now the European countries are the ones at risk of holding Russian currency that could be frozen. International trade in dollars (or any other national currency) can only be sustained if an army is willing to defend it. An "international" policeman, if you will. History is very clear, showing that no political organisation last forever. One could say, "This time is different", as jokingly said Reinhart and Rogoff in their book.

    Is Bitcoin too volatile to perform such a role today? Of course, it is. Can Bitcoin go to zero? Yes, of course. Will Bitcoin be the final mean of exchange for the future? Not necessarily, but it has many of the required properties. I will gladly engage in any of the arguments of why bitcoin or any other cryptocurrency could go wrong. However, a plain dismissal of the possibility is just folly.

    1. Countries hold reserves so that they can cover imports and financial obligations. You can’t buy almost anything in the legal economy with Bitcoin. Which is exactly why no country is stupid enough to hold their reserves in it.


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