By Noah Smith
(Bloomberg View) --A financial mania is an amazing thing to experience. The crash of 2008 sent a chill through the American financial system, making it seem like the psychic scars might prevent another asset-buying frenzy for decades. But then a new force appeared from outside the financial system entirely, and the heady days of price charts and bubble talk are back.
That force is bitcoin. The cryptocurrency has appreciated spectacularly since the beginning of the year:
Globally, the total capitalization of all cryptocurrencies is now estimated to be about $600 billion, of which Bitcoin represents about two-thirds. Even if all of that turned out to be a bubble, it wouldn’t be a very big one -- both the tech crash in 2000 and the housing crash in 2008 wiped out about $6 trillion of wealth in the U.S. alone. But a crypto crash might still produce adverse economic effects, so it’s worth thinking about what happens if investors decide to stampede out of bitcoin. (Disclosure: I own a small amount of bitcoin.)
First, let’s think about why such a crash might happen. The long-term case for bitcoin is based on its viability as a currency -- basically, if people stop using government-issued fiat currencies to buy cars and TVs and bread, and start using cryptocurrencies, early investors who happen to have stashes of the new money on hand will benefit mightily.
But there are good reasons to think bitcoin won’t replace fiat money. The currency is so volatile that if people’s salaries were paid in bitcoin, they wouldn’t know how much they were getting paid. If they tried to make purchases in bitcoin, their paycheck might be much smaller by the time they went to the grocery store. Conversely, just imagine the regret of the developer who bought two pizzas for 10,000 bitcoins in 2010 -- an amount that would now be worth more than $100 million. Whether bitcoin goes up or down, using it to pay for real goods and services looks like a bad idea. This is why people tend to use currencies that have slow but predictable inflation -- like the U.S. dollar, whose 2 percent inflation target is maintained by an independent central bank -- while hoarding assets that they expect to go up in price.
That doesn’t mean, however, that bitcoin has no real-world uses. People who want to pay for black-market goods like drugs, or who want to launder money, will continue to use it, as will those who want to evade capital controls like those used by China. Other cryptocurrencies, such as ether, are also part of software platforms that allow people to execute smart contracts.
And the rise of initial coin offerings, in which companies (or scamsters) fund their ventures by trading cryptocurrency for cash, shows that this new form of money will also be useful for evading financial regulations. Because cryptocurrencies are global, national-level regulations -- like the ICO bans in China and South Korea -- will never stamp out their use.
So bitcoin, ether and the rest do have some enduring real value -- they are not pure bubbles. But if their price does fall a lot from its current heights, could that send the U.S. and other developed nations back into a recession, like the crash of 2008?
It probably depends on how much debt is associated with the bubble. A 2012 paper by economists Oscar Jorda, Moritz Schularick and Alan Taylor looked at the history of recessions, and found that when private credit is larger during an expansion, the recession that follows tends to be longer and more severe. This fits closely with the U.S.’s experience in recent decades -- the tech bubble was mostly equity, so the recession that followed was short and mild, while the debt-heavy housing bubble produced the Great Recession and a lost decade.
Why does debt make bubbles so much worse? When equity crashes, notional wealth simply vanishes. That makes people feel poorer, which makes them consume less -- a phenomenon known as the wealth effect. But when companies or households have borrowed a lot of money from each other, an asset price crash can also cause other bad effects. Lenders who see their loans go bad will themselves be forced to borrow money, which slows the real economy because borrowing is costlier than funding a business internally. Debt also creates systemic risk, because key financial institutions can go bankrupt easily if they have too much leverage. Banks whose debts suddenly go bad have trouble lending to businesses due to their own capital adequacy requirements, or even require a government bailout. And households saddled with an overhang of debt may shift into deleveraging mode, hurting consumption -- a phenomenon known as a balance sheet recession.
Now, private debt in the U.S. economy is down from its pre-2008 peak, and hasn’t been growing very rapidly in recent years:
So the time to worry about bitcoin will be if and when people and companies start either borrowing money to invest in cryptocurrency, or using bitcoin as collateral for loans. These worrying signs are just starting to appear. There are stories of people taking out mortgages to invest in bitcoin, and new outfits are popping up to lend people money against their cryptocurrency accounts.
So far these stories are scattered and the amounts involved are undoubtedly small compared to what was seen in the mid-2000s. But regulators and the Federal Reserve should keep their eye on the phenomenon of bitcoin-associated lending, and get ready to crack down if things get out of hand. Without a big pile of debt, a bitcoin bubble and crash isn’t nearly as scary a prospect.
Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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