Practical analysis for investment professionals
17 November 2022

The Alchemist’s Paradox, Central Bank Sovereignty, and the Fate of Crypto

“It is difficult not to marvel at the imagination which was implicit in this gargantuan insanity. If there must be madness something may be said for having it on a heroic scale.” — John Kenneth Galbraith

The cryptocurrency exchange FTX filed for bankruptcy on 11 November 2022 as Sam Bankman-Fried’s estimated net worth plummeted from $16 billion to roughly $0. While I’ve always been a crypto skeptic, I tempered my opinion because I did not understand the technical underpinnings or fully grasp the broad use cases. This led me to discount what was obvious: That the crypto craze had all the signs of a speculative bubble and that cryptocurrencies fulfilled none of the critical requirements needed to replace major currencies or serve as “digital gold.”

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Whatever the value of the technical innovation that minted them, cryptocurrencies suffer from two major and insoluble problems that make it extremely doubtful they will ever supplant fiat currencies or be used as the underlying commodity to which the value of a currency is pegged.

Problem 1: The Alchemist’s Paradox

One of the keys to crypto’s value proposition is the concept of supply constraint. According to their proponents, cryptocurrencies cannot be minted ad infinitum the way paper currencies ostensibly can. Each cryptocurrency can supposedly be reined in by programmatic constraints that prevent arbitrary increase in supply and preserve a cryptocurrency’s scarcity value. This sounds great in theory, but it only applies to single cryptocurrencies. Because crypto technology is so easily replicated, nothing prevents entrepreneurs from launching new cryptocurrencies. Which is precisely why there are now roughly 12,000 varieties circulating in cyberspace.

This is the same problem ancient alchemists would have encountered had they discovered how to create gold out of lesser elements. Once the secret was out — and it would get out — gold would lose its scarcity value and no longer serve as a reliable store of value. The same rule applies to cryptocurrencies. The technology that gave rise to bitcoin was novel, but other cryptocurrencies have since emulated it. This distinct lack of supply constraint has made cryptocurrencies, in aggregate, a poor store of value.

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Problem 2: Central Bank Sovereignty

The next hurdle to broad cryptocurrency adoption is the central banks. They must accept cryptocurrencies as a viable form of reserves. For that to happen, they would first need to abandon the current system of fiat currencies that most employ and repeg their currencies to some other commodity. No major central bank is likely do this willingly and, contrary to popular belief, for good reason. Doing so would significantly reduce their ability to adjust the money supply in response to financial crises. It was precisely this constraint under the gold standard that prolonged the Great Depression in the 1930s and caused repeated panics and depressions throughout the 1800s and early 1900s. Central bankers will not voluntarily reintroduce this structural weakness into their financial systems.

Second, even if central banks retired fiat currencies, they would have to determine that a cryptocurrency, rather than gold, silver, or something else, was the best commodity to which to link their currency. In what sort of scenario would any major central bank willingly harness its currency to something over which it could exercise no control of the supply? At least with gold, the supply is limited by formidable natural constraints. The last time a major sovereign country relinquished control over its money supply to my knowledge was in early 18th-century France, when the regent for Louis XV handed the money supply, tax collection system, and control of Mississippi Company shares to John Law. The Mississippi Bubble that followed decimated the French economy and reverberated for the remainder of the century. Louis XV suffered a tremendous loss of wealth, and his successor, Louis XVI, lost his life. This is not something central bankers would dare repeat.

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Relegation to the Shadows of Finance

Without broad-based central bank acceptance, cryptocurrencies will be permanently exiled to the fringes of the financial markets. The black market, failed or failing nation states, and the 24-hour casinos run by FTX-like firms may find limited use cases. But even if these are viable, we can only guess how large the potential market might be and which or how many cryptocurrencies will emerge as viable mediums, which makes buying and selling them no more than speculation. What’s worse, those who play this game will need to accept the risk of bank runs, bank robberies, and fraud without the protections of a well-regulated banking system.

For those who made their fortunes in this shadowy market, I bear no ill will. Every bubble has its share of winners. But those looking to make crypto fortunes should be aware that there are more Bankman-Frieds lurking in the shadows, and whether or when they divulge the real value of their assets or steal yours is anybody’s guess.

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

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About the Author(s)
Mark J. Higgins, CFA, CFP

Mark J. Higgins, CFA, CFP, is an author, financial historian, and frequent contributor to Enterprising Investor. His work draws from his upcoming book, Becoming an Enlightened Investor, which will arrive in bookstores in fall 2023. For those interested in receiving updates on the book and his research, please feel free to send your contact information. Prior to founding The Enlightened Investor, LLC, Higgins served as a senior investment consultant for more than 12 years. In this role, he advised the trustees of large pension plans, foundations, endowments, and insurance reserves that had aggregate assets of more than $60 billion. As a consultant, he discovered that understanding financial history proved much more valuable than tracking the latest economic data. He also discovered that there was no single book that recounted the full financial history of the United States. Becoming an Enlightened Investor seeks to fill this void. The insights are intended to help investors contextualize current events and thereby improve their investment decisions. The book will be published and distributed by the Greenleaf Book Group and will be available for purchase online and in bookstores in fall 2023.

2 thoughts on “The Alchemist’s Paradox, Central Bank Sovereignty, and the Fate of Crypto”

  1. Justin Gibbs says:

    Thank you for this well written article. I enjoy reading different perspectives on this topic. I would like to offer up some common retorts to these arguments in hopes to spark a good conversation.

    The Austrian response to the quote below would be that loose policy causes the bubbles in the first place. Centralized control is both the cause and solution to the same problem. I’m curious if there is a good response to this viewpoint.

    “ Doing so would significantly reduce their ability to adjust the money supply in response to financial crises. It was precisely this constraint under the gold standard that prolonged the Great Depression in the 1930s and caused repeated panics and depressions throughout the 1800s and early 1900s. “

    In response to the Alchemists problem: yes there have been many bitcoin copycats. However among pure money cryptos (exclude smart contracts, NFTs ect) none have ever taken any meaningful market cap from bitcoin. This leaves bitcoin as a solid store of value.

    Why would central banks ever give up control? They would not willingly. It would need to be forced upon them through a lack of faith in government currencies. A common statistic used by crypto proponents is that amongst countries who reach 130% of debt to GDP only one has not defaulted on their currencies. That example being Japan. We are now at a point where most developed economies are beyond that threshold. This mismanagement of centrally planned currencies is why bitcoin was created.

    Thank you for considering these questions.

  2. Mark Higgins says:

    I agree that monetary policy played a role in the bubble, although I actually think fiscal stimulus was a bigger problem over the last two years. More importantly, however, I generally believe in the necessity of central banks mostly because I have read so much about what the United States (and other countries for that matter) looked like when they don’t have one. The wildcat banking was disastrous in the mid-1800s in the United States, and I don’t think that’s something we want to go back to.

    With regard to rising US debt levels, I agree with you that it is probably the biggest long-term challenge for the United States — but that is more of a fiscal issue. I get that our reserve currency status enables us to continue doing this to a large degree, but I still think of it as more of a fiscal issue. In researching the last 230 years, the shift in our philosophy on public debt is probably the biggest change that I have seen in U.S. policy. Prior to World War II, the United States increased public debt during wars and then paid it down during times of peace. This is no longer the case and it is one of the biggest problems that I see for our country right now. I don’t know how it gets solved, but I’m pretty sure returning to decentralized, unregulated financial systems is not the cure.

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