Start with the main uses. Some of them are already established, others are more speculative. A well-founded basic use is that you can use crypto assets to pay your blackmailer or data thief. (Crypto proponents hate this example, but when it comes to basic usage, it’s the closest thing crypto has to a “safe thing”.) Whether it’s socially desirable is another matter, but it is privately advantageous to hold crypto in order to pay ransoms.
Other primary uses could involve crypto assets as “digital gold”, crypto assets in gaming environments, crypto assets in the metaverse, crypto assets as a way to redeem “smart contracts”, and crypto assets cryptographic as underpinning decentralized finance, or DeFi. These uses vary in their degree of acceptance and likelihood of success, but all are possibilities.
Crypto prices are partly a rolling bet on increasing demand for crypto to satisfy these varied uses. For my purposes, it is enough that some basic demands exist, and thus the value of more useful crypto assets will not fall to zero. What interests me most is what forces might act in addition to these relatively well-understood factors.
Much of the core value of crypto assets comes from their price volatility, which is part of their appeal. I brought up this possibility a while ago, ironically, but on reflection, it strikes me as a really helpful (albeit counter-intuitive) way to think about crypto assets. The general idea of price volatility as a value goes back at least to Fischer Black, one of the founders of option pricing theory.(1)
In standard economic theory, investors are risk averse, meaning they prefer more stable patterns of consumption to less stable ones. This is generally true, but it does not mean that investors always prefer more stable investment prices – a crucial distinction.
Consider this hypothesis: you are given an envelope containing a dollar. You then have the option to exchange it for an envelope containing either double the money (i.e. $2) or half the money (50 cents), each with a probability of 50 %. Essentially, you accept some exchange rate volatility.
Most people will find this bet pretty good. The new expected value of your envelope is (0.5 x $2) + (0.5 x $0.5), or $1.25. It is a higher expected value than your original dollar.
If you’re perched on the edge of livelihood, this bet may seem too risky. But for most investors, who have some level of wealth, this is an improved outlook, but with added risk.
Bitcoin and other crypto assets essentially give you a form of this bet. Admittedly, this 50-50 bet does not accurately describe the price dynamics of crypto assets. But it is a way of illustrating that crypto prices, relative to the dollar, will go up or down a lot. The bet helps show that some investors might welcome price volatility – or, if you like, call it exchange rate volatility. And with even greater fluctuations in value, the price volatility is even more extreme, which can be even more attractive.
So when Bitcoin and other crypto assets arrive, they are a new source of expected gain precisely because of their price volatility. It’s like being invited to a casino where the odds favor you over the house! You won’t always win, but a lot of people will want to keep playing.
Conventional wisdom is that people fell in love with crypto because it grew so rapidly for so long, and that’s surely a big part of the story. But even a crypto asset that is just as likely to fall as it is to rise in value is a very attractive asset, at least from the perspective of expected pecuniary returns.
In any case, this is the basic assumption. But there are some counter-intuitive complications, the first of which is that you cannot take the volatility value of the crypto as given.
Suppose, for example, that over time more and more people see that holding crypto is a good investment. This stimulates demand and increases the price of crypto assets, making crypto prices more stable as knowledge of the benefits of holding crypto spreads.
As crypto prices become more stable, the benefits of crypto volatility diminish. After a while, when investors see lower price volatility, they will be less interested in crypto. They will sell, creating downward pressure on prices.
But the story does not end there. Then the volatility game starts all over again. As the price drops, investors will wonder: how much exactly has crypto volatility dropped? How much do other investors care? What kind of process exactly is behind these developments?
All of these issues will re-introduce further volatility into the market and, in turn, drive demand for crypto again. A seesaw game will set in, with no obvious resting point.
The market will go back and forth. There is no particular reason to believe that this process will converge to a single “appropriate price” for crypto – thus matching the price patterns of major crypto assets such as Bitcoin and Ether.
In the longer term, there could also be a downward trend in crypto price volatility. As investors repeatedly experience these fluctuations in value, they might better understand them. They might take them for granted. They might even get a little bored by them. All of these factors could make the demand for crypto more stable, thereby lowering the volatility value of crypto and, in the longer term, lowering the prices of major crypto assets.
There is another factor that could reduce the volatility value of crypto assets. Consider again the main uses of crypto, starting with ransom payments and ending with DeFi. Whatever you think of this menu of options, over time its value will become better understood and more certain. Thus, price volatility resulting from “changes in estimates of the value of major uses” will at some point decrease. It will also reduce the volatility premium on the crypto and could reduce crypto values in the process.
This is another reason why the strategy of buying more crypto now is not straightforward: even if crypto proves itself beyond a shadow of a doubt and commands broad social consensus, its long-term value could end up falling as much of its volatility premium could disappear.
This theory also explains why so many distinct crypto assets have proliferated. One might have expected network effects to lead to one or two dominating crypto assets, and as certainty about crypto uses increases, that is likely to happen. But in this phase of Wild West crypto, investors are looking for volatility. If there is a new crypto asset with at least one primary use and a lot of volatility, investors may find it attractive. They won’t just stick with bitcoin. That said, if these basic initial uses don’t pan out (and they usually don’t), the market may indeed end up with a few dominant crypto assets – after much experimentation with even more volatile assets.
At this point, you might be wondering if, from a social perspective, this analysis damns crypto. Holding crypto can (under certain circumstances) be a good investment decision, but does it create value for society at large? Or is it just a vacuum pump, increasing the wealth of its holders and sucking up the wealth of others?
On reflection, the crypto looks better than it looks. First, in the short term, most crypto wealth goes unspent. Some people simply enjoy the feeling of greater wealth and protection. By the time they and their heirs spend all that wealth, crypto prices could be much lower.
Second, the same questions can be asked more broadly about exchange rate speculation. Its social value is uncertain, but given the difficulties of maintaining fixed or pegged exchange rates, much of it is not going away. But perhaps the crypto volatility premium will decrease, just like with most normal currencies, exchange rate movements are small compared to the total value. Exchange rate volatility is something the world has managed to live with, and perhaps crypto volatility will be the same.
Calm rather than hysterical analysis of crypto and predictable regulatory treatment of crypto can help create more mature crypto markets. This in turn could reduce the volatility premium on the crypto as well as the price. Unfortunately, so far none of these developments are in sight – but I’m optimistic they will be in time.
In summary: even risk-averse investors can look for volatile price movements. This means that the future of crypto assets will be more persistent than many people expect and will not require these assets to become more stable or fully satisfy a long list of practical uses. That said, when greater stability eventually arrives, the crypto will lose some of its luster – and future prices may disappoint some of the crypto’s staunchest advocates.
More from Bloomberg Opinion:
• When Crypto Tulipmania meets the real economy: Lionel Laurent
• Dreams of an algorithmic stablecoin will not die: Trung Phan
• This crypto winter will be long, cold and harsh: Jared Dillian
(1) See Fischer Black on exchange rate hedging, and the relevant underlying mathematics follows from Jensen’s inequality.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives and Winners in the World”.
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