The New Dynamics Of Market Crashes

Or Why The Next Financial Crisis Could Be Much Worse.

Our economy is built on a requirement for perpetual growth and because no one wants to find out what happens when the growth stops, we’ve just kept piling on debt to keep the growth going. In practice this has lead to a constant cycle of extreme growth and crippling depression.

Market crashes are a symptom of a system where growth isn’t just pleasant, it’s a necessity. With capitalist forces at play, humans will do just about anything to grow just a little more and this quickly becomes unsustainable, financed by ever growing amounts of debt. A massive house of cards that almost everyone consciously or subconsciously knows about and one that must come down eventually.

There is definitely real, tangible wealth being generated, but looking at the historical context, it seems clear that there is much less real wealth than we think. This is why crashes occur. The entire house of cards comes tumbling down when one card turns out to be a little soggy and structurally unsound, suddenly revealing an entire layer of cards that are dripping wet.

A History Of Crashes

Growth of the S&P500 from December 1927 to April 2017 on a logarithmic scale and adjusted for inflation.

The graph above charts the growth of the S&P500 from December 1927 to April 2017. The black columns represent depressions.

There are many reasons for crashes, but fundamentally they are a result of too much debt and central banks having the ability to create an essentially unlimited money supply for banks, which in turn leads them to provide people and organisations with more debt. Once this becomes unsustainable, we crash.

When there is a long period of prosperity and growth, people and organisations take on more debt, because they overestimate their future ability to pay the loan back. Unfortunately the period of growth usually comes to an end and everyone still has all that debt to pay off. This is a Minsky Moment, where everything suddenly comes crashing down due to excessive amounts of debt which cannot be paid back.

How The Economy Survives Crashes

When the crash happens, it’s usually sudden and devastating, but painfully obvious in hindsight. In the last 20 years we’ve lived through the Dotcom bubble which burst at the beginning of the new millennium and the 2008 financial crisis, considered to be the worst crisis since the Great Depression.

At the bottom of the 2008 crash around 34 trillion dollars of wealth had been wiped out, but as with previous crashes, the economy survived. The select few who had seen the crash coming and had the resources to protect themselves, made a lot of money. The vast majority, though, lost a lot.

People continue to remain in the system because there is no alternative. A tiny minority have the information and resources to profit from these crashes. The rest of us are stuck and there’s no alternative to just riding it out.

When almost all of us come crashing down together, there is a point at which the bottom is found. We need to be able to buy and sell things and we can’t get out of the economy even if we wanted to. Crashes aren’t economy disrupting events, because we fundamentally need a medium of exchange and people are stuck within the only system that historically has provided one.

Rise Of Cryptocurrencies

Enter Bitcoin. Released in 2008 by a mysterious online figure going by the name of Satoshi Nakamoto, Bitcoin showed the world a way to remove money from the traditional financial system.

As the price started to go up and the fledgling cryptocurrency entered the consciousness of the tech community, privacy advocates and speculators jumped on the bandwagon.

As the price kept on rising, eventually suffering a crash of its own, Bitcoin slowly entered the mainstream as everyone simultaneously declared it’s demise.

However, because cryptocurrencies inherently are not under any central banks control, while crashes can be bad, they are also real. If prices are too high, the market should crash. The market should not be artificially stimulated, because it actually stops the market from pricing assets accurately. If the market corrects the prices in the traditional system, our central banks fight back to keep the growth going, essentially ensuring another bad crash in the future. Cryptocurrencies, then, over time are likely to create a healthier relationship with price corrections. Accurate pricing is in everyone’s best interests, except the interests of those benefitting from the flawed system.

Another important distinction between cryptocurrencies and traditional financial markets is related to debt. Loans can still be made in cryptocurrencies, as with any transferable asset, but the risks are much higher. I would argue this higher risk is also a more accurate representation of the risk incurred when giving a loan. Currently our banks operate by engaging in fractional reserve banking, essentially allowing them to give many times more money out in loans than they have in deposits. If they are too big to fail and know they will be bailed out by the government, they can do this with little to no risk. This behaviour is what leads to Minsky Moments. Cryptocurrencies have no fractional reserve system and giving loans is a big risk, as it should be.

Now 8 years later, Bitcoin has hit record prices and the market capitalisation of the entire cryptocurrency market is around 80 billion dollars.

New Market Dynamics Of Crashes

It’s highly likely that the markets will crash again very soon. Historically, we’ve had crashes every 10 years or so and it’s now been 9 years since the last one. I have no interest in speculating when the crash will happen, but the historical evidence should act as a warning that we may be nearing one presently.

Whenever the crash does occur, this one will be very interesting indeed. Due to cryptocurrencies, for the first time in history, anyone, not just the supremely privileged, can escape the traditional financial and regulatory system. Previously investors have sold off all their assets, tried to hedge against the crash with assets like gold that supposedly correlate negatively with market downturns or held and braced for a few years of misery. In the end everyone has still been tied to the dollar and thus the traditional economy and even gold wasn’t what it used to be during the 2008 crash.

So what happens when markets crash and people not only get out of their investments, but out of the dollar as well? I don’t know, but I can offer a possible scenario.

Markets crash. People panic and move more and more money into cryptocurrencies. Governments panic and take extreme measures to stop the outflow of capital from the traditional economic system. These extreme measures may include vast censorship of the internet, artificial blocks to withdrawing money from banks, crackdowns on known operators of Bitcoin companies whether illegal or not. All very unpleasant business.

This may happen in the next market crash or it may not. In fact I think it’s likely that cryptocurrencies are not yet robust enough to carry the amounts of capital necessary to facilitate a major movement out of the traditional economy. Eventually, though, they will be robust enough and if cryptocurrencies have skyrocketed during every previous crash, every investor will know where to put their money in the next one.

What to do?

A better outcome will be difficult to create. Pioneers see an opportunity to build a new global economy and governments see an existential threat to the carefully maintained system they represent. Personally I think that if people opt-out of the current system en masse, that’s a pretty compelling reason to change it. After all, what are governments for if not to enact the will of the people?

As far as I can tell, there are two avenues we should pursue in parallel.

Align Interests

If we can align pioneer and government interests, we can ensure a much better baseline for discussion if a meltdown were to occur. This is best achieved by having governments directly participate in this new economy. It won’t be easy, but at this point I think there is a valid argument to be made for governments diversifying their investments by having some exposure to cryptocurrencies.

Sovereign wealth funds should allocate capital to funds holding buckets of cryptos, just as they allocate to private equity companies, VCs, etc.

Thus if a crash were to occur, the citizen’s and the government’s interests would at least be more aligned, hopefully allowing for a more productive discussion on how to proceed in the future.

Remove Reliance

If governments are completely unwilling to entertain the idea of hedging their bets by investing in cryptocurrencies, there is something else we can do. We need to remove the cryptoeconomy’s reliance on the internet.

Cryptocurrencies have an achilles heel: the internet. As long as cryptos require the internet in it’s current form to operate, governments hold disproportionate power in denying people the right to opt out of the old economy. Even in todays world it is not uncommon for governments to block access to certain parts of the internet. It is well within their power and I don’t think we’ve seen the full extent of that power anywhere in the world yet. Even though the internet is theoretically decentralised, there are a few mega-corporations that control access to it (ISPs), thus also providing governments with that power.

The solution, then, is to create systems that do not rely on the internet to ensure uncensored communication, financial transactions and basic services in any event.

Large-scale mesh networks built on the blockchain seem like a promising way forward or more likely a mesh of mesh networks where depending on your proximity to the person you are interacting with, a different technology could be utilised (and a different price charge). It doesn’t really make sense that you need to be connected to the same global internet regardless of if you’re transacting with someone 3 feet away or someone in China. It also doesn’t make sense that these two scenarios cost the same amount of money.

Phones could be interconnected in a mesh network, making short distance transmissions almost free. Additionally you could have more robust systems for city or country wide communication, that resemble mini-ISPs. I think the best way to understand it is by imagining every Bitcoin miner on the planet turned into a router that connects you with other people around you. Finally for international and intercontinental transmissions you could utilise the traditional internet infrastructure for the time being. If that’s not an option interesting alternatives include satellites and old school radio transmissions.

We live in exciting times.

The good news is that smart people are already working on parts of the proposition outlined above, but there’s still much to be done. An actionable step would be to get everyone working on these technologies to communicate and help each other. Cryptocurrencies have given us a fantastic way to organise and financially incentivise large amounts of people to work towards a common goal. Maybe we should have a cryptocurrency that tracks an index of cryptocurrencies, similar to what index ETF’s do in the traditional economy. That way, anyone working in cryptos as a whole would be financially incentivised to help make not just their project, but the whole economy as successful as possible.

I think I’d call it metacoin. Imagine if everyone in the world was financially incentivised to improve the world as a whole. That ultimately is the promise of cryptocurrencies.

As the buddhists say: Such is the suchness.