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Stray Thoughts: The Next Crypto Scam

💱 We are the dollars and cents and the pounds and pence...

So the cryptocurrency market appears to have mostly crashed--thank farking gourd! I'm taking for granted that crypto and NFTs are almost* all scams, and if you're unsure of why I would think that, I will point you to the definitive explainer on the subject: Dan Olson's sublime video essay Line Goes Up: The Problem with NFTs.

*The token counter-example is HNT, which is used to create a market for bandwidth on the Helium network--that is, it's actually being used as a currency rather than purely speculation.

Instead of going into the details of why it's a scam, I instead want to talk about why scams like this arise in the first place and why we're inevitably going to see more of them. So strap in, because this is a long one.

Actually I'll just skip to the end here: rich people are hoarding too much wealth. That's the cause. That's it. With the corollary that rich people--or hell, most people, frankly--don't really grok how the market for loanable funds works. But yeah, that's the problem: wealth-hoarding at scale causes bubbles.

Let me back up a bit... There are, broadly speaking, two categories of investments. The first are "capital" investments. These are things that give you a pecuniary return regardless of the sale value of the asset. What is a "pecuniary return"? Basically it's money you get just for owning the thing. Rent on a property you lease. Interest on a savings account. Bond yields. Stock dividends. That sort of thing. You own it, so you get paid. (For a great primer on "capital" and how it influences society, check out Jonathan Levy's Ages of American Capitalism.) The second type are "speculative" investments. These are investments that don't offer a pecuniary return. Instead, you make money by selling them at a higher price than you bought them. And speculative investments come in a broad spectrum of sophistication--everything from hedge fund managers trading pork belly futures to Uncle Cletus picking up Beanie Babies at the swap meet. What's important is that you don't get money just for having them. Any gains you make are purely from buying low and selling high. And it is worth noting that there can be overlap. A dividend-paying stock may technically be capital, but an awful lot of stock traders will treat it like a speculative asset regardless.

Of the two classes of investments, capital is the more desirable because it comes with guaranteed income (for very flexible definitions of the word "guaranteed"). A bad capital investment isn't going to net you very much money, but you're unlikely to lose money on it. Speculative investments, on the other hand, are riskier. You genuinely can lose money, and indeed, someone is going to, eventually. Speculation bubbles are the result of what's called "The Greater Fool Hypothesis". You buy something that's overvalued because you're pretty sure that there will be a "greater fool" after you who will be willing to spend even more money on it. If this sounds suspiciously like a Ponzi or pyramid scheme to you, award yourself one gold star. And, of course, what happens to bubbles is that they ultimately burst. At a certain point there are no more fools, the value of the asset plummets, and whoever is left holding the hot potato is out. Clearly, capital is the better choice, but there's just one problem...

There's a finite amount of capital out there.

So, here's where I really want to drop in an explainer of the theory of supply and demand, but this is already going to be long enough without me throwing up a bunch of graphs. Maybe that can be a second post. The salient bit for this discussion is that shifts in demand are positively correlated with the natural market price. If demand goes up, so does price, and vice versa. Shifts in supply, meanwhile, are negatively correlated. A supply glut drives prices down, a shortage drives them up. Good? Good.

So yeah, there's only so much capital to invest in. Ergo, an increase in demand against a relatively fixed supply drives up prices of capital investments. And you can see this going on in, for example, the real estate market. Properties are being bought up by leasing companies as capital investments, and this is one of the factors driving up house prices. The more expensive a capital investment is, the more of a return the owner expects. I mean, if you just spent $85,000 over asking price on a house, you're going to gouge on the rent in order to make some of that back. That's just science. However, housing/rental prices are still subject to market forces, which means there's a point at which capital becomes too expensive to purchase and expect a worthwhile return. Which means there's a practical ceiling to the amount of investment money that can be absorbed by capital assets. So, where does the rest of the money go?

Two places. One of them, you might have surmised, is speculation, but we're going to circle back to that in a few paragraphs. The other is a subset of the capital investments that's broadly defined as "loans", and that's the one we're going to look at first. You probably know this, but when you buy a treasury bill, you're making a loan to the government. Or when you open an interest-bearing account at a bank, what you are actually doing is making loans to other people--or, more accurately, the bank is making loans on your behalf. And it turns out a lot of "capital" is really just a few levels of abstraction away from being a "loan". And that's great! Loans are one of those engines of capitalism that actually work. And, as a bonus, it turns out you can use supply and demand to model them! And here's where I really wish I could throw out some graphs, but we're gonna power through. Time to talk about the market for loanable funds.

In the market for loanable funds, the "good" being traded is short-term liquidity with deferred payment. When you take out a loan, you are getting liquidity now (read: money you can spend immediately). When you make a loan, you are selling liquidity. When you think about it, a loan is still counted as an asset, but it's not something you can just pull your money out of. The value of your portfolio hasn't changed, but that money has become illiquid. Following me so far? Good. And the "price" of this liquidity is measured in the per-unit return on the loan, which is a fancy way of saying the interest rate.

The other thing you have to factor in is risk. Since you are selling your liquidity for deferred payment, there is a chance the borrower won't make their payments. If a borrower is considered risky, then you get a higher rate of return to price that risk into the transaction. And there's a natural ceiling here too, as there's a finite supply of trustworthy borrowers. Putting it all together, in the market for loanable funds, lenders represent supply, borrowers represent demand, and the interest rate is the price with a risk-factor adjustment baked in. And the laws of supply and demand still apply. A spike in demand for liquidity--lots of people wanting to borrow money--drives the interest rate up. A glut of supply--lots of people wanting to lend--drives the rate down. Makes perfect sense. There's just one problem...

Investors don't think of themselves as being the supply side of this transaction. They don't think of themselves as selling liquidity; they think of themselves as buying an asset. It's all just capital, right? An increase in demand for houses drives the value up, so why would an increase in demand for T-bills drive the value down? Why do we have two different types of capital assets that move exactly the opposite direction? And this disparity between an investor's expectations and market-driven reality creates perverse incentives for people with loose morals who want to make a buck, that is to say, scammers. If you can create an asset that appears to have a high rate of return, there are a lot of buyers out there for it--especially if it's exorbitantly expensive.

There are a number of ways to do this. You can take a risky loan with a high rate of return and hide the risk from the lender. That's effectively what a CDO was (I'm simplifying, there was a lot more going on with the 2008 housing crisis but this post is already too long). Alternately, you could just lie. Take the Bernie Madoff approach and run a Ponzi scheme. The problem is... Ponzi schemes are illegal and you're eventually going to get caught. What you really need is a scam that's got the same structure as a Ponzi scheme--where future investors are paying off present ones--but with some kind of medium to buy and sell, because if there's a "thing" being transacted, it's no longer illegal. It's still going to collapse, but maybe you can get your payout before it does, and you won't go to jail afterwards. Now, in order to get that sweet sweet payout, you're going to need to lure in a bunch of greater fools after you. And, oh look, interest rates are low... What if we market this as a bold, shiny new opportunity to everyday folk so they can take out loans to buy our "investment"? (Pro tip: never borrow money in order to invest it!) Maybe get Matt Damon to do a commercial for the Super Bowl. Sure, everyone who buys in after seeing it will lose their shirts when the bubble bursts, but as long as we get that sweet sweet payout...

(If you ever wondered why every major economic downturn in this country has been preceded by a major expansion in credit... this might have something to do with it.)

That's how you end up with speculation bubbles. Sometimes they arise naturally, like with Beanie Babies. Sometimes they're fostered by opportunistic businesses, like the comics boom in the 90s. And sometimes tech bros just cook something up to try to cash in, like NFTs. Is crypto itself a scam? Well, I don't think Bitcoin started out as one, but it was a failure as a currency and it slid into the speculation slot pretty easily. It kind of doesn't matter why or how it happened. If it wasn't Bitcoin it was going to be something else--scammers gonna scam. Because the problem isn't that there are unsavory people in Silicon Valley (although there definitely are), the problem is that there is more money in the system than the system can absorb. There's too much wealth being hoarded invested for the capital markets to be able to accommodate it. That money's got to go somewhere, and wherever it goes, bubbles will follow. So as the rich get richer and the middle class disappears, what you can expect is to see more bubbles that eventually burst and do more damage to the poor and working and the ever-shrinking middle classes.

This is why wealth taxes exist, people. Not to punish the rich or to make them "pay their fair share", it's to keep them from wrecking the economy by fueling yet another bubble. And the truly hilarious thing is that the only reason this happens at all is because people with insane gobs of money feel obligated to put that money to use getting them even more money! If they just locked it up in a vault a la Scrooge McDuck, this wouldn't be a problem. But a portfolio that isn't growing doesn't count, I guess? This, incidentally, is also why the wealthy shit themselves at the first sign of inflation, not because of any harm it might do to the economy or the lower classes, but because it's the one thing that can make their wealth actually shrink.

So the crypto/NFT scam may be kinda sorta drawing itself to a close. Hoo-freaking-ray! It doesn't matter. The next scam is just around the corner, because the circumstances that create it haven't been dealt with at all. Mark my words, there will be another shiny new investment opportunity that's all the rage and if you get in at the ground floor, you too can be as rich as Matt Damon. And some of you are going to fall for it.

That's what I think anyway,