The Bear’s Lair: Cryptocurrencies and the South Sea Company

Cryptocurrencies have not taken over as the new Gold Standard, but nor have they disappeared, and they have been showing something of a revival in the last few months. We are thus in a similar position to the investors of 1720, inspecting the new phenomenon of a publicly traded company whose shares take off. Like those investors, we have no track record to guide us, but now both the hype and despair are past, we can perhaps draw some conclusions on what role cryptos will play in our future.

In 1720, investors did not know what a stock market bubble was, yet in France and Britain two almost simultaneous bubbles reached enormous size. In France, the Mississippi Company, with the rights to develop France’s new territories around New Orleans, was interlocked with a bank, the Banque Royale, to reach enormous size and take over most of France’s money supply. Because that bubble sucked in middle-class savings through spurious banknote issuance, it was both more of an inspiration to today’s Keynesians and a bigger long-term disaster to France’s economy than its companion South Sea Bubble in Britain.

The latter bubble involved shares in the South Sea Company, which under the 1713 Treaty of Utrecht had been granted limited slave trading privileges to Spain’s colonies in the Americas. The company then made a tender offer for the large and miscellaneous British government debt outstanding, offering to exchange it for the company’s shares. The shares peaked at 1050% of par value, in market capitalization about 3 times Gross Domestic Product, so about 60 Amazons. However, being share-based, the South Sea Bubble involved mostly the gambling losses of the rich and thus did less long-term damage to the British economy than the Mississippi bubble did in France (also, the company was bailed out to a limited extent and did not go bankrupt, surviving until 1853).

Cryptocurrencies share several features with the Mississippi and South Sea Companies. They represent an entirely new form of investment, which is impossible to value by existing metrics. Like the Banque Royale’s banknotes, they are a substitute for existing forms of money, and to their more enthusiastic practitioners may replace it altogether. Like the other stock market companies floated in 1719-20, some of them are unquestionably scams, though the overall market has some elements of genuine value. Like South Sea and Mississippi Company stock they rocketed in price, although they have now come down to earth. In recent weeks there has been a revival in their prices, suggesting that they may have a longer-term future, although the total cryptocurrency market capitalization is still less than a third of the $800 billion it reached at the peak in January 2018.

Unlike the innovations of 1719-20, cryptocurrencies appear largely a product of legislative meddling, in two areas. First, the intrusive “know your customer” banking regulations, passed with the excuse of combating terrorism, have excessively limited financial privacy, so that it is now possible in principle for Big Brother to know the location of every cent of your conventional currency assets that is not in physical cash. Naturally, even though people Love Big Brother, they seek ways of avoiding this grotesque intrusion. Cryptocurrencies, especially those whose anonymity is well designed, offer a mechanism to do this and hence have a value in today’s naughty financial world.

Second, the obscene monetary policy of the last decade has frozen small and medium sized businesses out of the banking market. Not only has the Fed kept interest rates close to zero until the last year, it also rewards bankers for falling asleep at their desks by paying them 2.35% for keeping their money on short-term deposit at the Fed, by definition a risk-free, intellect-free activity.

Since banks pay negligible interest rates on their consumer deposits, and deposits at the Fed require no capital, the Fed’s build-up to a $4 trillion balance sheet in the last decade has killed small-business lending, which the ever-officious, ever-stupid Basel risk regulations regard as the most risky bank operation, hence requiring most capital. (Actually, because small-business lending is undertaken in modest tranches and diversified between many businesses in different sectors, it is far less risky than the idiotic leveraged buyout lending to large private equity managed deals that banks find so attractive; it is also less risky than banks’ poorly-risk-managed trading activities.) The Fed’s modest run-down of its balance sheet in the past year has done the economy untold good (because reducing the free money for the banks) – it is thus unpopular with the banks and apparently with President Trump.

As a result of the freeze-out from banks, small and medium businesses have taken finance from other sources. One is so-called business development companies, publicly listed companies that lend to medium sized businesses and leverage themselves, paying a handsome (in today’s markets) dividend to shareholders through doing so. In the earlier stage of the business cycle, these were attractive investments (albeit with a tendency to erode capital); not so now when we must on any calculation be near the top.

Another source of finance for small business are private equity companies themselves, which are readily available but both expensive and intrusive, tending to meddle in management when they miss an aggressive and intrinsically uncertain plan. A third is peer-to-peer lending, a banking sector fad that appears to have peaked as investors have discovered the relatively unattractive risk-reward ratio from doing your own credit analysis (local banks are much better set up to do this work.)

Finally, there are cryptocurrencies, which have set themselves up as sources of finance for new and risky ventures, especially in the tech sector. If cryptocurrencies continue to flourish, they will be an increasingly important source of small business support, unless somebody sorts out the banking system.

In the Mississippi and South Sea cases, the phantom profits produced by the bubbles were immensely “stimulative” to the economy, in the Keynesian sense. Sir Robert Walpole built Houghton Hall with his profits from the South Sea, for example, reinvesting his ill-gotten gains in real estate while the going was good. Cryptocurrencies similarly are providing an equivalent stimulus to today’s global economy. However, the stimulus is not as much as you might think.

In principle, with cryptocurrencies having a value of $260 billion, and the total investment in them having been no more than $20 billion or so, including all the inflated Daddy’s power bills from teenage nerd coin-mining basements, there should be $240 billion of gains around to act as stimulus (that figure having been some $780 billion briefly in December 2017). In practice, it’s nowhere near as much as that. For one thing, since many of the Bitcoins were indeed manufactured by teenagers in basements in 2009-12, many of the hard drives on which they were stored, being at that stage worth say $0.50 each, were then lost, when Daddy moved house or cleaned out the basement.

Second and more serious, various thefts and frauds involving the less scrupulous exchanges have also caused losses. The Mt. Gox exchange, which went bankrupt in 2014, is thought to have “lost” 650,000 bitcoins, worth over $5 billion at today’s price. Combining “teenage basement” losses early on and fraud losses, many of them as yet undetected, more recently as much as half the global stock of cryptocurrencies may be unaccounted for, making the unrealized profit only $100 billion or so.

For this reason, a cryptocurrency monetary standard would be impossibly deflationary, even if prices rose to make the cryptocurrency market capital comparable to the current $8 trillion of gold outstanding. Gold is by its nature indestructible; the gold that was mined to make Tutankhamen’s royal finery is still in existence today. Hence, we have only the problem of finding increased supplies to match increasing population and wealth. Cryptocurrencies, on the other hand are by no means indestructible, as we have seen over the last decade. Hence, they are either impossibly deflationary as a monetary standard or impossibly inflationary, as new cryptocurrencies are relatively easy to create.

If governments would only stop playing Big Brother and put the world back on a stable commodity based monetary standard (gold or otherwise) cryptocurrencies would have no value. As the evil meddling tendencies of governments and their foolish Keynesian and Marxist advisors appear irrepressible, cryptocurrencies will remain with us, as a valuable means of escaping from Big Brother’s all-seeing gaze, with a side benefit of financing some small businesses. It’s just a pity that, in terms of indestructibility and stable value, they represent such a very imperfect escape.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)