Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sun, 22 Oct 2017

Bitcoin as a way to short bad things

Many people are perplexed that there is no asset underlying Bitcoin. One answer is that there is nothing underlying fiat money either. But, it is more interesting to think about Bitcoin not as being long something good but as being short something bad. Bitcoin is short untrustworthy/incompetent banks/politicians.

Bitcoin has soared in value as trust in G7/G10/G20 politicians has eroded. Capital flight from untrustworthy peripheral countries has historically been to core country safe havens like the US dollar. But when trust in the core is eroded, where does one go? Traditionally, money poured into gold, and to some extent it still does, but today's technology utopians see gold as Luddite and medieval. Bitcoin has many of the key attributes of gold (most importantly, it is beyond the control of politicians), but it is modern and futuristic.

So one way to think about Bitcoin as an investment is to ask yourself whether you are optimistic about today's G7/G10/G20 politicians in terms of trustworthiness and competence. If your answer is yes, you should probably forget about Bitcoin, but if your answer is negative, Bitcoin deserves some serious consideration. In the latter case, you would think of Bitcoin (and Ethereum and the rest) as the way to reinvent capitalism so as to make it less dependent on bad/stupid politicians and their crony capitalists.

In this vein, I have been thinking about two episodes separated by a quarter century. In September 1992, the UK government was battling the Hungarian, and in order to defend the British pound, the Bank of England raised interest rates an unprecedented second time on the same day (the first hike at 11:00 am was from 10% to 12%, while the second hike at 2:15 pm was from 12% to 15%). For the first few minutes, the London stock market fell sharply in response to this shock and awe strategy. At that time, the stock market was essentially short the politicians: if the politicians won, the UK economy would suffer from an overvalued currency and the high interest rates required to sustain it: stocks would fare badly. If the politicians lost, then lower interest rates and a weaker currency would propel the economy and the stock market higher. So the initial response of the market was one of dejection: the politicians seemed to be winning at the cost of inflicting even more damage to the economy.

But within minutes, the London stock market began to rally furiously as it realized that the second rate hike in the day was a sign not of strength but of despair. The market was now convinced that the politicians would lose, and so it turned out. The pound crashed out of the ERM and the second rate hike was canceled before it came into force. Jeremy Siegel tells the whole story quite nicely in his book Stocks for the Long Run (in the section on Stocks and the Breakdown of the European Exchange-Rate Mechanism).

Twenty five years later, in September 2017, a few weeks before the five-yearly Congress of the Communist Party of China, the Chinese government launched a crack down on crypto currencies including Bitcoin. Clearly, the thought of people investing in an asset beyond the control of the state and the party was anathema to the Chinese rulers. Again the initial response of the market was that the politicians would win this fight and Bitcoin dropped about 30% very quickly. It took a couple of weeks for the market to realize that (like the Bank of England's second rate hike), the Chinese crackdown on Bitcoin too was the outcome not of strength but of despair. The ban would only reduce the influence of China in the growing global Bitcoin ecosystem. Bitcoin began to rebound and the centre of Bitcoin trading shifted out of China to elsewhere in the world. When the party Congress began in mid October, Bitcoin was trading at record highs well above the pre ban levels.

It is possible that the Chinese crackdown would come back to haunt them. China's geopolitical rivals (US, Japan, India and others) are surely reflecting on this episode and wondering whether Bitcoin could be the Achilles' heel of the Chinese state's control over their economy. At the same time, Russia and China are probably wondering whether Bitcoin is the Achilles' heel of the US control of the global payment system.

So if you believe that the world is run by somewhat honest and tolerably competent politicians, you could bet that Bitcoin is just a passing fad that we would all be laughing at in a few years' time. If you want to short this rosy view, Bitcoin beckons: it is now too big and strong to be shut down by untrustworthy/incompetent politicians.

PS: I have recently started referring to the man who broke the Bank of England simply as the Hungarian because of the current Hungarian government's extreme hostility to him.

Posted at 12:39 on Sun, 22 Oct 2017     View/Post Comments (0)     permanent link