Cryptos ain’t no ‘digital gold’

Outside the echo-chamber

Now that the crypto bubble has burst, it is a good time to examine the myth built around owning it and equating it to ‘digital gold’.

Bitcoin was the first crypto. The first tokens were mined in January 2009. At that time, bitcoin was projected as a peer-to-peer payment mechanism; something you and I could use to pay each other without involving the conventional financial system of central banks, commercial banks and other financial intermediaries.

Bitcoin and then many more cryptos were seen as a response to the rich-world central banks going overboard printing money in the aftermath of the 2008 financial crisis. As Satoshi Nakamoto, who invented bitcoin, put it in February 2009: “The root problem with conventional currency is all the trust that’s required to make it work…The central bank must be trusted not to debase the currency, but the history of fiat currencies (paper money) is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles…We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”

Bitcoin was supposed to take care of these problems by being a peer-to-peer mechanism. But, as usual, there was a huge difference between what was proposed in theory and what emerged in practice. While Bitcoin and other cryptos did not emerge as a medium of exchange (money’s primary function), they did emerge as an object of speculation, something people could buy and sell, and hope to make quick money in the process.

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What helped Bitcoin and other cryptos become successful objects of speculation was a neat marketing trick. They were marketed as ‘digital gold’. The economist Eshwar Prasad explains this in The Future of Money. As he writes: “The total stock of gold that exists in the world (above ground) is estimated at about 185,000 metric tons. Roughly 3,000 tons of gold are mined each year, which amounts to about 1.6 per cent of the existing stock.” The point here is that gold, unlike conventional paper money, cannot be created out of thin air.

As Prasad puts it: “It would take that many years for annual gold production, assuming it continues at the average rate, to reproduce the existing stock.” Bitcoin worked on a similar logic. Only a maximum of 21 million Bitcoins can be mined. And as time goes by, the rate at which they can be mined keeps falling. Hence, Bitcoin was like digital gold and unlike paper money, which central banks could keep printing at will.

The trouble with this argument is that while there is an upper limit to the total number of Bitcoins that can possibly be mined, there is no such limit to how many such cryptos can be created and launched. Data from Statista tells us that the number of cryptos has gone from 66 in 2013 to 10,397 in February 2022 – and fallen to 9,310 by November. So, the ‘digital gold’ argument is nothing but marketing that people fell for, for a while.

When investors invest in different financial assets, there is always something underlying these assets. Stocks are backed by company earnings; and when it comes to investing in commodities, different commodities have different uses. Bitcoin and other cryptos, on the other hand, have nothing underlying them. As Darren Tseng, Stephen Diehl and Jan Akalin write in Popping the Crypto Bubble: “There is no mode of “investing” in crypto that is not gambling. The underlying assets themselves have no intrinsic value or fundamentals and are a pure manifestation of the greater fool theory; the value of a crypto token is only a gamble on what the next fool will pay for it.” Trouble is, the world eventually runs out of fools.

Crypto believers say that the lack of utility/underlying argument can be made for gold as well. But that’s not true. Data from the World Gold Council shows that in 2021, nearly 48 per cent of global gold demand came from the jewellery fabrication sector. The technology sector used 7 per cent of the total gold produced during the year. So, gold has some ‘real’ use, with the rest of it being used by investors as an inflation hedge and stored by central banks.

It is worth remembering what the authors of Popping the Crypto Bubble point out: “Traditional stores of value such as gold have persisted and retained value through long stretches of human history, famines, wars, recessions, and the rise and fall of empires, while almost all [crypto] tokens have imploded on short-time frames.” That is the long and the short of it.