Why the administration is letting crypto burn

I've touched on this before, but as we embark on what may be the first plain-vanilla recession of the 21st century it is worth reflecting on how unusual the period between 2008 and 2021 was in hindsight. 

During those 12 years, the federal funds rate was mostly zero, slowly inching its way up to a whopping 2.25% before the pandemic, then back down to zero until earlier this year when inflation came roaring back. The Fed has raised interest rates in four months as much as it had in four years before the pandemic. 

It was during that interim period between highly unusual crises — when the normal laws of gravity had apparently been suspended and accommodative monetary policy had been turned on its head — that the crypto market emerged. Bitcoin, the proof-of-concept original cryptocurrency, was sketched out in a white paper published on Oct. 31, 2008, just as the financial crisis was hitting its stride. The cryptocurrency was founded the following year and gradually built not only a dedicated following but a number of imitators and innovators, ultimately ballooning into a multitrillion-dollar global industry by November of last year. 

Bloomberg News

Times, as we all know, have changed. The total cryptocurrency market cap has lost about two-thirds of its value since its peak; crypto is on fire, and no one is coming to put it out. That's a notable departure from the last two times trillions of dollars have gone up in smoke. After the 2008 financial crisis, Congress and regulators went to extraordinary lengths to keep the Wall Street titans, General Motors, General Electric, AIG and other key cogs in the financial system afloat. During the initial economic fallout from the COVID-19 pandemic, Congress and the Fed bailed out everyone else, potentially contributing to a host of factors that awoke inflation from its long slumber. 

But whereas in those past crises the Fed and Congress were unwilling to stand by and let markets correct themselves, this time they are taking a decidedly different tack, and there is no better example of this than the lack of any real discussion anywhere of propping up the crypto market. 

I suspect that is for several reasons. Crypto is a speculative market and it's rife with bad actors, but the same could have been said for banks and insurance companies before 2008. What's different this time is that crypto is sufficiently siloed from the broader financial system that it can deflate dramatically without a great deal of collateral damage. And, more to the point, the government — and especially the Federal Reserve — has to send the message that the music is stopping and not everyone will get a chair when it does.

The low interest rate environment of the last decade or so has had a number of effects, but one of the most salient has been that if you want to make your money turn into more money, you have to invest it in something. What that something is almost doesn't matter — values have ballooned in everything from housing to commercial real estate to stocks to commodities to the magic beans that many crypto tokens have turned out to be. 

FSOC calls for legislation on crypto spot markets

And all the while there has been a nagging concern about what we used to call "moral hazard" — the idea that markets had internalized the message that even if you screw up, someone will come through to bail you out. Until recently, there have been few viable ways for the government to dispel that notion without pulling the pin on the global economy just to make a point — 2008 wasn't the time for it, and 2020 wasn't either. But now, the government — and, again, especially the Federal Reserve — means business.    

The pain of the coming recession has not yet arrived, but it will, and just as the last decade or so has been dubbed the "everything boom," the indeterminate period between now and when we peek our heads out again will see values drop across the board. I don't think crypto will go away completely, just as stocks and commodities and housing and everything else won't go away completely. But neither I nor anyone else has a very good sense of what the true baseline value of cryptocurrencies or DeFi protocols are. 

As the administration — and, perhaps, the following one — moves forward with its efforts to set up prudential and supervisory expectations for crypto markets, we will likely gain a better understanding of which of the crypto innovations is here to stay and which are not. But for now, the crypto winter is here — and it's going to be a hard winter.