In my last blog post I explained why I thought that the current crash in the cryptocurrency markets looked like a liquidity crisis to me.
In this post I will explain the Financial Instability Hypothesis proposed in the 1970s by the American Post-Keynesian economist Hyman Minsky's and how it applies to cryptocurrencies.
The take away point it that the crypto-markets and maybe even the broader financial system are probably entering a period of stop-go cycles of growth.
But first a little financial economic theory and history.
Minsky argued, in a nutshell, that stability is de-stabilizing. He argued that the financial system tended to transit from being composed of financial units depending on income to finance operations and investment (hedge financing units) to using borrowings to fund investment and attain growth and profits (speculative financial units) to ponzi units that were highly leveraged and relied on capital gains to ensure their future viability.
For Minsky, the business cycle was characterised by the transit of the composite units of the financial system (banks, hedge funds etc) from hedge into speculative into ponzi units. This occurred via an 'upwards instability of credit' (Mehrling 2011) in the financial system whereby investment of income creates growth which encourages borrowing and leverage that creates more growth that encourages a reduction in funding costs, an increase in asset prices and the assumption of more debt to capture asset price increases.
This is what stock prices looked like in the 1970s in America when Minsky was writing
In the 1970s the cost of capital (the interest rate) was controlled by government policy rather than set by markets. However, in the 70s the commercial banks found ways to get around government regulation of the cost and supply of credit by creating new forms of credit, commercial structures and global relations that formed the 'money markets' for short term debt. These new networks and structures enabled the commercial banks to escape government controls over their ability to source and set the price of capital in the money markets.
This of course relates to crypto in China and Korea - which are countries that maintain financial controls that resemble those that the US had in the 1970s. China wants to be able to control capital flows in and out of the country and into it's asset markets in order to maintain stability, tax income and control bubbles. China has just followed up on its ban of domestic exchanges with a ban on accessing off-shore exchanges for Chinese citizens. Korea has also recently introduced controls.
In the 1970s the US government reacted to the development of the institutions and networks that composed the money markets by extending regulation to cover them and occasionally banning them for fear that they were undermining their regulatory structure. This often created a crisis in asset markets as these sources of funding could no longer be used to fund investment in these assets. The government would then get scared of causing a recession and loosen it's restrictions kick starting growth again (see Wojnilower 1980, Jefferis 2017).
I could see this pattern of growth re-occurring with crypto as regulators figure out how to engage with it and integrate it into the financial system. Regulators in the US are not likely to behave like Chinese regulators instituting an outright ban because they want to facilitate liquidity and innovation. Their main approach is likely to involve focusing on transparency and accountability. However, regulatory actions in China and Korea where a heavy handed approach is likely will probably continue to have effects.
Crypto may have other flow on affects de-stabilizing the regular financial markets because it jeopardises the investment case of banks and web 2.0 tech companies. If banks suffer disintermediation by crypto and tech companies like google and facebook can no longer hoard all the info and content that web users on distributed user controlled blockchain applications produce, apply statistics to it and use these databases to inform development of AI, then their future business case looks a little more fragile.
The DOW just dropped 5% yesterday following on the heals of the crypto boom and bust. Perhaps the boom drew the attention of the mainstream finance community to crypto who could now be seeing potential for instability.
Reference
Minsky, H.P. (1986). Stabilizing an Unstable Economy. New Haven: Yale UP.
Wojnilower, A.M. (1980). The Central Role of Credit Crunches in Recent Financial History. Brookings Papers on Economic Activity, 1980(2): 277-339.
Jefferis, C (2017) Dialectics of Liquidity Crisis; an interpretation of explanations of the causes of the crisis of 2007-08. Routledge, London.
https://medium.com/@matteozago/why-the-web-3-0-matters-and-you-should-know-about-it-a5851d63c949
Congratulations @chrisjefferis! You received a personal award!
You can view your badges on your Steem Board and compare to others on the Steem Ranking
Do not miss the last post from @steemitboard:
Vote for @Steemitboard as a witness to get one more award and increased upvotes!
further to the points in my last two paragraphs see http://markets.businessinsider.com/currencies/news/bank-of-america-just-showed-how-terrified-wall-street-is-of-cryptocurrencies-2018-2-1016867690?nr_email_referer=1&utm_source=sailthru&utm_medium=email&utm_content=crypto_insider&utm_campaign=post%20blast%20%28moneygame%29:%20crypto%20insider:%20wall%20street%20is%20terrified%20of%20cryptocurrencies&utm_term=crypto%20insider
and also http://www.businessinsider.de/bitcoin-exchange-coinbase-wants-to-be-next-google-2018-2?nr_email_referer=1&utm_source=Sailthru&utm_medium=email&utm_content=Crypto_Insider&utm_campaign=Post%20Blast%20%28moneygame%29:%20CRYPTO%20INSIDER:%20Wall%20Street%20is%20terrified%20of%20cryptocurrencies&utm_term=Crypto%20Insider&r=US&IR=T
https://hackernoon.com/state-of-cryptocurrency-regulation-february-2018-a316c291320
https://medium.com/@vijayb_24615/the-bullish-case-for-bitcoin-part-3-of-4-2e2c002593f1
https://medium.com/@vijayb_24615/the-bullish-case-for-bitcoin-part-4-of-4-dd2ccd4fcfb3
https://thenextweb.com/contributors/2017/10/17/watch-google-blockchain-will-set-us-free-data-tyranny/
Congratulations @chrisjefferis! You have completed some achievement on Steemit and have been rewarded with new badge(s) :
Click on any badge to view your own Board of Honor on SteemitBoard.
For more information about SteemitBoard, click here
If you no longer want to receive notifications, reply to this comment with the word
STOPCongratulations @chrisjefferis! You have completed some achievement on Steemit and have been rewarded with new badge(s) :
Click on any badge to view your own Board of Honor on SteemitBoard.
For more information about SteemitBoard, click here
If you no longer want to receive notifications, reply to this comment with the word
STOPI realise now I omitted a key point in the article above which is the following. To understand Minsky's theory of cycles you have to appreciate the paradox that it occurred at a time when the quantity of debt in the US financial system was heavily controlled. The cycles - the shift from hedge to speculative to ponzi financial relations were only made possible by the creation of new forms of money/debt relations that weren't able to be regulated by the existing post-war regulatory structure. Hence the debt cycles in theory were actually regulatory cycles in practice as regulators over extended constraints and then walked them back. Crypto is a new form of money that looks like it is subject to the same issues now as affected the money markets in the US in the 1970s.
Is crypto winter coming? Gary Gensler, who was head of the Commodity Futures Trading Commission from 2009 to 2014, has been making waves this week. It started with a profile in the New York Times, which highlighted his recent move to MIT and new post as a senior advisor at the Digital Currency Initiative. That piece, which came out Sunday evening, foreshadowed a controversial statement that Gensler made yesterday on stage at our event: that the second most valuable cryptocurrency, ether, as well as Ripple’s XRP token, may in fact qualify as investment contracts under US law and be subject to much stricter regulations.
Gensler said he wants to see blockchain technology succeed, but it will not reach its full potential until it becomes compliant with laws meant to protect investors from fraud. At the moment, the industry is “not in very good shape,” he added, estimating that more than 1,000 ICOs and 100 to 200 cryptocurrency exchanges are failing to comply with the law.
There has recently been increasing speculation that XRP is indeed a security, given that Ripple holds so much of it and maintains so much control over its monetary policy. But Gensler’s argument that ether might be one as well is significantly more contentious. It would also have significantly deeper consequences for the industry, given Ethereum’s prominence. Who knows how regulators would handle such a complicated, retroactive designation. It might lead to a slowdown or pause in investment and development—or even a dreaded “crypto winter.” FROM MIT TECHNOLOGY REVIEW 24 April 2018
Congratulations @chrisjefferis! You received a personal award!
Click here to view your Board