There’s an old folktale about a factory worker who is suspected of stealing. One evening, the worker leaves the factory with a wheelbarrow that’s covered with cloth. The security guard lifts the cloth to check underneath but finds it is empty and lets the worker pass. The next evening, the factory worker again approaches the gate to leave and the guard again inspects the wheelbarrow, only to find nothing. The dance continues each night until it’s finally revealed that the worker has been stealing the wheelbarrows themselves.
The security guard, distracted by the valuables the worker could be moving around, never once considers the vehicle he might be using to move them. The obvious presence of the wheelbarrow is what allows it to remain unquestioned - it is hidden because it is in plain sight.
Our own financial system has its proverbial wheelbarrow: the dollar.
In the midst of each financial crisis, we conduct post-mortems on offers and deals that were made. We question federal actors. We fire the person that gave the other person the greenlight. We bail institutions out. We introduce new legal and financial guardrails. In short, we try to be better prepared for the next collapse.
But what if the actual problem lies within the nature of the dollar itself? This question led Satoshi Nakamoto to begin working on Bitcoin - which was eventually released to the world on the heels of the 2008 financial crisis.
Because we have yet to see how a novel digital asset performs during a world-wide financial crisis, there are plenty of theories around the fate of bitcoin during the next crash. No one, of course, can know for sure, but history allows us to draw a reasonable blueprint. What happens to bitcoin in a global financial collapse largely depends on bitcoin’s position in Exter’s pyramid and the time horizon being considered.
A flight to the bottom
Exter’s pyramid, as described in the Bitcoin Standard Monthly Bulletin, was developed by the late New York Federal Reserve Bank vice chairman John Exter and provides a model that organizes financial assets according to risk and their corresponding liquidity.
The higher the reward of an asset, the higher the risk associated with it. And the more the risk and reward of an asset, the less likely it is to be liquid. The bottom of the pyramid is narrow, because the assets at its bottom are hard to increase in supply. As you rise up the pyramid, the assets increase in volume, as they become easier to produce, which both increases their risk, and reduces their liquidity.
At the bottom of the pyramid is gold, which offers no returns, but is the safest asset because it is no one’s liability. It also has the highest liquidity because it is a financial asset that has been accepted in a vast majority of places throughout history and because it is an asset whose value is not dependent on anybody fulfilling any obligations. History shows that no matter how many newfangled new monetary inventions are made, once the going gets tough people flock back to the familiar, liquid, impersonal, and trustless safety of gold.
As we move up Exter’s pyramid, assets’ riskiness (and reward) increases while the liquidity of the asset declines.
Above gold is the USD, which offers no return and is highly liquid, but is riskier than gold because its value is dependent on the behavior of the US Federal Reserve. Above gold are government bonds, which are less liquid than paper money, but offer returns. Above government bonds are commercial bank deposits, above which lie various financial assets with increasing riskiness and decreasing liquidity, since the riskiness strongly compromises the suitability as a liquid medium of exchange.
Exter's pyramid grows wider as it nears the top. Riskier assets are often more lightly collateralized, and so supply can expand far more quickly than those which require tangible backing. This was seen in the 2008 housing crisis, where synthetic CDO's quickly eclipsed the value of the mortgages underpinning them.
Though a pyramid is the most stable geometric structure, an inverted pyramid is only stable with a heavy gold base. When it becomes too top-heavy, it begins to collapse in on itself. In other words, as debt obligations proliferate, and the creditworthiness of borrowers declines, the likelihood of defaults causing contractions in the money supply - and thus a collapse in the pyramid - increases.
Bitcoin's Monetary Status
An extreme example of a collapse of Exter’s pyramid can be seen in Venezuela: where inflationary monetary policy leads to the collapse in demand for the monetary asset itself, leading to a scramble down Exter’s pyramid to more liquid assets, such as the US dollar, or gold, and most interestingly, recently, Bitcoin. This race to the bottom of the pyramid, this attempt to transfer capital from “risky” investments to “safer” investments, is known as a flight-to-quality or flight-to-liquidity. People are not willing to take on risks, and prefer to just preserve their wealth, and have it liquid.
Uncertainty in the markets naturally catalyzes a flight-to-quality as investors sell their risky assets for established safe havens like cash and gold. A less extreme collapse in Exter’s pyramid was the financial crisis of 2008, where the higher reaches of the pyramid, containing risky financial assets, witnessed a collapse in liquidity, whereas the lower reaches of the pyramid, which had the US dollar, gold, and government bonds appreciated in value as investors sought them as a safe haven.
Bitcoin’s fate in a financial crisis, then, depends on where it sits in the global economy’s Exter’s pyramid, in terms of how it is held by its owners, and its potential owners. Should the majority of bitcoin holders be of the short-term speculative type, then bitcoin is likely to be nearer the top of Exter’s pyramid, and likely to suffer in the same way as highly risky assets did in 2008, as short-term speculators in Bitcoin have to liquidate their positions to hold more liquid and less risky assets like the US dollar.
If, on the other hand, demand for Bitcoin is driven by its liquidity and usefulness for international quick payments, then bitcoin can be viewed as being closer to the base of the pyramid. In such a situation, you would expect demand for bitcoin to rise in the midst of a financial crisis, as people choose to sell less liquid assets for bitcoin. While this might not sound plausible at first, remember that bitcoin is extremely useful for moving wealth around the world very quickly, and could thus attract demand for that property in the midst of a crisis, even as short-term speculators exit the market.
Further, Bitcoin can already be understood as the golden base of the digital Exter pyramid of the cryptocurrency space. It is by far the most liquid digital currency, and in a financial crisis where people seek to liquidate risky positions from the cryptocurrency space, bitcoin stands as the most liquid resort for people who want to exit riskier markets.
Only time and a fully-fledged financial crisis will tell where Bitcoin lies in today’s Exter’s pyramid, but there are a few important economic considerations to keep in mind in the long-run. Even if Bitcoin collapses significantly in value over this financial crisis, it would likely continue to operate and perform its functions as usual, which would go a long way to illustrating its usefulness and value proposition as a neutral global settlement system. Even with a collapse in its value, it would lose significant demand as a short-term speculative asset, but it would continue to have demand as a global liquid instrument. Over time, this property will tend to drive bitcoin toward the lower reaches of Exter’s pyramid.
More importantly, perhaps, is the other unique value proposition of bitcoin, emphasized in The Bitcoin Standard, which is that Bitcoin is the first strictly scarce liquid asset. Even if Bitcoin’s value growth turns out to be largely driven by short-term speculative demand, the supply of bitcoin remains strictly scarce, and completely unresponsive to increases in demand and price. This will differentiate it from all other assets in the higher reaches of the pyramid whose supply can be inflated in response to demand. As the supply of all these other assets expands as a response to demand over time, Bitcoin’s difficulty adjustment will likely keep bitcoin progressively scarcer over time compared to all other assets, and thus naturally drive it down in Exter’s pyramid to a more foundational position.
Scarcity over time
For its first financial crisis, the judgment and action of most bitcoin holders is going to be hard to guess, but the most important thing to understand here is that as time goes on, and more financial crises happen, bitcoin distinguishes itself from every other asset in Exter’s pyramid in one distinct way: its supply cannot increase. Whereas in these early days as Bitcoin goes into its first crisis, the subjective opinions of various bitcoin holders are likely to determine the course of action, with each extra recessions bitcoin’s fundamental economic quality, its strict scarcity, ensures its supply increases the least.
This quality also shines through more as time goes on because bitcoin’s stock-to-flow ratio, continues to drop significantly, making mining output a progressively smaller part of the new supply, and thus making bitcoin more of a pure monetary good.
If a new financial crisis is around the corner, bitcoin will distinguish itself from other assets with the fact that its supply is likely to not increase a lot. Former JP Morgan head of global macro Alex Gurevich eloquently explained this in a blogpost last year:
When bitcoin first started trading, I was mostly unaware and fairly agnostic of its value. As a trader, I became interested in its vertical rise in 2013 which was followed by a bear market in 2014. Notably, its drop found support; it didn’t continue to fall to permanent obscurity below the event horizon. Instead, it stabilized, put a solid double-bottom in 2015, and started to creep up. This trading pattern is consistent with precious metal behavior, only compressed to a shorter horizon. For example, [...] the slow consolidation in gold after the spike of 1980.
This trading pattern has so far been only exhibited during Bitcoin’s own bubbles, but we have yet to see it during the context of a global financial crisis. It may not happen with the first crisis, because the supply growth rate is still not very low, the number of holders is still very little and so they are quite price sensitive.
Whenever money flows to an asset in Exter’s pyramid, there is a large supply response. When people flow to the US dollar, the Federal Reserve is likely to resort to more inflation of the supply. When people resort to homes as a store of value, their supply increases as builders build more, eventually depressing the price. When people resort to mortgage-backed securities, these securities themselves proliferate quickly, as do the houses backing them, bringing the price down.
But as more and more money flows to Bitcoin, there can be no supply response, and therefore it behaves similar to precious metals, as Gurevich observes.
Consumer behavior after a crisis
An undermentioned part of the recession conversation is the psychological transformation of the consumer during and post-financial crises. In a study analyzing the main changes in buying behavior in times of economic crisis, consumers’ sense of self-reliance and control is examined:
“[After a financial crisis] consumers seek for change and know they can rely only on themselves. Recession is an opportunity to step back and think deeply. They will look for something ‘bigger than self’, from ‘active pessimism’ to ‘proactive mindfulness’. Despite their anxiety, people are changing the status quo and take greater control of their present lives and futures. A primary way in which they will do this is through their consumption choices. Their strongest means of power and influence it is the advent of ‘proactive mindfulness.’”
And is it any wonder consumer behavior would trend towards more self-reliance and control? During economic crises, the inability to withdraw money from banks as needed, coupled with the sobering realization that our financial system’s perceived invincibility betrays its fracturable nature, can only culminate in a severe distrust of financial institutions. And there isn’t a clearer, more frictionless path to reclaiming that level of control than by owning your own bitcoin and keys.
The behavioral shift towards more control, self-reliance, and break from tradition post-recession is precisely the type of fertile environment required for bitcoin adoption to flourish. Coupled with the usual hallmarks of a recession - including the drying up of liquidity and interbank markets seizing up, it's clear to see how bitcoin's perceived value will increase over time, after weathering a few financial crises.
A new pyramid base
For its first crisis, bitcoin may drop significantly, but no matter how much it drops, it is likely to eventually stabilize around some level due to the scarcity of its new supply. This is the key difference between bitcoin and other assets, except arguably gold. An expected stability, is likely to give bitcoin some credibility as a hedge and store of value. Given that bitcoin will continue to operate, and will maintain some value, even a significant drop would likely only set it back temporarily before new users begin to recognize its value proposition.
It might not happen with the first or second recession, but over time, as the supply growth rate continues, and perhaps after several financial crises have raised bitcoin’s profile as an alternative asset, bitcoin will likely find its way down Exter’s pyramid in a similar way to gold. Its wide salability across the world, and its scarcity and volatility, will ultimately make people more interested in holding it as a long-term store of value, rather than as a short-term speculative bet.
Hypothetically, a bitcoin-based Exter triangle would be likely to be more stable than our traditional gold-based one; it would grow very little beyond the creation of productive assets, and contain very few unsustainable expansions through fractional reserve banking, rehypothecation, and maturity mismatching. Regardless of bitcoin’s performance in the next financial crisis, one thing is clear: it’s time to take a hard look at our wheelbarrow.
Subscribe to Saifedean’s Monthly Research Bulletin here.