Crypto is in big trouble. One of crypto’s biggest exchanges, FTX, just filed for bankruptcy and therefore many are now making the comparison to the infamous collapse of the U.S. bank Lehman brothers. This bank nearly ended the global financial system. <We are in the midst of a serious financial crisis.. Major financial institutions have teetered on the edge of collapse and some have failed> The only reason that it didn’t was that central banks stepped in to save the system. But, since crypto has no central bank, many are now asking the question,

Is this the end of crypto?

Well, based on what economists have learned from the previous financial crisis, yes it could very well be. I think that crypto is likely heading to a bottom that is so low, that many would basically consider it the end of crypto.

But, why now? I mean, many economists already argued in 2017 that crypto was a speculative bubble that would collapse in the long-run, and they were always wrong. Well, the difference now is that the crypto industry has committed the same sin as the banks did in 2008, they are up to their necks in debt. Debt that was based on one assumption, crypto prices will keep going up. And now that they have been falling for a year, crypto institutions are collapsing left and right, just like the banks did in 2008. Luckily, economists have learned two key lessons from that 2008, that can help you make sense of the current crypto collapse.

But, before we get into that, a quick shout-out to our sponsor the free, business newsletter, The Daily Upside, more about that later.

Lesson 1: Speculators Breed Speculators

Speculators breed speculators. This first lesson economists re-learned after 2008, comes from a well-known behavioral framework. In this framework, financial market prices can roughly be explained by the interactions of two types of traders: fundamentalists and speculators.

For crypto, fundamentalists are those who use it to buy non-crypto-coin stuff like groceries. On the other hand, speculators are those who purely own crypto as a way to get rich quickly. The demand of fundamental crypto users sets the base value of the entire crypto industry. Economists call this the fundamental value. However, as currency acceptance and therefore the fundamental value rises, speculators might come in and try to profit from the rising price.

Simply because they now also want to own some crypto, this actually pushes the price above its fundamental value.

This type of speculation in financial markets can be extremely successful thanks to a positive feedback loop between prices and actions.

This makes financial markets fundamentally different from the normal markets you might learn about in a standard economics class.

You see, in normal economic markets, there is a negative feedback loop. For example, if I decide to drastically increase my consumption of oranges, this might initially push up the price of oranges at my local market. However, seeing its price go up, others will now find them less attractive, instead preferring to switch to apples.

This is called a negative feedback loop because my increased demand is offset by someone else’s decreased demand.

However, if this speculator buys an asset, he pushes up the price of that asset. And so, he and other speculators will get richer. Now other speculators might see this, and also buy more assets, making the other speculators even richer. As you can see, speculators don’t really need to know much about the fundamental value of the asset they are investing in, as long as they convince others to buy more, their strategy will pay off.

This explains why so many charismatic or famous people, that seemingly didn’t know much about investing or money, got really rich with crypto.

Now, of course, this dynamic cannot go on forever. Speculation is risky, it is not for everyone. At some point, there are no more potential speculators left to buy in, at this point, the price might start declining as some speculators start to cash out.

Now, the positive feedback loop becomes a bad thing. In the normal market, if I change my mind and stop eating oranges, its declining price makes it more attractive for others, stabilizing the price.

For investments this again doesn’t work. Remember that speculators were only trying to get rich. Now that the price keeps falling, they face a stronger and stronger incentive to cash out by selling the asset, and if everyone is selling, this will make the price drop even more.

Using experiments and simulations, economists have discovered that the dynamic between these people leads to a cyclical price dynamic, around the fundamental value. From time-to-time speculators enter the market, inviting more and more, driving the price up, until there are no more. At that point the cycle turns and they all start selling. Thanks to the positive feedback loop, the crash is pretty bad and will fall below the fundamental value. Of course, at some point, demand from the fundamental users will make the price return to its fundamental value. Seeing the price move up again, the speculators might return, and the cycle starts all over again.

So, let’s apply this to crypto. What you see here is the S&P broad crypto index, which represents the value of all major cryptocurrencies. We can clearly see some speculative cycles. But, they have been moving upwards. So maybe the fundamental value has been moving upwards? Could this actually mean that we already are close to the bottom for crypto?

Well, perhaps. But, that wouldn’t be enough to save crypto at this point. The reason is that compared to the crypto bust in 2018, its speculators now have committed one cardinal sin: [getting themselves into debt]( to speculate way more than ever before.

Lesson 2: Don’t Speculate With Debt

After 2008, economists learned a very painful and valuable lesson, it is a really really bad idea to get into debt to speculate. Perhaps not for the individual, after all, it might make you fabulously rich. No, it’s a really bad idea for the system, because it basically turns your financial system into a house or cards.

You see, even though crypto, and specifically Bitcoin, was created by people who hated the 2008 bankers for their debt-fueled excesses, the crypto industry has slowly but surely added possibilities for speculators to get into debt to buy more crypto.

So, okay, to make sense of this, let’s go back to our speculative investor example and give them all a loan. The most obvious consequence of this extra money is that speculators can push up prices faster and higher.

But, it gets worse because of what is seemingly a good thing.

You see, lenders are not stupid, they know speculation is risky. Therefore, they are going to ask the speculators to give them some collateral. The deal is that speculators can buy crypto with borrowed money. But, if they cannot repay their loan, the crypto they purchased will automatically go to the lender.

As you might recognize, this is the same principle that underpins mortgage lending. Sure, you can get a mortgage to buy a house. But, if something goes wrong, the bank now owns the house.

What could go wrong?

Well, the problem is that this triggers several other positive feedback loops. The main reason for this is that the asset you speculate with can serve as collateral for more loans. Crucially, this means that if asset prices go up, you can get more loans. Of course, the reverse also holds, if asset prices start dropping, the value of your collateral decreases. So, your lender will ask you to post more to protect your loan, and if you cannot, you will automatically get liquidated, meaning that the lender will sell your collateral for you to minimize their loss.

In total, I’ve identified five positive feedback loops in a debt-fueled speculative bust.

First, if asset prices drop, speculators loose interest, leading to a further fall.

Second, once asset prices fall, speculators will find it difficult to borrow more, this means there is less demand, which in turn mean prices will drop even more,

and then, things are starting to break. Loans cannot be repaid, collateral will automatically be sold on the market, asset prices drop further…

and now, are you ready for a fourth positive feedback loop?

At this point, the value of collateral gets so low that the lenders themselves will start to get into trouble. They will need to start selling their assets as well.

Okay, then, what about a final positive feedback loop?

Let’s say that the lenders have all also been lending to each other. Now, if one big one falls, it could very well take the rest of the lenders with it.

Because With crypto, we are already well into this last phase. It started in May, when stablecoin Luna / Terra collapsed, soon after crypto bank Celcius collapsed. And now, after the fall of FTX, many more are at risk.

What you are seeing here is the full force of these five positive feedback loops. Falling asset prices reduce the speculative hype, the value of collateral then falls, this reduces borrowing, asset prices fall further, now borrowers get into real trouble and will be liquidated, and finally financial institutions are starting to fail, taking the rest of the system down with them.

In other words, while lending to speculators and accepting their speculative asset as collateral makes sense from the perspective of an individual lender or borrower, it is something that economists have been warning against ever since the great financial crisis because it potentially creates much more severe asset bubbles. The same forces that pushed crypto so close to the moon in 2021 are now crashing it right back to earth.

But, how close to earth will it stop? To answer that question, we basically need to determine what crypto’s fundamental value is.

What is Crypto’s Fundamental Value?

So, how close is crypto to its fundamental value. To find out, we need to know how many people use it for speculative purposes vs. how many use it for real, fundamental reasons.

Sadly, as Elon still hasn’t finished his neurolink brain interface, all we economists can do at this point is ask crypto users.

So, I asked my followers the following question:

Have you ever owned crypto for any “real” economic purpose? (E.g. buy groceries, start a (non-financial) business)

And, what I learned wasn’t very encouraging for crypto. Only just over 13% of you that had ever owned crypto, had ever used it for some productive purpose. And those 13% had mainly used it to buy less legal goods, or to transfer money across border. But, it is really important to note here that this 13% includes people who had used it just once or twice for a productive purpose like this.

So, given that information, as well as research pointing to the fact that the vast majority of crypto users use it to speculate, I would roughly estimate that crypto’s fundamental value, given to it by people that use it as money to buy non-crypto stuff, is very low.

How, low? Well, honestly, nobody really knows. Prestigious economists like Nobel winner Eugene Fama argue that the fundamental value of crypto is zero. On the other hand, true Bitcoin believers like Michael Saylor, argue that when Bitcoin becomes the world reserve currency, it’s fundamental demand will skyrocket.

Personally, I think that there are some coins specifically, like Monero for illicit transactions and Stellar for cross-border transactions, that indeed have a fundamental value. However, even for these it is far from clear if their price will stabilize around it when central bank digital currencies or more government regulation arrives and makes them much less useful.

But, for now, it might not even matter what the fundamental value of crypto is because the sector appears to be in a full-blown financial crisis, with no central bank to save them. A 2008 style central bank rescue not being a possibility now, means that the value of crypto could crash far below its fundamental value, even below the lows of 2019.

But, hey, let’s make one thing clear, economists such as myself cannot accurately predict what happens next in financial markets. After all, we do not have data on individual investment strategies nor on how indebted important financial institutions really are because they are actively trying to hide it. Still, I hope you can use the key lessons presented in this video to shape your own thoughts about what will happen to crypto in the future. What’s more, I hope that you found the behavioral framework helpful to structure your thoughts around crypto and other financial markets.

What do you think are the fundamental, speculative, and debt-fueled speculative values of crypto? Let me know in the comments or talk it through with me in the crypto channel on our Patron, Member Discord server.