The boundary between crypto and fiat money is becoming more permeable

FINANCE HAS its squabbling tribes, much like the rest of society. A contest that attracts a lot of attention just now is the demographic-cum-digital divide between crypto kids and fiat dinosaurs. The crypto kids believe that blockchain-based finance is the future and a haven from the inevitable degradation of fiat money. In the opposite corner are the titanosaurs of the fiat world, the central bankers. “I’m sceptical about crypto assets, frankly, because they are dangerous,” said Andrew Bailey, the Bank of England’s boss, this week.

This is a good moment for the dinosaurs. The dollar price of bitcoin, the mainstay of crypto assets, fell from $58,000 or so in mid-May to around $33,000 in the space of a couple of weeks. The steepest part of that decline came after Tesla’s chief executive, Elon Musk, said his firm would suspend its policy of accepting bitcoin for purchases of its cars. A pledge by Chinese regulators to crack down on the mining of bitcoin gave the sell-off additional impetus.

The consequences have so far been few. Because there has been no visible collateral damage, crypto has been widely seen as a side-show in financial markets. This view is too dismissive, though. Crypto, like gold, is built on a collective belief about its value. But so to an extent are all asset prices. And crypto is moving past the point where it can be considered its own self-contained world.

To understand bitcoin’s ascent it helps to go back to the work of Thomas Schelling, a Nobel-prizewinning economist and game theorist. Schelling contended that people are often able to act tacitly in concert if they know that others are trying to do the same. Many situations throw up a clue, a “focal point”, around which people can co-ordinate without explicitly agreeing to do so. For instance, if asked to pick a positive number, people will offer a variety of responses—one, seven, 100 and so on; but if asked to choose a number that others will also select, there is a preponderant choice: the number one.

This insight applies to certain assets that lack intrinsic value. The investment case for gold, said Schelling, can best be explained as a solution to a co-ordination game. Gold bars have value because enough people tacitly agree that they do. Their value is bolstered by their scarcity, and their longevity. Willem Buiter, a prominent economist, once aptly called gold the “six-thousand-year-old bubble”. Bitcoin is newer, but similar. Yes, the technology behind it is ingenious (although Ethereum, the next-most-valuable crypto asset, arguably has the more compelling user case). And, yes, bitcoin is used in transactions, if no longer for Tesla’s cars. But its selling points are scarcity and fame. It is a natural focal point. As with gold, you can make a theoretical case that it is proof against paper-money inflation.

The latest gyrations seem to confirm that crypto is a walled garden unconnected with the rest of finance. But if you look more closely a different pattern is emerging. There is already a pathway linking crypto prices with gold. Flows into exchange-traded funds (ETFs) that invest in gold started to revive just as money was flowing out of bitcoin futures and ETFs, according to a recent analysis by Nikolaos Panigirtzoglou of JPMorgan Chase, a bank. That suggests that institutional investors are shifting back into gold after a flurry of interest in crypto, because bitcoin prices had risen too quickly. Viewed this way, the fall of bitcoin and the revival of gold are a relative-value trade within the broader set of inflation hedges.

Furthermore, it is hard to shake off the feeling that crypto-crashes now matter. This is the third bear market in four years, but a lot more money is now involved. The market capitalisation of cryptocurrencies tracked by a specialist website, coingecko.com, was more than $2.5trn in mid-May. A fortnight later it had fallen to $1.5trn. That is a big loss in anyone’s money. Crypto prices are creeping up again, so those losses are already being eroded. But at each new peak, the asset class looms ever larger. And a dollar lost in crypto investing is the same as a dollar that was once earned or borrowed—even if, at present, it is hard to know precisely who bears the loss.

There is something else to consider. Cryptocurrencies are highly speculative assets. It is thus hard not to think of their prices as a signal of shifts in risk appetite more broadly. Beliefs matter for all sorts of asset prices, whether in dollars or bitcoin. You might be able to dismiss this crypto-crash. But the next one will be harder to ignore.