Of bitcoin, the South Sea Bubble and the madness of crowds

Creating a bitcoin "strategic reserve" makes no sense but it will probably happen anyway

There are few original ideas in finance. Governments often have lots of debt. The financial markets create lots of fast-growing asset classes. Why shouldn’t governments take part in those asset markets and reap the rewards? They might even use the money to pay down their debts.

Such an idea seems to have occurred to supporters of the incoming Trump administration who are pushing for a “strategic bitcoin reserve”. Such purchases would, it is argued, be profitable, establish the US as the home of cryptocurrencies and even help pay down the national debt.

Three centuries ago, both the British and French governments sought to take advantage of a relatively new financial innovation - the joint stock company - to transform their fiscal positions. In Britain, the South Sea company had been given a monopoly over slave trading with the Portuguese and Spanish empires. This proved to be nothing like as lucrative as had been hoped but shares in the company soared. As a result, the company switched to financial engineering; buying up the national debt and financing the cost with repeated share issues. 

This was an 18th century leveraged buyout, only with equity being used to buy debt rather than the other way round; the leverage resulted from the ability of people to buy South Sea shares with only a small downpayment. In France, something similar happened with the Mississippi bubble, which concerned a company with the rights to trade with French possessions in North America; the profits from this trade turned out to be illusory. Eventually, both bubbles popped and the shares fell even faster than they rose.

In one sense, bitcoin has an advantage over those two previous schemes. By its very nature, it is not tied to any particular business operation; it has no earnings or assets. In that sense, it cannot disappoint with an unexpected profit warning. It is a tabula rasa on which people can place all their hopes and dreams.

On the other hand, bitcoin is so bizarre it is tempting to believe it is the invention of some left-wing satirist trying to troll 21st century capitalism. It is an entirely notional asset which is used almost entirely for speculative or tax-avoidance purposes. Producing this asset is an energy-intensive process that requires more electricity than the country of Pakistan, with more than 230 million people. It is as if the finance industry has put up a giant two fingers to all the climate negotiators at Cop-29.

Still, those who back Bitcoin have the air of a religious cult. And the advantage they possess is that the more believers they can recruit, the higher the price is likely to go and the more correct they will appear to be. Recruiting the US government, lynchpin of the global financial system, will be a massive coup, akin to persuading the Pope to join a Satanic cabal.

But Bitcoin is limited in supply, they say. Yes, but few go on to mention that there are around 10,000 cryptocurrencies in circulation. And there is little to stop more from coming into existence. El Salvador and the Central African Republic may have declared bitcoin to be legal tender but no government stands behind cryptocurrencies, and no regulator will compensate investors if they lose money. While cryptocurrencies are sometimes used in transactions, take-up has been very slow for obvious reasons (why would you want to pay with, or accept payment in, a token whose value changes so suddenly and dramatically?) Bitcoin was created in 2009, just two years after the iPhone and it is still rarely used for anything other than speculation. In technological adoption terms, it is in the very slow lane when it comes to payment.

There can be little doubt that, if the US did actually start to buy Bitcoin, its price would go up. Nevertheless, as Toby Nangle pointed out here, it would be a struggle to pay off the entire national debt with this strategy. The value of the US national debt is $36 trillion. Eventually 21m Bitcoins could be potentially issued. If the US owned 10% of them, the price of each coin would have to reach over $17 million to equal the value of the debt.

Furthermore, what on earth does the idea of a strategic bitcoin reserve mean? The US has a strategic oil reserve which it can use, in the case of a sudden surge in price or an interruption to supply. But when would US citizens suddenly need access to a lot of Bitcoin? If there were some national crisis, say a cyberattack that cut off the internet, you would need to use notes and coins. Bitcoin, to quote Blackadder, would be as much use as a chocolate teapot. 

Another argument is that bitcoin would offer some asset diversification, just as the Federal Reserve owns some gold. This is a bit of an odd idea. One of the main investment rationales for owning the digital currency is that paper money issued by sovereign governments will eventually collapse in value, because governments can’t control their deficits and central banks, like the Fed, will not restrain them. Enthusiasts see bitcoin as a great rival to the dollar. Why should the US give its rival a leg-up? After all, most other nations think the dollar’s status as a global reserve currency gives the US a great advantage; an “exorbitant privilege” that allows it to run budget and trade deficits ad infinitum. 

Furthermore, as Brendan Greeley argues here, turning the US government into an owner of bitcoin will completely hamstring the authorities when it comes to regulating the market. Limit bitcoin mining or trading and the government’s own portfolio will plunge in price. Indeed, under one proposal the US would be unable to sell its bitcoin until 2045. That is why, of course, bitcoin enthusiasts want to recruit the government; it is a bit like those boiler room share salespeople who spot an easy mark with deep pockets. 

But as the Trump administration thinks exports are good and imports are bad - ideas that Adam Smith considered outmoded back in 1776 - the reserve will probably be created anyway. As Isaac Newton, who was suckered into investing in the South Sea bubble, remarked, “I can calculate the motion of heavenly bodies but not the madness of people”.