Coinsights #17: The Coin Crash
Thank you to Kristen and Sridhar for their contributions to this article.
Ouch.
The total crypto market cap is down since its peak of $3T USD in November, falling as much as 30% to $1.9T USD just a few days ago. While many of us know that volatility is inherent in web3, it’s tough to swallow nevertheless.
Why is this downturn happening now? Today, we’ll examine some global economic trends and analyze how they are affecting coin prices. Let’s go!
Inflation & Interest Rate Overview
To break down what’s happening in the web3 world, I’ll first take a step back and talk about two important macroeconomic concepts: inflation and interest rates.
Investopedia defines inflation as:
The decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.
Inflation is often measured by calculating how much a standard set of goods – such as gas, food, and utilities aka a “basket of goods” – costs. Moreover, the Consumer Price Index (CPI) is a metric that explicitly tracks this fluctuation in purchasing power.
While small increases in yearly inflation (~2%) are considered normal for the U.S. economy, high inflation can lead to steep drop offs in purchasing power. One way that governments can prevent inflation from rising too quickly is by raising the federal funds rate, which determines interest rates. Again, from Investopedia:
“In the U.S., the interest rate (which is the amount charged by a lender to a borrower) is based on the federal funds rate that is determined by the Federal Reserve. The Federal Reserve System is the central bank of the U.S.; it is sometimes just referred to as the Fed.”
As a result, inflation and interest rates are inversely correlated:
In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend. This causes the economy to grow and inflation to increase.
The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save because returns from savings are higher. With less disposable income being spent, the economy slows and inflation decreases.
If you prefer watching to learn, this video is a great summary of what I just covered:
Recent Economic Trends
The U.S. has recently experienced a period of high inflation. In an effort to stimulate the U.S. economy during Covid, the U.S. government printed ~$16 trillion dollars in 2020 and 2021. That’s 80% of all U.S. dollars in existence today! You might have received some of this newly printed cash in the form of a stimulus check.
Unsurprisingly, the CPI (a metric that tracks inflation) rose 7% from December 2020 to December 2021, the highest year over year jump since 1982.
Put simply, when everybody has more money to spend, things get more expensive.
Furthermore, many other countries experienced insane inflation last year. If you think the 7% is bad, try Venezuela’s 9986%! Already restricted by economic sanctions, Venezualans need a safer place to store their money:
What Does This Mean for Web3?
2021 was a perfect storm that led cryptocurrency prices to rise astronomically: web3 went mainstream and people had extra money to spend! Supply chain disruptions due to Covid only drove prices higher as people and institutions sought to invest their money in areas immune from viral infection.
In addition, it was clear that the U.S. was undergoing a period of mass inflation. Therefore, people looked to invest in non-inflationary assets like Bitcoin and other similar coins.
In conclusion, web3 gaining popularity was only part of the reason why cryptocurrency prices skyrocketed last year. Worldwide inflation contributed a large part too.
So why are crypto prices crashing now?
In the above video, Federal Reserve Chairman Jerome Powell makes it clear that the Fed will raise interest rates in 2022. As I talked about earlier, the purpose of raising interest rates is to combat rising inflation. Therefore, people who invested in cryptocurrencies as a way to escape inflation may feel like they no longer need to do so in 2022.
Bitcoin in particular is dominated by large stakeholders: 0.01% of Bitcoin investors control 27% of the wealth (for comparison, 1% of people control 30% of the U.S. dollar). As a result, it only takes a small percentage of large crypto holders to think that it’s time to sell and consequently tank the price of an asset.
While it’s impossible to determine what exactly has led to crypto’s recent fall, the interest rate announcements play a large part. Other potential reasons include the internet blackout in Kazakhstan that caused a temporary 20% decrease in mining power and simply the fact that crypto markets tend to react much stronger and quicker to news than traditional stock markets (which are also down!)
I’d love to hear your opinions on why you think crypto prices are down in the Coinsights Discord or on Twitter!