How the Federal Reserve helped create and burst the FTX crypto bubble

As the Fed boosted liquidity, the odds of cooking up a successful scam improved greatly – and more people did
Now that the Fed is winding down its bloated balance sheet, hot-air assets like cryptocurrencies are losing their life line

Andy Xie

Published: 1:00am, 30 Nov 2022

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The Federal Reserve’s liquidity tsunami, especially its response to the Covid-19 crisis, supercharged financial bubbles and Ponzi scams. The collapse of the cryptocurrency exchange FTX is just one of many inevitable failures, as the US central bank unwinds quantitative easing.

The Fed has actually kept the pace of balance-sheet unwinding rather slow (more on this later), given fears of a financial meltdown. But it is just prolonging the inflation crisis and keeping up the pressure for monetary tightening. Even if the Fed avoids the prospect of a thousand FTXes going bust together, the world will still see one collapse after another for the next couple of years.

The founder of FTX apparently believed in “effective altruism”, a fad among the ruthless billionaire class. The idea, it seems, is to maximise total contributions to society: technically, it is OK to do a few bad things to make money, as long as you put that money to good use eventually.

In the case of FTX, the money might have gone to top executives as loans. Good uses for that money may also have included donating to politicians to amass influence and buying a penthouse in the Bahamas.

As the Fed’s liquidity engulfed markets in recent years, the odds of cooking up a successful scam improved greatly and more people crossed over to the dark side. “Effective altruism” is something these people say to convince themselves that everything is OK.

Throughout history, questionable things have been done in the name of morality. One result is that Europeans have taken over much of the world, including North America and Australia, eliminating massive numbers of local peoples in the process.

An aerial view of the FTX Arena, which the Miami Heat call home, on November 18 in Miami, Florida. Miami-Dade County and the Miami Heat are ending their arena naming rights deal with the crypto trading firm FTX, which has gone bust. Photo: AFP

The whole world of cryptocurrency is pretty much a scam that was sold to the public as a way to replace fiat money. Cryptocurrency assets became popular with the public when they rose and rose in value, fuelling a retail mania like yet another Chinese A-share bubble.

As crypto assets mushroomed in value and created billionaires, Wall Street scrambled for a piece of the action. This was when the Fed’s liquidity really took over.

With the collapse of FTX, famous investors are likely to end up losing big. Lack of regulation has been blamed. The new boss of FTX, a restructuring expert who oversaw the bankruptcy of the energy giant Enron, said he had never seen anything worse than FTX.

Well, basically, anyone who had bothered to check FTX’s books would have known. But the investors who poured money into FTX never bothered. This raises another question: how has the financial sector grown so much in recent years?

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Since the global financial crisis of 2008, the world economy has been slow and unsteady. Obviously, opportunities haven’t been mushrooming. While there may be more opportunities in new technologies, total opportunities are ultimately driven by growth. Technology can only be a means of redistribution.

And yet the financial sector – private equity, venture capital and shadow banking – has grown rapidly. A new billionaire is minted every day or two. Much of the billionaires’ money has been made in the money game. Is this because they are smarter? The fact is that average IQ scores have declined over generations in rich countries. Financial guys can’t be getting smarter.

The real driver of the anomaly is quantitative easing, especially by the Fed. It makes crazy leverage possible. As the leverage magic swamped every tangible asset, some smart people invent hot-air assets, like cryptocurrencies and NFTs, for speculation.

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After all, if something worth a dollar can jump 10 times in value, why not start from zero? While this would blur the line between overvaluation and fraud, from a financial perspective, the difference between the two is small. In this environment, entities like FTX could pop up anywhere, like bamboo shoots in spring.

You can bet the Fed has played sugar daddy to thousands of FTXes out there.

The current financial crisis is unfolding more like a Netflix series than a Hollywood blockbuster. Bombs aren’t going off together, unlike in 1997, 2000 or 2008. The reason is the slow pace at which the Fed is reining in liquidity. So far, the US central bank has trimmed its balance sheet by 3.7 per cent. The ongoing pace of quantitative tightening is US$95 billion a month, or about 1.2 per cent of the remaining balance sheet value. While the Fed has raised interest rates to 4 per cent, real interest rates are still negative against any inflation benchmark.

Fed’s excesses of 2008 put the world on course for another disaster

So when will the Fed be done? If the market has been obsessed with when the Fed will pivot towards less aggressive policy, it is because it is feeling too much pain already. Inflation is a long-cycle phenomenon. Without removing excess money supply and two years’ worth of positive real interest rates, inflation wouldn’t be tamed. If you are feeling the pain now, it’s going to get a lot worse.

The FTX bust is a signal that cryptocurrencies are being relegated back to the fringe. Government regulation would only kill the sector faster. The real value of cryptocurrency has been in illicit financial services for drug dealers and rogue states. Of course, there will always be people who want to try their luck in cryptocurrencies, causing prices to surge from time to time.

But the dream of cryptocurrencies replacing fiat money or being traded like oil and gold remains a pipe dream.

Andy Xie is an independent economist