The Rise of Digital Scarcity: Economics of NFTs and Tokenized Assets

In the 2010s, the world watched in awe as cryptocurrency became the hot new commodity, with investors paying lots of money to purchase electronic units of digital tokens (technically, not currencies) that were, theoretically, unhackable and unforgeable.  Many people have been attracted to crypto because it is unseizable (all tokens are registered remotely), untraceable, and will not experience inflation.  Thanks to the blockchain technology behind Bitcoin and other popular cryptocurrencies, there is a mathematical limit to the number of tokens that can be digitally mined and there is no realistic way to remotely “hack” someone else’s tokens (although they can be stolen from owners’ digital wallets).

Several years after the emergence of crypto, a new digital commodity gained rapid attention:  non-fungible tokens, or NFTs.

What Are NFTs?

Non-fungible tokens are unique digital assets that represent individual ownership.  Similar to cryptocurrency, NFTs use blockchain technology to publicly record ownership, preventing theft or hacking.  People purchase NFTs and own the rights to that digital asset, which is usually an image.  An NFT boom between 2017 and 2022, with the market slumping significantly in 2022, saw artistic images sell for millions of dollars as NFTs.

Why Was There an NFT Boom?

Between 2017 and 2021, many consumers were intrigued by unique digital ownership of images and the fact that it was virtually impossible to take away one’s ownership.  This uniqueness of each NFT - the coded ownership token, not necessarily the image or file to which it was attached - created a perception of intense scarcity.  This artificial feeling of scarcity led many investors to rapidly purchase NFT artwork for millions of dollars apiece.

Marginal Utility, Animal Spirits, and Bubbles

Unlike bonds, which pay annual or semiannual interest, or shares of stock, which often pay quarterly dividends, NFTs provide owners with no revenue.  NFTs are commodities, or items, like precious metals or cryptocurrency.  Gold, silver, and cryptocurrency are sometimes mistaken for currency because they resemble currency.  However, they are not legal tender.  Commodities, which provide no revenue, are valued primarily based on marginal utility, or the satisfaction one receives from consuming an additional unit.  

When there is a widespread and rapid change in many consumers’ feelings of marginal utility toward something, it can be considered a macroeconomic change in animal spirits.  Animal spirits are the psychological factors affecting consumer and investor confidence, effectively meaning the propensity to spend one’s income.  If consumers are highly confident in economic growth, they are likely to spend more of their income (marginal propensity to consume).  During the period from 2017 to 2021, during the NFT boom, most Western economies were rapidly expanding outside of the brief-but-intense Covid recession of 2020, resulting in healthy consumer and investor confidence.

Even during the Covid recession, stimulus payments and PPP loans helped maintain consumer and investor spending.  Many blamed high government spending in 2020-21 for creating inflationary bubbles in 2022-23, with prices buoyed by artificially-increased demand.  A combination of NFTs being a popular new fad emerging after years of strong economic growth, energized with a sudden influx of government stimulus spending, likely led to radically high prices for those digital assets.  

What Happened to NFTs After 2021?

Between 2022 and 2023, the market for NFTs rapidly collapsed.  Many purchasers of NFTs admitted to being lured into the market by FOMO (fear of missing out), which can be linked to the Demand determinant of expectation of future prices.  Some bought NFTs virtually sight unseen, with the goal of reselling them and making a profit.  This worked…up through 2021.  Thanks to generous fiscal stimulus, many middle-class and wealthy consumers easily weathered the Covid recession of 2020. 

When Western economies began suffering from high inflation in 2022, many consumers may have been quick to cut back on NFTs due to their perception as entertainment.  Luxury goods and entertainment tend to have relatively elastic demand, meaning consumers will reduce their consumption quickly when price rises or income falls.  As soon as the economy began to feel unstable, NFTs may have been among the first expenditures cut due to the widespread belief that they were luxuries rather than necessities - even for the wealthy.  Crypto, despite being similar, may have been less affected by economic instability due to consumers feeling that it was an investment, akin to a currency, rather than an entertainment good.

NFTs a Complement of Crypto

Some analysts blame the NFT crash of 2022 on the cryptocurrency crash of the same time period.  Crypto and NFTs both use blockchain technology to record transactions and have similar attributes, making them both popular with many young investors.  When crypto began crashing after a peak in November 2021, it was not unexpected that NFTs would also decline in popularity.  However, while crypto recovered somewhat in the aftermath of its crash, NFTs have not rebounded.  Many former purchasers of NFTs may have decided to shift their investments to crypto as a substitute for NFTs, seeing cryptocurrency as more stable and desirable.

Valuing NFTs

With no interest or dividends backing them up, NFTs are valued almost entirely on utility (feelings).  Like many fads, this makes them highly vulnerable to sudden shifts in consumer tastes and preferences.  Many potential customers may have lost their appetite for NFTs after January 2022 due to the Bored Ape Scandal, in which scammers were able to steal three Bored Ape NFTs from actor Seth Green in a phishing scam.  Media coverage around the NFT theft may have lent an air of silliness to the entire digital asset industry, dampening consumer enthusiasm.  

Supply and Demand

Part of the utility around digital assets comes from perceived scarcity.  People value NFTs and cryptocurrency more if they believe that they are rare and difficult to attain.  Unfortunately, digital assets are often easy to create because they are, well, digital.  By 2021, there was a massive influx of NFTs into the market, swiftly erasing the perception that NFT artwork was rare.  Quickly, NFTs went from seeming exclusive to seeming overused.  Today, it is declared that most people with Internet access can create an NFT.

Market Implications of NFTs and Tokenized Assets

While crypto has recovered somewhat, it is still vulnerable to investor panics.  Both cryptocurrencies and NFTs suffer from being commodities with no claim on income or revenue.  Like precious metals, they may be visually appealing and thus maintain some value due to utility, but are unlikely to be major investment sectors.  NFTs lost much of their luster after 2021 when it was revealed that they were far from rare, unlike mathematically-limited cryptocurrencies, and could still be copied.  

Demand for NFTs will likely remain low due to the fact that there are many substitutes for them, including “theft” like right-clicking on an NFT image and saving a copy to one’s own hard drive.  While some might still wish to own the actual NFT, such as an art collector preferring to spend millions to own a famous painting, most consumers are willing to settle for a copy - similar to many people purchasing low-cost prints of famous artwork for their home decor.  NFTs have become, therefore, very niche and not possessing much utility for the average consumer.