Posted on 02/14/2018 7:44:46 AM PST by SeekAndFind
By Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics. Originally published at VoxEU
Cryptocurrencies are supposedly a new and superior form of money and investments – the way of the future. The author of this column, however, does not see the point of cryptocurrencies, finding them no better than existing fiat money or good investments.
I have been trying to understand what the point of cryptocurrencies is, without success. They may not be an immediate financial stability concern (den Haan et al. 2017), but I just don’t get them.
As far as I can tell, they are supposed to be some combination of:
Are Cryptocurrencies Money?
What do we need money for? Three things:
Any form of money should be evaluated according to those criteria.
We have used many things throughout history as money, like seashells, cigarettes, silver and gold. These are all scarce real assets with value to their users, available in small units and easy to transact.
No country has such money anymore. Instead, what we use is fiat money, a currency without any intrinsic value. Paper printed by the government, whose quantity is amplified by the financial system. It is only valuable because the government guarantees it is.
Fiat money issued by a credible modern central bank is vastly superior to money based on real assets like gold, not least because the supply of fiat money can be adjusted to best serve the economy, rather than be dominated by the production of some natural resource. The volume of cryptocurrency cannot be adjusted in the same way.
Of course, governments are tempted to abuse fiat money and print too much, as the first creator of fiat money did, the Chinese government in the 13th century. More recently, the stagflation of the 1970s is due to the central banks being bad stewards of money.
Because the governments of the time could not be trusted, several thinkers proposed free monetary systems, such as Hayek in 1977, discussion which presages current cryptocurrency debates. Still, advances in monetary policy eventually gave us more stable money by the 1980s.
So how do cryptocurrencies stack up on the criteria for money mentioned above: as a store of value, ease of transactions and for lending of last resort?
They are vastly inferior for transactions. Transactions with cash are costless, anonymous, and immediate. Electronic transactions are very cheap and also immediate, and can be done in any amount.
Bitcoin transactions take an hour or more, with a cost of at least $25, and they are not all that anonymous. Yes, there are cryptocurrencies that promise more efficiency or privacy. But even then, while it can take a long time to find someone who accepts Bitcoin, it is much longer with the competitors. Meanwhile, the largest amounts that can be transacted by cryptocurrencies are dwarfed by those one can transact with fiat money.
And what about store of value? Neither cryptocurrencies nor fiat money have any intrinsic value. What matters is credibility – our expectation that the money will retain its value over time.
For fiat money, the central banks are committed to keeping its value stable at a decreasing rate of 2% per year. The major central banks have been quite successful at keeping their tracking error small for a long time.
Bitcoin and other cryptocurrencies are much inferior in this regard. Their value doubles or halves in a span of few days. One cannot say with any degree of certainty that one’s holdings of cryptocurrencies will hold their value over the next week, not to mention a month or year. If one holds cryptocurrencies, it is for speculative reasons, not as a store of value.
That leaves lending of last resort (LOLR), providing liquidity to financial institutions in times of crises. This has been an essential function of central banks ever since Walter Bagehot’s 1873 analysis of the 1866 crisis. LOLR was last used in 2008, and will certainly be needed again at some point in the future. There is no such facility in any of the cryptocurrencies.
If cryptocurrencies are money, they are a much inferior to existing fiat money.
Are Cryptocurrencies Investment?
Cryptocurrencies, along with fiat money, have been called Ponzi schemes. Not quite. The definition of a Ponzi scheme is an investment where existing investors are paid for by new investments. Neither cryptocurrencies nor fiat money fit the definition.
But are the cryptocurrencies an investment? It depends on what one means by investment.
The value of a stock or a bond reflects future income appropriately discounted to the present. Not so with cryptocurrencies or fiat money. They have no intrinsic value. Their value is caused by scarcity, as well as the cost of mining or government promises. However, mining is sunk cost, not a promise of future income.
The only reason cryptocurrencies retain value is because we expect other people in the future to value them the same, or more than we do now. Just like collecting stamps. The value of stamps is created by scarcity and expectations of future investors pricing them more highly than we do now.
Cryptocurrencies are not an investment in the same way as a stock or a bond. They are an investment in the same sense as stamp collections are.
However, even then, most people don’t use fiat money directly as a store of value except in small amounts. At the very least, one can keep fiat money in a bank account or government bonds that earn interest. An investment that is as safe as the government. The possibility of such near riskless lending at stable rates is absent for cryptocurrencies.
So if cryptocurrencies are an investment, they are more like stamps or lottery tickets than fiat money, stocks, or bonds.
Credibility
The intrinsic value of fiat money is underpinned by the credibility of the government and the central banks tasked with controlling money.
Central banks are independent and with considerable political cover, essential to ensure the credibility of fiat money. Countries that disregard the latest developments in monetary policy, like Venezuela, do that to their cost.
Central bank independence, political cover, and reputation for competence are key. Jerome Powell, the current chair of the Federal Reserve system, is the most powerful bureaucrat in the world. General Joseph Dunford, Chairman of the Joint Chiefs of Staff, might have nuclear weapons in his arsenal, but he reports to President Trump. Jerome Powell does not.
While our faith in central banks has increased considerably since Friedrich Hayek wrote his article cited above, it could still be higher. However, I can download detailed performance statistics on fiat money dating back decades. I know the supply of money and I know the policy tools used and I can make up my own mind. Information about cryptocurrencies and other activity statistics is much harder to come by and have a much smaller history.
The value of the euro and of the dollar is underpinned by the credibility of the ECB or the Fed. With cryptocurrencies, it is the credibility of some unknown entities and processes.
I trust the central banks in developed economies much more than I trust any of the cryptocurrencies.
Privacy and Security
That leaves privacy and security.
Cash is 100% anonymous, but one is at some risk of theft. Electronic transactions are not anonymous, but are safer.
While some cryptocurrencies promise anonymity, the most popular, Bitcoin does not, unless one is really careful in hiding one’s tracks using skills that are only available to a small group of users. The reason is that transaction records on the blockchain cannot be changed or deleted and are therefore searchable.
Meanwhile, not a day passes without reports of theft from cryptocurrency investors. The best advice is to keep one’s private key on an air-gapped burner laptop.
Cash and electronic money are also subject to theft. Still, there is no need for a private key with cash transactions and keys are much less important for electronic cash transactions. There are multiple layers of security that protect us. The fiat money of non-expert users, provided they take basic precautions, is very safe.
I feel quite confident in doing online banking without resorting to an air-gapped burner laptop.
Cryptocurrencies are only safe from theft if one is expert and takes elaborate precautions. We are much more likely to be a victim of a crime with cryptocurrencies than cash or electronic money.
So…
Cryptocurrencies are inferior to most fiat money and investments, while they do not provide privacy or security.
When I say this to advocates of cryptocurrencies they usually respond in two ways – that I don’t understand cryptocurrencies, and that they have new and wonderful qualities that I miss.
There are many things I don’t get, but I have put some effort into understanding the mechanics of cryptocurrencies. However, one can know all the mechanics, all the geeky technical details, and still not have a clue about what they mean.
Take as an example human beings. I can know all the physics and chemistry and physiology, understand how molecules and organs operate, yet still don’t know the first thing about an individual.
Its the same with cryptocurrencies. Knowing the mechanical details does not translate to understanding their economic function.
Cryptocurrencies are more like a religion or a cult, not a rational economic phenomena. They even have their own foundation myth, the elusive Satoshi Nakamoto.
I await my enlightenment.
Good. Because if you did it would make you sick to your stomach.
I dont see Bitcoin replace the dollar. But as an international exchange medium, it is better suited than working with large banks.
IMHO cryptocurrencies most resemble stocks. Stocks also are limited in quantity by the directors, who stand to lose by irresponsible expansion of the quantity of the stock outstanding.The other thing a cryptocurrency is is a brand. Cryptocurrency software is, AFAIK, public domain. And that means that you could create your own cryptocurrency which would be exactly as good ay Bitcoin excepting only the branding problem you would have trying to stand out among the (theoretically infinite number of) competing cryptocurrencies.
Bitcoin is the first and most famous cryptocurrency, and therefore is the strongest brand. I get the willies thinking of investing in any other cryptocurrency - not that I have invested in Bitcoin, either.
This sentence is the tell.
He's a keynesian, so deflationary-money haters are gonna hate.
My faith in the dollar is so low that the only retirement “savings” I have that are based on the dollar is my Social Security. No stocks, no bonds, no “serious” amounts of cash, etc.
No you don't. You cannot be convinced, no matter what. You are a central-bank loving Keynesian.
Hayek's plan is described in his book Denationalisation of Money (free PDF). In this scheme, banks issuing their own currency would be forced by market pressure to keep the buying power of their currencies as stable as possible. Cryptocurrencies (unregulated commodities being whipsawed by speculators) are completely different.
The whole point of your rant was that non-governmental currencies are only used to commit crimes and should therefore be verboten.
The creator of bitcoins seems to have wanted to have something not controlled by central bank; thus everyone gets the blockchain rather than a central clearinghouse. Yea for decentralization!
However, as the difficulties ramp up, the effect is that a very few exchanges are consolidating all the transactions and ‘mining’ with the effect that about 4-6 mega-entities run everything from a trusted position, without even the recourses of physical stability, attachment to a stable political entity, or auditability.
If (when; it’s already happened several times) the people in charge of these exchanges are hacked, ‘hacked,’ or simply let their virtual personae vanish while they walk off with fortunes in cryptocoin, there’s exactly zero to be done about it.
As others noted, a lot of the traffic is gray or dark, and so there’s a very good chance some or all of the hubs are controlled / strongly influenced by the bad people on the planet.
Overall, definitely not meeting the original, rather worthy, intent at all.
If the dollar hyperinflated in an economic crisis there would still be payments for social security and welfare. Devalued, but the payments would continue. However there would be riots in the streets because it wouldn’t buy anything, and the uneducated/liberal educated masses would demand the government fix the problem.
-at that point “fixing the problem” would likely involve stripping us of our constitutional rights to property, among others... scary time ahead at that point.
Those in the know would want to find refuge in some sort of lifeboat for their wealth, like gold and silver, but they can also be confiscated. Bitcoin can be hidden a million different ways, because the “coin” consists of a 30 or so digit public number or “key”, (for deposited only) and a 40 or so digit key for withdrawal or spending. Keys that are kept on privately kept wallets, or a piece of paper, not on a website or exchange are pretty safe.
I know there is a lot of skeptical opinions, and crypto currency is certainly a risk at this point, especially the volatility it has had the last tree months, but the potential is being recognized overseas especially in those countries where the currency is devalued. Coinbase is opening 30k to 100k new accounts every day supposedly.
Its not going to change overnight. And it will never be THE player in the international market. But there is a place for it. And a function where it excels.
It is not for everyone. But when you hear or read someone completely dumping on it, the clearly dont understand its function or uses.
If you substitute a dollar for every argument about bitcoin, there are benefits to each one.
The whole point of your rant was that non-governmental currencies are only used to commit crimes and should therefore be verboten.
My point is that they are like tulip bulbs. And I think people should have the right to buy and sell tulip bulbs at whatever price the market justifies and always with an eye toward “caveat emptor”.
Well, they are not “exactly” like tulip bulbs. Tulip bulbs do actually have intrinsic value.:)
But the coins (their worst mistake is their name) should not be kept on an exchange. The exchanges are not BANKS. People really should not confuse that issue.
The entire environment is still in the wild west phase. And the average person would probably never buy a whole coin.
Your concern for others is so touching.
And rightfully so.
A good plan has room for new things. I bought the first bitcoin years ago for under $100. I’ve used the after tax proceeds (I am one of the few to actually reports their gains) to pay off ALL of my debt. Every day I move some into traditional assets—but on average, the crypto continues to out grow my transitions to traditional assets.
As a friend of mine said, its a champaign problem to have.
No they don't. And the Lightning Network, a second layer built on top of the bitcoin blockchain, already live on the mainnet, speeds transactions waaaay up (multiple millions per second) with negligible fees (makes micropayments feasible).
The author of this article is uninformed.
Heh. Taking the approach that everything is relative. If I walk across the room, I'm not delusional enough to claim that in fact I stood still, while it was actually the rest of the universe that moved instead.
Everything I might consider buying is priced in US dollars. If the US dollar was fluctuating wildly like bitcoins are, the prices of everything those dollars would buy would be changing just as fast. The reasons that the US dollar is the default global currency include that it is relatively stable in value, and exists in large enough quantities that any transaction can be made in dollars. If somebody wants to buy 1,000 tankers of oil today, they can complete the transaction in US dollars. Could they do that with bitcoins?
The stability of the US dollar is determined by the prices of the universe of things it can be exchanged for, including other currencies.
Show me an example of something you can buy that is priced in bitcoins. As far as I know, everything you might want to buy is priced in dollars, but some places may give you the option of PAYING with bitcoins.
“Cryptocurrencies are more like a religion or a cult, not a rational economic phenomena. I await my enlightenment.”
Nope, but ignorance is bliss. If you were truly seeking enlightenment, you would be doing real research instead of writing nonsense clickbait.
My concern is for their personal freedom. It is not really concern for others in this case. I don’t know them personally.
Yeah. I think I’m too late for that one.
FWIW, I think some people made an absolute killing in tulip bulbs. It’s all about timing. :)
What would that be? All I can think of is as a means for the people owning them to look trendy and cool.
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