Certainly one can appreciate the appeal of anything that purports to prevent an economic Armageddon. No less a figure than Frederick Hayek, the Austrian Nobel prize-winner known for his work on the theory of money and demigod of free-marketers, called for the elimination of state-controlled money and the abolition of “money-printing” central banks. He considered fiat currencies and the inflationists predominant in the post-gold-standard policy-making world as the root causes of destructive financial bubbles.
If bitcoin and its equivalents could deliver what its champions promise, what’s not to like? Even allowing for the recent gyrations, if you had bought $100 in bitcoin back in 2011, your investment would be worth millions today. But intuitively, it hardly seems believable that an instrument that bears many of the hallmarks of a classic speculative bubble realistically represents a cure for the ills described by Hayek. Having risen to a high of around $20,000 by mid-December, the price has recently fallen by almost half. The real question now seems to be whether this fall will have broader implications for the economy as a whole.
Let’s first do a quick ABC on these newfangled “cryptocurrencies.” To use the most famous example, bitcoin: It is a digital currency coupled with an online ledger, called a block chain. The “block chain” records all transactions that have occurred since the inception of the bitcoin system. The system is set up so that every ten minutes or so a new page—called a transaction block, or just block—is added to the ledger. This new page refers to all past transactions requests (by referring to the immediate previous block) and records all the new transaction requests.
To use a simple example from Eric Tymoigne, the monetary economist:
“Mr X. uses the bitcoin payment system to send a request to buy a pizza from Joe’s Pizza. Joe’s Pizza wants to make sure that this is a valid transaction. That requires verifying that Mr. X holds enough bitcoins to pay for the pizza (the ledger will tell from which past transactions he got his bitcoins), and that he is not trying to double spend the bitcoins. This verification process is done by the accountants of the system, who are called the ‘miners.’ Usually Joe’s will wait for confirmation from several miners (the rule of thumb seems to be six confirmations) before agreeing to sell the pizza (‘confirmation’ means that a recorded transaction request is included in following blocks). Anybody can be a miner, you just need a computer.”
Sounds great, doesn’t it? You get rid of bankers, credit card companies and all sorts of pesky financial intermediaries, who extract their pound of financial flesh from the consumer with regularity. Again, what’s not to like?
Well, for one thing, as bitcoin usage has grown, the math problems computers must solve to make more bitcoin (the “mining”) have become more and more difficult—a wrinkle intended to control the currency’s supply. That’s good in the sense that limiting the supply helps to preserve the underlying value of the currency. The bad news is that “mining” for currency is almost as environmentally unfriendly as traditional mining, because of the high amounts of computing power required, which guzzle energy. You wouldn’t believe it, but bitcoin’s fatal flaw is an electricity problem. In fact, there is a “bitcoin energy index” that shows that each bitcoin transaction requires the same amount of energy used to power nine houses. There are many pejoratives one can ascribe to central bankers, but “environmental vandal” is usually not one of them.
Of course, many of the libertarian champions of bitcoin and its ilk are in the climate change skeptics’ camp, so it’s unclear that this fact would bother them. It’s doubtful they would welcome “green initiatives” if it meant the end to their precious bull market in cryptocurrencies. But the truth is that the aggregate computing power required to sustain Bitcoin makes it, all by itself, unviable in the developing world, where electricity shortages are a fact of life. At the same time, what good is a currency if it creates a resource constraint that hinders global growth and prosperity? The appeal of most monetary instruments is that they avoid the inflexibility associated with the old gold standard or fixed exchange rate systems. This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies.
Proponents would argue that environmental concerns notwithstanding, the ongoing price rise validates bitcoin’s growing acceptance as an alternative store of value. The counter-argument is that much the same might have been said about Dutch tulips in the mid-17th century. At least tulips (or flowers of any kind) have some sort of aesthetic value. You can see them at any marketplace, buy them, and put them in a vase, where they’ll last for a few days. And they represent a nice gift for a loved one.
What do you actually get when you exchange dollars (or yen, sterling, or euros) for a cryptocurrency? Drill down to the essentials, and they are, in effect, no more than digital, decentralized, partially anonymous currencies, not backed by any government or other legal entity, and not redeemable for gold or other commodities.
But, say the defenders, any paper or “fiat” currency, be it dollars, yen, pounds sterling or euros, are all created digitally via computer keystrokes and also have no intrinsic value since we’ve moved off the gold standard. The paper currency issued in the U.S.—the dollar—proclaims on its face, “This note is legal tender for all debts, public and private.” And that’s all it says. It does not say “backed by the gold stored at Fort Knox.”
There is, however, one crucial distinction between, say, a bitcoin and a dollar: One of the most important powers claimed by sovereign governments (perhaps the most important) is the authority to levy and collect taxes (and other payments made to government, including fees and fines). Tax obligations are levied in the national money of account—dollars in the U.S., Canada, and Australia, yen in Japan, yuan in China, and pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In all modern nations, it is the government’s own currency that is accepted in payment of taxes.
In the words of the American economist Abba Lerner, from his essay in the 1947 edition of the American Economic Review:
“The modern state can make anything it chooses generally acceptable as money… It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done.”
The modern state, then, imposes and enforces a tax liability on its citizens and chooses that which is necessary to pay taxes. The unit of account has no real value if not ultimately sanctioned by use from the state. By extension, the state is never revenue-constrained because it alone determines what constitutes “money.” The tax (and the corresponding ability to enforce payment) is what gives an otherwise worthless piece of paper with pictures of dead presidents on it its value. Even though this paper is not “backed” by anything, taxes function to create the notional demand for said paper dollars. Value is imparted by requiring it to be used to fulfill a tax obligation. Seen in this context, the idea of “denationalizing” money, as Hayek advocated, makes about as much sense as divorcing childbirth from procreation.
Ironically, if governments were to allow bitcoins (or other cryptocurrencies) to be used to extinguish existing tax liabilities, this would certainly entrench them as a viable alternative currency, since they would automatically become designated legal tender. It would, however, be an irony of historic proportions were the bitcoin bubble to be preserved by the very governments whom its libertarian enthusiasts purport to despise. Although they believe that the cryptocurrency heralds a new age of sound money separate from the debt and corruption of the dollar-hegemonic world, paradoxically the only real means of salvaging said currency is via its incorporation into this very world they wish to escape.
Put in those terms, why on earth would the government voluntarily surrender this monopoly privilege? In fact, many countries—notably, China, Vietnam, Sweden—have already banned cryptocurrencies on the grounds that it enables criminals and terrorist organizations to move value around the world out of sight of national governments and law enforcement.
National security concerns aside, as appealing as it sounds to have a monetary system that stands apart from the “tyranny” of government and central banks, bitcoins and their peers violate all of the rules of finance. To quote Tymoigne again:
“There is no central issuer guaranteeing payment at face value to the bearer; in fact, there is no underlying face value, and subsequently no imputed value at maturity, which means they are completely impractical for use in servicing of debt. The fair price of bitcoins as measured by the discounted value of future cash flows is zero.”
Of course, that hasn’t stopped our modern-day financial engineers from jumping on a good bubble when they see one. The Chicago Board Options Exchange (CBOE) has already launched the first bitcoin futures market. Rival exchanges such as Chicago Mercantile Exchange (CME) and the over-the-counter NASDAQ are expected to follow, and it is certainly only a matter of time before the City of London jumps in unless regulators begin to adopt a more proactive stance.
Yes, innovation can be a good thing. But recent experience should make us understandably wary about the consequences when it is applied in banking and finance. To the extent that cryptocurrencies such as bitcoin contaminate the credit system, they represent a real and present danger to our economic well-being. It is true, as venture capitalist William Janeway has argued (Doing Capitalism in the Innovation Economy: Markets, Speculation and the State), some speculative bubbles, such as the railways, or the dotcom boom, do not have as malign an impact. When these kinds of manias exhaust themselves, at least society is left with innovations scattered across the landscape for our use. But bubbles that take root in the very credit system itself (such as the housing mess) leave behind a literal wasteland.
It’s early days, but so far, bitcoin’s cataclysmic fall does not seem to be triggering any systemic concerns, which would suggest, thankfully, that it has not yet taken root in the credit system. But again, what’s to like? Anything that enables participants to exchange a legal tender dollar or some other real asset for a cryptocurrency, which has no intrinsic value or yield, is environmentally toxic, trades in cyberspace, outside of the regulated world of banks and financial payments is a recipe for fraud. And haven’t we had our fill of that for a while?
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This is an updated version of an article originally published on Feb. 2, 2018.
