“Stock
prices have reached what looks like a permanently high plateau. I expect to see
the stock market a good deal higher within a few months."
-Yale
Economist Irving Fisher, 12 days before the 1929 stock market crash.
Unless you live in a belljar, you have certainly heard
of the term cryptocurrency—or at least of Bitcoin. Bitcoin is today’s rage: the
seminal digital currency has put in a dizzying run, gaining more than 300,000%
in only the last seven years. If you had purchased $10 worth of Bitcoin in July
2010, your investment would command $705,217 as of this writing. In 2017 alone,
Bitcoin’s price has almost sextupled. The upward trend in Bitcoin has been
replicated by other cryptocurrencies, some of which have had equally enormous
surges in only the past year. Expectedly, Bitcoin’s rise has divided investors
and financial commentators: some see it as the manifestation of the rough
beginnings of a new monetary order; others see it as a mania that will end as
all manias do. Recently, JPMorgan CEO Jamie Dimon raised heckles when he described
Bitcoin as a fraud and likened its run to the Dutch Tulipmania of the
Seventeenth Century.
Bitcoin
and other cryptocurrencies are riding the cryptowave, with its narrative of an impending monetary revolution. According to this narrative, cryptocurrency is poised to
dominate the future of global finance. To be fair, cryptocurrencies like Bitcoin offer a radical
alternative to government fiat currencies, which are prone not only to
inflation but also to a variety of counter-party risks, as the citizens of
Greece and Cyprus have found out. However, as with many things, devil is in
the detail.
Even
among critics and skeptics, little doubt is expressed about the technical
integrity of the blockchain technology that undergirds cryptocurrency. But does above-par technology provide
sufficient claim to monetary preponderance? To answer this question, we must
look at cryptocurrency in the context of the three crucial functions of money:
money as a means of exchange, as a store of value, and as a unit of account.
These functions are actually linked rather than discrete. To be accepted as a
medium of exchange money has to pass muster as a store of value—and it has to
be accepted as a medium of exchange to be usable as a unit of account. Gold, silver,
and copper (to a lesser extent) have been used as money for thousands of years
because they fulfill all these functions, furnishing a monetary framework free
from vagary and uncertainty. Precious metals stood out from competing
commodities such as cattle and rice because they bore all the characteristics
of good money: they were marketable, fungible, rare, divisible, portable, and
durable. None of their competitors packed all these qualities.
Bitcoin
possesses all of these characteristics, with a crucial exception:
marketability. Gold and silver were prized the world over for their cosmetic
properties. A merchant could accept payment in gold because he knew it was just
as popular (and liquid) in Persia as it was in China, India, or Greece. The
merchant may have had no use for gold, but he knew a lot of people did, and
would therefore be willing to exchange their goods and services for his gold.
That is the essence of indirect exchange.
Money has invariably evolved from barter exchange, as certain means of payment in direct exchange proved marketable enough to be used in indirect exchange. Every commodity that has been used as currency was at first a marketable consumer good that gradually acquired monetary preponderance through the sequential elimination of competing commodities. Whether with salt, rice, or silver, monetary utility is always (and must always be) preceded by consumption utility. This is not arcane economics; it is common sense.
Money has invariably evolved from barter exchange, as certain means of payment in direct exchange proved marketable enough to be used in indirect exchange. Every commodity that has been used as currency was at first a marketable consumer good that gradually acquired monetary preponderance through the sequential elimination of competing commodities. Whether with salt, rice, or silver, monetary utility is always (and must always be) preceded by consumption utility. This is not arcane economics; it is common sense.
Bitcoin
and other cryptocurrencies have no consumption utility. Apart from being employed in exchange (insofar as this is actually possible), they cannot be used for anything else. Cryptocurrencies are de novo
currencies. The
problem with a de novo currency’s
claim to being money is that it is based on circular argumentation: it is money
because it is widely accepted, and it is widely accepted because it is money. In
other words, it is money because it is money. One might counter that government paper money, which is just as inutile as cryptocurrency, proves that a de novo currency could actually work. It is true that paper money has no consumption value, but there are a few things we should remember. First, that the fiat
currencies used today were at one time backed by marketable commodities; none of
them were introduced de novo. A
British pound, for example, originally referred to a pound of silver. A dollar—the Anglicized form of ‘thaler’—was
originally a designation for a one-ounce silver coin of the Holy Roman Empire. Until
1971, today’s fiat currencies were pegged to gold either directly (as in the
case of the dollar) or indirectly (as in the case of most others). After the demonetization
of gold and collapse of the Bretton Woods monetary system, these currencies
continued to serve as money because of their past association with precious
metals. It is also important to note that fiat currencies enjoy many legal protections,
the most notable of which is legal tender laws. Cryptocurrencies enjoy no legal protections or privileges.
But
there are bigger problems with cryptocurrency. We have seen that for money to
enter common use, it must maintain its value over time. This enables users to
employ it confidently in their financial endeavors: insurance, accounting,
banking, contracts, money and capital markets, and retail—to name but a few. Because cryptocurrencies are speculative instruments, they are notoriously volatile. Daily swings of up to 10% are not uncommon in the crypto markets. An asset with such volatility,
needless to say, does not make a very dependable currency. It cannot form the basis of a stable monetary system.
Volatility
aside, the competition in cryptocurrencies is perhaps the gravest cause for
concern. With more than 1000 cryptocurrencies on the market, how can one be
certain that their cryptocurrency of choice will not be eclipsed by a new or existing
cryptocurrency? It is a truism of technology that today’s dominant technology
might be outmoded tomorrow. There is no guarantee that the current crypto hierarchy
will stay intact over the next year, still less the next ten. As easily as Facebook supplanted MySpace, Bitcoin could be supplanted by another cryptocurrency, and
the blockchain technology could itself be supplanted by a new technology.
Knowing this, it would be foolhardy to employ cryptocurrency in the
denomination of any financial
instruments or obligations. At best, cryptocurrencies could be used for daily hand-to-hand
transactions.
We
are left to conclude that cryptocurrencies cannot provide a basis for a new
monetary order. They simply do not meet the criteria for money. One could still contend, however, that whether or not Bitcoin and other
cryptocurrencies qualify as money tells us nothing about the sustainability of
their current prices; that on this basis alone we cannot determine that the crypto
market is in a bubble.
First
of all, to the extent that the prices of cryptocurrencies represent investors’
feelings about the prospects of digital money, it matters how much grounding
these sentiments have in fact. If it should become apparent that digital money
is unfeasible, as I contend it will, the prices of cryptos will crash. Then
again, when we observe the goings-on in the crypto market, we see many of the telltale
symptoms of bubbles. One of these is the willingness (and even zeal) to rationalize
prices that have little to no economic basis. During the Dutch Tulipmania,
people could rationalize the fact that a single tulip bulb was selling for
more than the value of the land on which it had been grown. During Kenya’s
quail eggs craze a few years ago, few people asked why anyone would be willing to
pay a premium for the diminutive eggs of a wild bird. And throughout the dot com bubble at the turn of the century, people came up with all manner of explanations for outlandish P/E ratios in the American stock market. Likewise, Bitcoin enthusiasts have no shortage of ‘rational’ explanations
for the 300,000% growth in the currency’s price in only seven years. During a
bubble, no price is inexplicably high.
In
addition, we observe the signature psychology and behavior of a manic-stricken crowd: families liquidating
all their wealth to invest in cryptocurrency, people quitting their jobs to
trade cryptocurrency, a scramble to explain why this bubble is different, and
dogmatic, wide-eyed optimism. One of the generic giveaways of a mania is that people who
would ordinarily not care about the frothy asset suddenly take an interest. During the American stock boom of the 1920’s,
shoeshine boys had their finger on the stock market pulse, and they could give you tips on the best stocks to buy. A few months ago, a Bodaboda rider who knows what I do for a
living asked me what I thought about Bitcoin. I expressed an unfavorable opinion and the rider proceeded--with remarkable zeal--to try to persuade me that I was wrong. When people this removed from the cut and thrust of international finance suddenly take an interest in an asset, you can be certain of trouble on the horizon.
The
cryptomania is today’s answer to the tulipbulb mania of the 17th
century. There’s no telling how high the crypto market will go, or how long the
mania is going to last. The market has already clocked $170 billion in
capitalization and it could go higher still, for much longer than I imagine
possible. Being detached from economic reality, frothy markets respect no
limits. In the last analysis, however, we can expect the Cryptomania to end as
every mania before it has: with a deflationary bang.
“The
four most expensive words in the English language are "this time it's different
-John
Templeton
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