## Cryptocurrencies

13 March 2018

Do cryptocurrencies live up to the hype? Are they sensible economic phenomena or just fraud?

After I wrote about cryptocurrencies last month, many comments quite interesting and worth responding to.

There is a large number of cryptocurrencies out there, but only a handful are gaining significant traction, and I focus the discussion on those.

The original cryptocurrency, bitcoin, is essentially a replacement for cash, but suffers from designed limitations that have been overcome in the more recent competitors. At the risk of oversimplification, the other cryptocurrencies either aim to be more efficient forms of bitcoin, or introduce features that are lacking, such as smart contracts or privacy.

So what are the main arguments?

1. technology;
2. money;
3. freedom;
4. trust;
5. privacy/anonymity;
6. the unbanked and those living in countries with crap currencies;
7. there is money to be made;
8. even the central banks are in on the action.

What most cryptocurrency advocates generally miss is that we are not discussing cryptocurrencies in a vacuum. There is entranced incumbent technology that works really well. Show how you plan to beat fiat money, preferably without resorting to mysticism.

It is not surprising that so much of the cryptocurrencies discussion verges into mysticism. Conventional fiat money also has mystical elements, as elegantly shown by John Moore’s Claredon Lecture “Evil is the Root of All Money”:

“money and religion have much in common. They both concern beliefs about eternity. The British put their faith in an infinite sequence: this pound note is a promise to pay the bearer on demand another pound note. Americans are more religious: on this dollar bill it says “In God We Trust”. In case God defaults, it is countersigned by Larry Summers.”

## 1. Technology

The technologies underpinning the various cryptocurrencies are quite elegant. However, elegant technology does not imply real world usefulness. Knowing all their mechanical details does not translate to understanding their economic or social function.

Take as an example human beings. I can know all the physics and chemistry and physiology, understand how molecules and organs operate, yet still not know the first thing about an individual.

Therefore, what the advocates of cryptocurrencies should show is how they solve real-world social problems, and not just resort to handwaving or mysticism to justify them.

Several points were made: (for the record, I am not quoting anyone specifically but distilling what was said)

“We dismissed the potential for flying before the Wright brothers and did not recognise the usefulness of email when it was invented.”

This type of argument does not work. There is a large number of technologies that have failed throughout history, and the success or failure of historical technologies has no bearings on cryptocurrencies or anything we are doing now. Today’s technology should be evaluated on current merit and not dismissed or accepted by how other technology was dealt with in the past.

“Blockchain is useful”.

Agree, and blockchain initiatives like id2000 are interesting. I am even involved with BARAC - blockchain technology for algorithmic regulation and compliance . However, blockchain can be useful while cryptocurrencies are not.

“Bitcoin might be inefficient, slow and insecure, but there are new types of cryptocurrencies that are much better.”

Yes, many of the new ones promise to solve the deficiencies of bitcoin. However, while it is not exactly easy to find someone who takes Bitcoin, it is even harder to transact with something else. And that leaves the question of why any of the proposed new cryptocurrencies improve on the incumbent technology.

Crypto currencies might be inefficient and insecure today, but that will improve in the future.

A marvellous technological solution where the real benefits are promised and not real is just a pie in the sky promise. Otherwise the flying cars and all the fantastic 2000s technology promises would be with us today.

“Fiat cash and electronic money are inferior technologies because they have problems with privacy and crime and don’t hold their value all that well”.

Yes, but neither do cryptocurrencies. In fact, they are inferior on all of these grounds as discussed below.

It is important to recognise the distinction between fintech generally and cryptocurrencies. Many of the good use cases of cryptocurrencies really are just fintech where one can plug in any type of money. This relates for example to the question of the unbanked as discussed below.

## 2. Money

Why do we need money?

1. facilitating transactions;
2. storing value;
3. lending of last resort.

1. medium of exchange;
2. measure of value;
3. standard of deferred payment;
4. store of value.

These aren’t really different, except Wikipedia misses out on lending of last resort.

We have been debating what money is for long time. My list above, and the textbook Wikipedia list, are what most mainstream economists would subscribe to. But, there are strong opinions to the contrary.

There are two related arguments made.

1. the supply of money should be tied to some real good, typically gold or bitcoin;
2. money should not be a government monopoly but created by the free market.

#### 2.1 “The supply of money should be tied to gold or bitcoin”

Over time, we have used a number of assets as money, silver, copper, seashells and cigarettes, just to name a few. However, the asset best associated with money is gold, and the longest period of monetary stability the world has ever seen, 1873 to 1914, was based on money being gold.

Of course, it isn’t quite that simple as Money and monetary stability in Europe, 1300-1914 show. There is plenty of room for manipulation.

So, does it make sense to use a real asset, like gold, or a cryptocurrency as money instead of fiat money?

If we want to link money to some real assets, gold is probably the best choice. But there are however several reasons why fiat money is better. Gold is not a good store of value, as seen in the following chart:

The price of gold has fluctuated quite a lot in real terms over the past hundred years. Bonds and the stock market have kept their value a lot better. But, if we got back on the gold standard this would change, since gold is not a good store of value and is highly volatile because it is not money.

But even more importantly, fiat money issued by a credible modern central bank is vastly superior to money based on real assets like gold or cryptocurrencies, not least because the supply of fiat money can be adjusted to best serve the economy

We want money to make the economy work more efficiently. To do that, its supply needs to adjusted to best facilitate economic growth. Things like gold or bitcoin just don’t do that. Well managed fiat money does.

#### 2.2 “Money should not be a government monopoly but created by the free market”

Suppose then we don’t think fiat money does this well. It didn’t in the 1970s, giving us stagflation.

In a free market, the best money would win out, as eloquently expressed by Hayek’s 1977, “Free-Market Monetary System”. A good modern analysis of that is by Jesús Fernández-Villaverde and Daniel Sanches “Can currency competition work?”.

However, monetary policy has improved since then, and we now know that a credible central bank, with sufficient political cover, using inflation targeting, is the best way to achieve price stability.

For all its faults, I cannot see how fiat money issued by a credible central bank in the 21st century is worse than any of the cryptocurrencies. There simply is no evidence to the contrary. Saying that fiat money is bad and therefore alternative such as cryptocurrencies must be better does not make any sense unless one can show how. And that should be done in the context of the real world and how people actually use money, instead of some abstract theories of how we should think about money.

I think many of the cryptocurrencies advocates who reference freedom or trust or theories of money might be well advised to keep the following in mind:

“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”
—John Maynard Keynes

## 3. Freedom

Cryptocurrencies do promise freedom, as this article Welcome to Liberland: the nation that Bitcoin built. This relates to the ideas on self sovereign identity.

In particular, fiat money is controlled by the government, and governments are anything but shy in using their powers over money to control their citizens and other countries.

Therefore, for those who resent such government control, forms of money that are outside of the control of government and whose quantity and integrity are guaranteed by a technical solution, are attractive.

This is a long-running debate that predates cryptocurrencies. For example, in the United States in the 19th century (witness the debate over the establishment of the Fed in 1913), and the free market monetary discussions in the 1970s.

And for those for which this matters, cryptocurrencies can make sense. This however is a tiny fraction of society.

And even then, I question the freedom one gets, because even with cryptocurrencies, the governments can and will exercise control.

## 4. Trust

The use of electronic fiat money requires money to go through several systems, often starting with a payment processor, then a bank on both ends and a payment system in the middle.

We have to trust that all these entities have our best interests at heart and are keeping our money safe. We also have to trust the government not to confiscate or devalue our money.

Cryptocurrencies promise to replace that with algorithms, see e.g. Bitcoin security model: trust by computation. We trust the network because the interaction between market participants is protected by algorithms that are practically impossible to manipulate. If we want to hold an an asset that does not require us to trust any trust third party, an asset that that can not be censored or confiscated, cryptocurrencies might seem attractive.

So long as we trust the algorithm, we are safe.

Except, this is only the theoretic middle part of the transaction. There are a lot of practical implementation details that erode the trust.

Some tiny segment of the population is sufficiently technically adept so that they can implement the entire thing themselves, and trust their own work. The rest of us have to rely on someone else for implementation.

And then we are left with trusting unknown entities. Here is a small list of what can go wrong.

1. Front running. If we are trading cryptocurrencies there is nothing preventing the exchange from front running. It is not illegal and it is not verifiable;
2. Pump and dump is illegal, except with cryptocurrencies. One can even hire companies that will do pump and dump;
3. Hacking. The best practice in trading cryptocurrencies is to keep one’s keys on an air gapped laptop. We are constantly hearing about people who have their money stolen;
4. The intermediaries are by a large unknown and shadowy;
5. If something goes wrong, one has no recourse.

Electronic fiat money and traditional assets are of course subject to all of these to some extent, but on a much smaller scale than cryptocurrencies, not the least because we are protected by securities law, financial regulations and the legal system.

If we take elementary precautions, internet banking and electronic fiat money transactions are quite safe, and we are protected by multiple layers of security. The chance of hacking is very low and in the event, we have recourse.

I am perfectly happy to do online banking without constantly looking over my shoulders or resorting to air gapped laptops.

The concept of trust does not only apply to the algorithm, it applies to the entire transaction. And I trust my bank and my payment system much better than any cryptocurrency intermediary.

So, from the point of view of trust, fiat money is much superior to cryptocurrencies.

## 5. Privacy/anonymity

Some cryptocurrencies promise privacy. That we can enter into a transaction without anybody knowing about it except we and the person we are dealing with.

There is no such thing as 100% privacy. Fiat cash is fully anonymous, but someone might be monitoring the transaction. Same with even the most privacy focused cryptocurrency, the starting point is the internet, giving scope to monitoring.

If we move to electronic fiat money, we are subject to tracking, both by private companies and government authorities.

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.

If we are putting our trust in a blockchain based cryptocurrency, we also have to give up privacy.

If then, there is an alternative that promises privacy, then what about trust?

And meanwhile, while bitcoin is the most liquid cryptocurrency, it is not exactly what one would call liquid in the sense that fiat money is. Moving to some untested and highly illiquid cryptocurrency that promises privacy and trust, needs a considerable leap in faith and belief.

However, this one area where a central bank issued cryptocurrency might have an advantage.

## 6. The unbanked and those living in countries with crap currencies

Many advocates of cryptocurrencies argue that while for those living in developed countries with relatively credible central banks and governments creating fiat money there may be little reason to move to cryptocurrencies, some countries have unstable governments and large segments of the population unbanked. Cryptocurrencies then solve that problem.

In countries with high inflation, people usually seek out other currencies, typically the US dollar. Transactions might be made entirely in dollars or prices may be quoted in dollars while transactions take place in local currency at the spot rate.

I can’t see how citizens of countries with unstable monetary policy are better served by cryptocurrencies than the most widely available fiat currency, the USD.

The problem of the unbanked can be solved by fintech, for example banking via cell phones, and the like. However, such a solution is currency agnostic. It’s a technological solution and one can plug in any currency. The unbanked would be much better served by a stable fiat currency that is accepted everywhere.

## 7. There is money to be made

Any asset can get into a bubble. People will buy it because they expect others to pay a higher price in the future, creating a positive feedback.

A bitcoin was worth $0.06 in 2010, and$9800 on last count. So a 16 million percent return.

Someone who invests early and gets out in time, will make money, just like an early investor in a Ponzi scheme will make money provided she gets out early.

So this leaves two questions:

1. what sort of investments are cryptocurrencies;
2. does it make sense to invest in them?

Investments like stocks and bonds have value because we have expectation of future income.

Other assets have value because we expect people to pay for them in the future.

Collectibles are of the latter category. The Wall Street Journal ran an interesting story recently Sorry, Collectors, Nobody Wants Your Beanie Babies Anymore “Over two decades after the great Beanie Baby craze, speculators are back, hoping someone will finally buy their floppy collectibles.” It is the same with collecting art and stamps. Collectable stamps have scarcity value, some cost more than \$200k, just make sure to buy at the right time.

Fiat money also falls into this category. It only holds value if the central bank and the government manage it properly, and in cases where they do not, the use of fiat money can be very costly, and in extremis result in hyperinflation.

Cryptocurrencies fall into the same category as stamps, fiat money and Beanie Babies, not stocks or bonds. Their price is derived from what people will want to pay in the future, not from a revenue stream like stocks and bonds.

That does not mean there is not money to be made. However, one is well advised to keep the lessons from global games in mind. You can see the model in my slides on this in a currency framework here, from page 57.

It is especially important not to be affected by hindsight bias. Just because the price of something increased in the past, does not mean that it will increase in the future.

Those who have made money out of cryptocurrencies have done so out of luck, not because of anything fundamental.

A counterargument might be that the supply of cryptocurrencies is limited by costly mining and may have a fixed asymptote — just like gold. As to the former, sunk cost should not affect the value of assets, but the limit to supply is more relevant.

However, that is only an advantage if the alternative is unstable fiat currency. In countries with credible and well-managed central banks, the ability to adjust the supply of money to meet the needs of the economy is highly valuable, as discussed above.

## 8. Even the central banks are in on the action

Most central banks are actively studying cryptocurrencies and have even considered issuing their own. See for example the Bank of England and the more academic BIS paper “Central bank cryptocurrencies” by Morten Bech and Rodney Garratt.

So why should a central bank do that? Besides just keeping up with popular technology, many central banks would like to get rid of cash, like the Bank of England (or at least its chief economist). While they might think they have a good reason to do so, it is a terrible idea.

But why should a central bank issue cryptocurrencies? Bech and Garratt argue that retail clients might benefit from anonymity and the ability to hold accounts directly with the central bank, while wholesale clients might benefit from increased efficiencies. Furthermore, a central bank issued cryptocurrency might have the advantage of a fixed supply and one to one convertibility to other forms of money. Such money might solve the problem of the zero lower bound. Furthermore, a central bank cryptocurrency would likely have the price stability that other cryptocurrencies lack.

All of these make sense, but seem to be rather minor advantages, except the zero lower bound and anonymity (and I suspect the central banks could not countenance that very same anonymity,) and the broader discussion of control of money supply. Under the current system, the central banks do not control the money supply, except M0 and perhaps M1. This is why we had all the experimental monetary policies, low interest rates and QE over the past 10 years.

So, if the central bank issues cryptocurrencies, the supply of money, in all its forms, all the way from M0 to M3, can be controlled — in theory.

That might be a good idea because conceptually it gives more fine-grained control of inflation, can insulate failing intermediaries in a crisis, and perhaps most importantly, provide control of higher forms of money in a crisis when everybody is rushing to convert M3 to M0.

Except, it is more complicated, as trust gets in the way of the efficiency.

## So…

I still think that cryptocurrencies are more like a religion or a cult, not a rational economic phenomena.

I still await my enlightenment.