When I sat down to write another blog post this morning, I had high hopes for what the topic would be. I wanted to write about something big. Something like the Keynesian economic system, since your Millennial Economist is a Keynesian. Or maybe something to do with Brexit. But I couldn’t escape it. We all, I’m sure, can’t escape the hype over cryptocurrencies.
It seems like they’re everywhere, doesn’t it? Scrolling down your social media, all you see are ads telling you how to “Buy crypto with no downside!” and “Quit your job to mine bitcoin!” It’s taken over the mind of the financial services industry, and more of these currencies seem to be popping into existence every day.
So for today’s post, I will be going over the pros and cons of cryptocurrency, compare it to the current currency in use, and give you my take of whether you sould (or should not) take the plunge.
What Is Currency?
Currency has served a vital purpose in civil society through our history. Broadly, currency facilitates the transfer of goods and services for other goods and services. For most of human history, we bartered goods and services we produced with other goods and services we wanted to buy. While this rudimentary concept of trade was important in establishing economic systems, there was no ‘fair’ way to trade different goods. Who’s to say whether a piece of furniture was worth the same as a bushel of apples, or an hour of house cleaning? Currency streamlined this process immensely, by creating something called Liquidity.
Liquidity, used here, means how quickly something can be transferred into currency. In this way, people could trade their goods and services using not many different kinds of measures (each individual good) but one universal measure (the currency). It is important to make a distinction here, readers, between the Value or the currency and the value of the goods and services it purchases. Adam Smith (yes, The Wealth of Nations’s Adam Smith) stated that a nation’s wealth is derived from the total value of goods and services produced (https://www.adamsmith.org/the-wealth-of-nations/). You may recognize that as the definition of GDP. This concept has not changed in over 200 years, the value of a country’s economy per year is the value of the goods and services it produces per year.
Now, why did I go over all that? Because the important distinction to make, my friends, is that between currency and goods. Since currency can be easily exchanged for goods and services based on liquidity, and since the value of goods and services are the basis for a nation’s wealth, you would assume that a nation’s wealth is more easily translatable to the value of its currency. However, you would be incorrect. Currency itself has no value! This is not to be confused with the function of money being a ‘store of value’, meaning holding the value of goods and services exchanged for it, and able to be exchanged for other goods and services of equal value in the future. This means currency, by itself, has no value.
Throughout history, currency has taken on many forms (shells, beads, tulips, gold & silver coins, paper, credit) but they all boil down to one common quality. Without anything to exchange, they serve no purpose, and thus have no intrinsic value. I believe that, in order to have intrinsic value, there needs to be a Utility, or use. You can live in a house, you can drive a car, you can make a business run better with consulting services, etc. Goods and services have utility, so they have value. What can you do with currency, other than exchange different amounts of goods and services?
Before I get into the finer points of the cryptocurrencies themselves, it’s important to understand what the process of creating them is. Unlike traditional currencies (herein referenced as the Dollar, or USD) which are printed from the Treasury and supplied by the Federal Reserve, cryptocurrencies (herein referenced as Bitcoin, or BTC) are created through something called blockchain technology. This is essentially an easily viewable, online ledger of all coins in existence and who owns them. The blockchain is made up on many individual Nodes, which contain complex math problems. These problems are worked at and solved by Miners, and the miner who solves the problem is rewarded with a bitcoin. This is unnecessary and stupid at its face, but there is another layer. The blockchain also facilitates instant, secure transfers of money between two parties, and the math problems are an algorithm to facilitate that process. The miner who solves the problem functions as the ‘custodian’ of the money transfer, the problem being completed means the transfer is completed, and the bitcoin payment is the reward.
Bitcoin is a fully online currency, meaning no form of it exists outside the internet. The coding of the blockchain only currently allows 2.147 million coins to be in existence at any time (the numerical limit of x32 coding language). Couple that with the processing power and electricity required to mine a coin, and you derive a significant layer of scarcity to the asset.
I’ve highlighted important terms above in blue, because these terms are the bedrock of what this millennial considers functional currency. Let’s go down the list and see if Bitcoin can compare to the Dollar.
First, there needs to be Liquidity, the easy exchange of goods and services to the currency and back. for the Dollar, this is a no brainer. The Dollar is used around the world as an exchange mechanism. The Dollar derives its liquidity from its widespread use around the world (meaning there is always reasonable assurance of at least an adequate amount of dollars in an economy to match goods and services produced), and its backing from the Federal Reserve (meaning the Fed will step in to add or subtract additional Dollars if needed to keep the economy from expanding or contracting too quickly). Where does Bitcoin stack up here? Despite a market cap of over $110 billion, Bitcoin does not have much liquidity. Some governments have allowed or expanded use of Bitcoin, but others have restricted or outright banned its use. If you see Bitcoin as a threat to government-backed currencies, then as long as there are governments, Bitcoin will not be as liquid as their currencies.
For further explanation on that last sentence, I point you to Gresham’s Law (https://en.wikipedia.org/wiki/Gresham%27s_law). Gresham’s Law states that ‘Bad money drives out Good money’, meaning an inferior form of currency will drive out a superior form. Think back to when man used Gold and Silver coins. Gold coins were the currency statdard, and Silver coins were denominated in the amount of gold coins they represented, ie. Five silver to every One gold. Because Gold was worth more than Silver here, people would spend their silver but keep their gold. The bad money drove out the good money. If you belueve Bitcoin is worth more than the Dollar, then you would not use your Bitcoin because you would not want to lose it. Conversely, if you think Bitcoin is worth less than the Dollar, then you do not think it is a currency worth using, so you would still not use it.
The second sticking point in this debate is the currency’s Value. I have already explained above that traditional economic theory states that a currency does not have any value in and of itself, but rather derives its value from the goods and services it exchanges for. The Dollar illustrates this very well, being simply a green piece of paper if not exchanged from something to something. However, a popular pro-Bitcoin argument is that BTC, due to its scarcity, is a deflationary currency, and the Dollar is inflationary. Further explanation of this in the next paragraph.
When a currency inflates, it requires more of the currency to buy the same goods and services. In terms of money supply and demand, this comes from increased supply (printing more Dollars) or decreased demand (more propensity to spend than to save). Refencing recent actions by the Fed and the ease of creating more Dollars, proponents of Bitcoin argue that the Dollar is being artificially inflated, while due to Bitcoin’s scarcity, the latter is a deflationary coin. This argument has some merit, but let’s revisit our historical example of Gold and Silver for some perspective. Gold and Silver coins were created from melting down bullion, and that bullion had utility and value. So, there were times when the coins were worth more than the bullion, and times when the bullion was worth more than the coins. When the former happened, people would melt down their bullion for coins, increasing the supply of coins and decreasing the supply of bullion. When the latter happened, people would melt down their coins for bullion, and the opposite conditions happened. These events would happen repeatedly and create a circular flow of inflation and deflation that has persisted throughout history.
The Bitcoin proponents say that the coin’s deflationary nature makes it rise in price. This argument on its face shows that Bitcoin isn’t actually a currency. If Bitcoin is a currency, then it should have no value in and of itself, it should only derive value from the goods and services it exchanges for. But Bitcoin seems to go up in price every day. If this is really due to supply and demand, then it does actually have value other than what it exchanges for goods and services, so it is not a currency. Rather, it is a commodity, denominated in dollars, the same as Oil, Gold, Timber, or other assets. If Bitcoin was a deflationary currency by nature, then there would be less Bitcoin in circulation relative to the goods and services in the economy, and those goods would be worth less Bitcoin, not more. The fact that it has a price at all, and not just a currency exchange rate, makes it a commodity, not a currency.
Third, we will see what separates Bitcoin and the Dollar in terms of Utility. This is the one facet of currency that USD and BTC have in common, that being they both have no utility. There actually isn’t much to say here, Dollars have no function other than an exchange for goods and services, and BTC has no function currently, other than an exchange for Dollars.
After this comparison, it is clear that Bitcoin does not fill the role of currency. At this point, it is still a commodity traded in dollars. Those people that are holding onto Bitcoin for the long term, because they think it will replace the Dollar as a currency, I think are mistaken. This does not, however, mean that the underlying technology is worthless. Blockchain technology is a significant step toward transparency in the financial services industry, and companies are already starting to invest in this technology. If you think blockchain has a place in the economy, then I would suggest buying stock in companies you think stand to benefit from it, and not the coins themselves. But if you want a quick buck, then you can join the millions of people buying and selling the coins and ride then wave up. At least, before it comes crashing down.