Two big questions for the future of cryptocurrencies

Cryptocurrencies have been a fabulous investment for early investors. A Bitcoin was worth $0.06 in 2010, and $6,500 now, an 11 million percent return. Does it make sense to invest in cryptocurrencies today? It depends.

Any asset can get into a bubble state. People buy it because they expect others to pay a higher price in the future, creating a positive feedback between buying and prices. Someone who invests early and sells in time makes money, just like an early investor in a Ponzi scheme profits, provided she gets out early.

This leaves two questions:

What sort of investments are cryptocurrencies? Does it make sense to invest in them?

The price of stocks and bonds follows from expectations of future income. Other assets have value simply because we hope people will buy them at a higher price in the future.

Collectables are in the latter category. The Wall Street Journal ran an interesting story on the risk of investing in collectables 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” (Wall Street Journal 2018). It is the same with art and stamps. Collectable stamps have scarcity value, with some costing more than $200k.

Money is also in the latter category. Fiat money such as dollars, yen and euros, the form of currency used in almost every country, only holds value because the issuing central banks and governments are expected to manage them properly.

So what about cryptocurrencies? They might make some sense, as maintained by Fatás and Weder di Mauro (2018). Perhaps, following from Friedrich von Hayek in 1977, they beat fiat money in the free market. Or not, as Fernández-Villaverde (2017) argues.

The promise of a 10,000% return

Most cryptocurrencies – like the most popular, Bitcoin – are envisioned as a new form of money. The best case for cryptocurrencies, then, is a full replacement of fiat money. So how much would that be worth?

It depends on what we mean by money. Suppose, it is M1, printed money, and demand deposits. The total value of M1 in the G20 economies is $31 trillion, as seen in Figure 1. The total market value of all cryptocurrencies is $235 billion, of which Bitcoin is the largest at $131 billion.

Figure 1 The volume of money in economies with the largest money supply compared to the four largest cryptocurrencies, 3 June 2018

Source: coinmarketcap.com

So what is the value proposition of cryptocurrencies? Their market value is about 1% of M1. While we can debate the specifics, the 1 to 100 ratio provides a useful guide to scale.

There are three possible scenarios.

- cryptocurrencies will fully displace fiat money;

-cryptocurrencies will partially replace fiat money;

- or cryptocurrencies will not usurp fiat money.

Under the first scenario, cryptocurrencies might increase 100 times in price. Under the last scenario, cryptocurrencies only have a logical terminal price close to zero, unless some use is found for them that does not involve displacing fiat money.

The zero times and 100 times returns are therefore sensible lower and upper bounds on the returns a very long-term investor can expect.

Sticking to my back of the envelope calculation for the extremes, a long-term, risk-neutral investor will hold cryptocurrencies if she expects the chance of them entirely replacing M1 to be higher than 1%. If not, she should either not hold or consider selling short, provided the cost of doing so is sufficiently low.

This leaves the intermediate scenario where cryptocurrencies partially replace fiat money. Bitcoin is already used for certain types of transactions. The central banks might also start holding cryptocurrencies as reserves, or large retailers like Amazon may begin accepting cryptocurrencies for transactions.

Unlikely. I don't think many people would like to earn their salaries in dollars, pay rent in Bitcoin, buy groceries with Ethereum and compensate the hairdresser in Ripple. We want to use a single currency, one that provides price stability and ease of transactions. I want to know how large my monthly mortgage payment is, and will be, as a fraction of my salary. This means using the same money for everything. If fiat money competes with Bitcoin or any of the cryptocurrencies, one will win. That leaves the two extreme scenarios.

The two tests for cryptocurrency success

For cryptocurrencies to have a hope of making substantial inroads into fiat, there are two tests to be met.

Cryptocurrencies have to show themselves to be a superior technology to fiat money.The government has to allow that to happen.

At least today, cryptocurrencies are inferior to fiat money on every practical criterion, as I discuss in a blog on Vox.

However, the value proposition is not based on today, but what might happen. Fiat money is a very efficient and entrenched incumbent technology, and I have not seen any credible projections of how cryptocurrencies can improve on, and hence beat, the incumbent.

There are plenty of opposite predictions out there, but they are either based on some abstract theories of how we should think about money, computer algorithms, or carefully chosen case studies, not on how money is used in the real world.

Besides, the governments won't let it happen.

The desire and power of governments

Suppose, then, that I am wrong and cryptocurrencies are found to be superior to fiat money, set to displace them in the free market for money. Would existing holders of cryptocurrencies profit?

Highly unlikely. Such views underestimate both the power of the governments and their strong desire for this not to happen.

What might be the governments’ objections?

- Seigniorage – the profits the government gets from printing money. If cryptocurrencies became real competitors to fiat money, someone is going to make a profit. Full fiat displacement means a $31 trillion transfer from regular citizens to a handful of speculators. That figure is almost the annual GDP of the US and China combined (at $34.5 trillion). No government will allow that to happen.

- The importance of managing the supply of money to suit economic and political demands, both routinely and with lending of last resort. In order to do that, not only does the supply of money have to be variable, it also has to be under the control of the government. The fixed mining schedule of Bitcoin implies increasing deflation if Bitcoin were to displace fiat money. The cost of that deflation would be a very high and unnecessary cost.

Cryptoadvocates might retort that none of these matters since the opinion of the government is irrelevant. Cryptocurrencies live in cyberspace, outside existing economic and financial structures, away from the long hand of the law. A libertarian paradise. It is then only a question of when, not if, we will be able to go about our daily economic life buying stuff on Amazon and paying in cryptocurrencies.

Nonsense. Governments have the power to ensure money controlled by them remains legal tender, and they will certainly do so.

Any transaction involving fiat money is monitored and controlled by the government. If it is US dollars, transactions go through the US payment system in the New York Fed. Any entity that refuses to cooperate can be denied access to the payment system so that it would be unable to transfer fiat money to or from cryptocurrencies. The US government has not been reticent in taking advantage of its reserve currency powers in the past and. Surely it will not be shy if it perceives cryptocurrencies as a serious threat in the future.

As long as money stays within the cryptocurrency universe, that is not all that relevant. However, the point of having money is to spend it. Most of our money is spent within a small radius of our house: real estate, schools, hospitals, grocery stores, hairdressers, etc. All of these are directly monitored and controlled by government regulators. Merchants can be (and are) required to report any transaction, and can easily be prohibited from accepting payment in cryptocurrencies. Perhaps, as someone told me recently, Amazon will accept payments in Bitcoin, but Amazon can easily be required to accept only national fiat money.

There is a reason why fiat money is also called ‘legal tender’ and for governments to insist on having a monopoly on printing money.

What is left is a prosperity gospel

This does not mean there is no money to be made. It can be rational to invest in cryptocurrencies even if agreeing with me that they will eventually become worthless. Just keep close attention to the time to jump and don’t be affected by hindsight bias. Also note that they are also about five times riskier than the SP-500 index (http://extremerisk.org/). Those who have made money so far have done so out of luck, not because of anything fundamental.

As I talk to the cryptoadvocates and read their work, I increasingly get the impression that they are not motivated by a rational analysis of the world but rather by an almost religious belief that cryptocurrencies will both change the world and make them really, really rich. Any counterargument threatens that worldview, to be dismissed like fake news. Discussing cryptocurrencies becomes akin to debating religion with the devout.

Cryptoadvocacy is just one form of prosperity gospel.

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

“[M]oney 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.”

When I wrote my first article here on VoxEU on why cryptocurrencies don't make sense (Danielsson 2018), I got a lot of flack. Social media really lived up to its promise.

I still think that cryptocurrencies are more like a religion or a cult than a rational economic phenomenon. They are a lousy investment.

I still await my enlightenment.