The price of Bitcoin zoomed up to the stratosphere in late 2017, making it either a huge speculative bubble or a statement for its acceptance as a real currency at the time. Nobody seemed to understand this sudden doubling of the price of Bitcoin. Within a scant three months, the price of Bitcoin went over $10,000 for a Bitcoin, from $4,341 at the beginning of the quarter, a jump of 120% in just three months. Come February 2018, barely two months after bitcoin touched its record high, price dropped sharply to around $6000 and in another 6 months it was back at $4k apiece.
After all, even as the financial world has been gripped by cryptocurrency mania over the last year, the “currency” part of cryptocurrencies has receded in importance in the public eye. As a Goldman Sachs executive put it last year, Bitcoin is, at the moment, more of an asset than a currency — it’s something people trade, like a stock or bond, rather than something they exchange for goods and services.
Still, the dream that cryptocurrency could replace our existing system of fiat money, in which the money supply is controlled by government-run central banks, remains a key part of Bitcoin’s appeal. The promise is of a system where the government can’t manipulate the money supply, and market competition determines which currencies people use. But what would happen if that dream came true?
The simple answer is: Chaos. Our economies and financial systems are built around fiat money, and they rely on the central bank’s control of the currency (and the government’s ability to issue debt in that currency) to help manage the business cycle, fight unemployment, and deal with financial crises. An economy in which Bitcoin was the dominant currency would be a more volatile and harsher economy, in which the government would have limited tools to fight recessions and where financial panics, once started, would be hard to stop.
The opposite of what you want
To see why this is the case, it’s key to recognize the crucial role that the central bank (which in the US is the Federal Reserve) plays to provide what economists call “liquidity” when the system needs it. That’s just a fancy way of saying that the central bank can pump money into the system, either by printing it and then lending it to banks (with the idea that they will then inject that money into the system) or by simply buying assets itself. Providing liquidity is especially important in times of financial crisis, because crises lead banks to cut back on lending and savers to pull their money out of banks. In those times, the central bank serves as a lender of last resort, stepping in when otherwise solvent banks are struggling to stay afloat and ensuring that we don’t end up with a flood of bank closings.
In an economy run on Bitcoin, these things would be impossible for a central bank to accomplish. A key aspect of the Bitcoin protocol is that the total number of bitcoins is capped at 21 million, after which no more will ever be issued. This makes Bitcoin appealing to many people because something that will never increase in supply is more likely to hold its value. The problem is that in the event of a crisis, there would also be no way to add liquidity to the system, since you can’t “print” more bitcoins. The central bank could build up a stash of bitcoins that it could then funnel into the system, but that would do little good because people would know the stash was limited. And in any case, the central bank’s demand for Bitcoin would drive up its price, which would make people more likely to hold onto it and less willing to spend it — the opposite of what you want in a financial crisis.
Bitcoin would also make it hard for governments to fight recessions, which they typically do by using what economists call countercyclical monetary and fiscal policy. Central banks slash interest rates, and — as the Federal Reserve did after the 2008 financial crisis — pump money into the system by buying assets (what’s known as quantitative easing). And governments try to get the economy moving again by cutting taxes and increasing spending, typically paying for that by borrowing money, as with the Obama-era stimulus package.
Here again, a Bitcoin economy would limit the government’s options. Since the central bank would have no control over the currency, it would also have no control over interest rates, and only a limited ability (depending on the size of its Bitcoin stash) to pour money into the economy. Fiscal policy, too, would be close to impotent. Today, when the government runs a deficit, it can have the Fed print money and then borrow that money from the Fed. That adds liquidity to the system. In the Bitcoin world, the government would have to borrow bitcoins to spend. And again, this would make bitcoins more valuable, making people less willing to spend them — the opposite of what you need to fight a recession.
Of course, bitcoin is far from the only cryptocurrency. Depending on how you count, there are now hundreds, if not thousands, of them. And while they’re all built, like Bitcoin, on the blockchain, some have features that might seem to make them more attractive as a potential global currency. Litecoin, for instance, can process more transactions per minute. Monero and Zcash offer genuine anonymity (as opposed to Bitcoin, where every transaction is associated with a given key that can be tracked). And not all cryptocurrencies have a rigid cap on the total number of coins. So perhaps a different cryptocurrency could replace the dollar or euro or yuan — or, more plausibly, we could end up with a system of lots of different private currencies, rather than relying solely on a single medium of exchange.
The problem with a world in which there are lots of different private currencies is that it massively increases transaction costs. With a single, government-issued currency that’s legal tender, you don’t have to think about whether or not to accept it in exchange for goods and services. You accept dollars because you know that you will be able to use them to buy whatever you want. Commerce flows more smoothly because everyone has implicitly agreed to use the dollar.
In an economy with lots of competing currencies (particularly cryptocurrencies unbacked by any commodity), it would work very differently. If someone wants to pay you in Litecoin, you have to figure out whether you think Litecoin is a real cryptocurrency or just a scam that could shut down any day now. You have to consider who else might accept Litecoin if you want to spend it, or who would trade you dollars for it (and at what exchange rate and transaction fee).
In the United States in the decades before the Civil War, there was no national currency. Instead, it was an era of what was called “free banking.” Individual banks issued bank notes, theoretically backed by gold that people used as money. The problem was that the farther away from a bank you got, the less recognizable (and therefore the less trustworthy) a bank’s note was to people. And every time you did a deal, you had to vet the note to make sure it was worth what your trading partner said it was worth. So-called wildcat banks sprang up, took people’s money, issued a host of notes, and then shut down, making their notes worthless. The same will be true in a world where some people use Ethereum, others use Litecoin, and others use Ripple.
That doesn’t mean that cryptocurrencies are useless. On the contrary, for transactions that one wants to keep hidden from the government (or other authorities), they will remain useful. Buying drugs, laundering money, evading capital controls, protecting your money in countries with hyperinflationary environments: these are all situations where cryptocurrencies can come in handy. But the notion that private cryptocurrencies might soon (or ever) be a meaningful competitor to fiat money for everyday transactions is little more than a pipe dream.
BIGGEST THREATS TO THE WORLD ECONOMY FROM BLOCKCHAIN was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.