Bitcoin and Ether (more commonly referred to as Ethereum) are the two most popular cryptocurrencies. They function differently, but despite their technical complexity they both operate like traditional money. In this article I will explain some basic economic mechanics about what role crypto currencies could play in our economy. I am personally neither a fan nor an opponent of crypto currencies; I am only looking at them as an economist.
The interest in crypto currencies has grown exponentially since Bitcoin was invented in 2008. It has gone so far, in fact, that Bitcoin has become legal tender in El Salvador. Four central banks have accepted Ethereum as a form of money under their jurisdiction, and the U.S. state of Colorado has decided to accept crypto currency for tax payments (although the payments are still converted into dollars before entering the state treasury).
Are crypto currencies on their way to become a serious challenge to traditional currencies?
The plain answer is no. Crypto currencies are here to stay, but they are not revolutionary enough to challenge traditional currencies.
Part of the reason for this is found in El Salvador, where as explained in an excellent article at restofworld.org, the decision to make Bitcoin legal tender has led to many problems. These are primarily short-term in nature and being addressed, but there are also long-term problems which are for the most part being ignored.
Two types of crypto currencies
There are many different crypto currencies out there; this essay is not long enough to give them all justice. To highlight the basic nature of crypto currencies, let us focus on the two most popular: Bitcoin and Ethereum (which is the more commonly used term for “Ether”). These two cryptos differ much in the same way as gold-standard currency differs from fiat currency.
When the amount of dollars in circulation was tied to gold, theoretically the total amount of money in the economy could only increase if the Federal Reserve acquired more gold. Over time, monetary innovation and the evolution of fractional banking made it increasingly difficult for central banks to maintain a gold standard.
Bitcoin works pretty much like the gold-standard dollar was meant to do. Just like there is a fixed amount of gold in the world—barring discoveries of new lodes in some mountain somewhere—the total possible amount of bitcoin is finite. The cap of 21 million blocks of bitcoins is coupled with a gradual increase in the marginal cost of digitally mining new bitcoins. For every 210,000 blocks of bitcoins added to the existing stock, the number of bitcoins per block is cut in half.
This feature resembles the rising cost of finding new deposits of gold. Just like in the real world exploring increasingly inaccessible precious metals comes with rising costs per ounce extracted, the digital mining for bitcoins becomes increasingly expensive over time. Higher energy costs and possibly longer man hours to operate and service the hardware raises the marginal cost for extracting the next coin.
The process for creating new coins of Ethereum is similar to that of bitcoin—it takes digital mining—but there is no absolute cap on how many ether coins can be created. The marginal cost for mining new ones does not rise. In this regard, Ethereum is comparable to a fiat currency: the cost to a central bank for printing another euro is the same as it was for the last euro it printed.
This may be the reason why, as mentioned earlier, Ethereum, not Bitcoin, has become “a critical part of a proposed platform for central banks of Australia, Malaysia, Singapore and South Africa to conduct digital currency transactions.”
The similarity between Ethereum and fiat currency is interesting also from the perspective of inflation. A fiat currency can create monetary inflation, provided that—technically speaking—its supply exceeds its transaction demand for a sufficiently long period of time. In practice, this means that the central bank over several years continues to print excessive amounts of money, again at a constant marginal cost.
The risk for crypto inflation
As the supply of a fiat currency expands, two things happen. First, government pumps more cash into the economy via entitlement programs and central-bank backed, no-cost credit, thus increasing demand for consumer goods and services. Initially, there is also a rise in business investments due to low, occasionally even negative interest rates. That rise reverses as inflation gets higher.
Second, the increased availability of work-free government cash disincentivizes people from participating in the workforce. Labor supply stagnates, as does entrepreneurship. Fewer businesses are started, people become less interested in career development, etc. As a result, demand in the economy gradually exceeds supply, and does so on a sustained basis. Prices begin to rise.
This is how a central bank causes monetary inflation. It is important to distinguish it from the more traditional demand-pull inflation where demand exceeds supply without any disincentives toward increasing supply, and without work-free income driving demand. The demand-pull type of inflation is characteristic of the peak sequence of the business cycle; since there are no artificial, monetarily created incentives at work, the free market cools itself off and inflation eventually subsides.
By contrast, monetary inflation can rise to outlandish levels, as the peoples of Zimbabwe and Venezuela have painfully experienced. Conventionally, monetarily driven hyperinflation is tied directly to central banks printing excessive amounts of money. This, again, is correct, but it is not necessary that the money printer is a central bank. In theory—and I emphasize in theory—a fiat-style crypto currency like Ethereum can cause monetary inflation. With the cost of producing more of the crypto currency being constant over time, the private sector could expand its supply to levels where it begins to cause inflation.
In practice, this is very unlikely to happen. The only circumstance under which it would become an acute risk is if everyone in the economy accepted a fiat crypto as a regular currency. However, so long as there is a traditional currency alongside the crypto currency, the free market will prevent inflation-driving excess supply. The reason is the exchange rate between the crypto currency and its traditional alternative.
Exchange rates keep crypto in check
To see how the exchange rate works, let us assume crypto currency as K, and simply call it “crypto.” It exists alongside a traditional currency, €, or euro. Both currencies are accepted by 100% of all vendors in the economy. Anyone selling anything, including his own labor, will take either currency as payment. Banks will be equally happy to open accounts in either currency; people and businesses will have parallel accounts for cryptos and euros.
Suppose there is K100 and €100 in circulation in the economy. All other things equal, this gives us an exchange rate of 1:1. If the central bank prints another €100, with supply twice as high as demand for the traditional currency, its price in terms of cryptos declines. The new exchange rate is €2 for every K1.
The same happens if instead digital miners double the supply of the crypto. With its supply exceeding demand by 100%, €1 is now worth K2.
As the exchange rate shifts either way, so do prices on goods and services for sale in the economy. Inflation annihilates the gain of a monetary expansion, regardless of which way the exchange rate shifts. This discourages excessive supply expansion, but it is important to remember that these market mechanisms only discourage excessive crypto expansion by private-sector digital miners. The central bank is a government entity and may choose to print more money regardless of its consequences for the economy.
The ever-present hand of government
The exchange rate between K and € is determined by many other factors. Government beyond the central bank is one of the more influential: if government only accepts € for paying taxes and fees, then everyone will need to hold at least some € on a regular basis. There is no similar mandate in place that forces people to hold cryptos. At some point everyone has to exchange K, the crypto, for € in order to honor their obligations to government. The larger government is, and the heavier the tax burden, the stronger the €/K exchange rate will be in €’s favor.
If the crypto is reduced to second-tier status vs. the euro, it could still play a role in the economy. That role can either be as an asset for speculation, or as a means for economic transactions.
No commodity (and money actually counts as one) benefits from being the subject of speculation. The wild price swings in crypto currency, primarily but not solely Bitcoin, is proof of this. In fact, when Bitcoin prices exhibit high volatility, it scares away people who might otherwise use the crypto currency for regular transactions (a problem that El Salvador has experienced first hand).
When there is stability in the crypto price—in other words its exchange rate vs. a fiat currency—it can definitely be used as a means of transaction payments. This role of money is simple: it is being used to pay for our expenses. In our hypothetical example with the crypto being established and generally accepted, there are no institutional hindrances to the use of cryptos for paying expenses. It can serve that function just as easily as the fiat currency.
Money as a means of payment can take many different forms: coins of precious metal; cash; sea shells; cigarettes; electronic funds, whether in a bank account or in the form of a crypto currency; etc. A standard rule in economics is that commodities with no alternative use tend to outcompete other means of payment. When crypto currencies are not used for speculation, they strongly resemble traditional money in this way: unlike a cigarette, you really cannot use the crypto for anything else other than money.
The problem for any crypto currency is to reach the point where it is as useful for transactions purposes as a traditional currency. One of the deciding factors in this regard is whether or not its acquisition is associated with any costs. Here, things get a little complicated:
- On the one hand, mining the crypto requires energy to run computers as well as the appropriate computer soft- and hardware;
- On the other hand, if the crypto can be sold at a price that exceeds its acquisition costs, then, all things being equal, more people will choose to mine for the crypto than to seek employment.
The cost-benefit balance is fairly simple. It costs money to buy the power needed for crypto-mining computers; unless you have money in the bank, you have to work to earn enough to pay for the power (and other crypto-mining expenses). If the profit from mining a crypto is sufficiently higher than the earnings from work, then digital mining will be more attractive than workforce participation.
If we reach the point where crypto mining becomes more attractive than traditional workforce participation, we set in motion the aforementioned forces of inflation. The economic mechanics involved are the same as the ones that drive monetary inflation; they are more subdued here and much less likely to have any material impact, but the crypto-inflationary mechanics nevertheless exist.
It is worth repeating that as of today, crypto-driven inflation is predominantly a theoretical problem. Whatever happens in the future, with advances in computer and crypto-currency technology, is an open question. However, if central banks get their hands on crypto currencies, the risk for crypto-driven inflation becomes more than theoretical. With their penchant for printing money for no other reason than to lend it to overspending governments, we may very well see the crypto revolution be sucked into the black hole of monetary inflation.
It would be sad if this happened. The crypto-currency revolution opens up many doorways of individual freedom. And that is a commodity that we need more of, not less.