Bitcoin symbols displayed at an exchange bureau in Pristina, Kosovo, where cryptocurrency mining has been temporarily banned due to the activity’s serious drain on energy. Photo: AFP
The View
by Willem H. Buiter
The View
by Willem H. Buiter

Cryptocurrencies like bitcoin solve none of the problems of fiat money, and add some new ones

  • Believers in cryptocurrency insist it offers a transparent, decentralised alternative to the fiat monetary system
  • In reality, it has all the same inconsistencies, with the added drawbacks of being spectacularly risky, carbon intensive and easily co-opted for cybercrime

The price of bitcoin has undergone yet another wild gyration, rising from US$41,030 to US$69,000 between September 29 and November 10 last year, before falling back to US$35,075 on January 23. That is its second-largest decline in absolute value, though it has suffered larger declines in percentage terms, notably falling by 83.8 per cent between December 15, 2017 and December 14, 2018.

More broadly, the cryptocurrency market (comprising some 12,278 coins) was estimated to be worth US$3.3 trillion on November 8, 2021, before plummeting to US$1.75 trillion as of January 30.

A private digital asset based on a distributed ledger technology known as blockchain, bitcoin is used as a decentralised digital currency – a peer-to-peer electronic cash system. With no intrinsic value, its market valuation (in terms of US dollars) is nothing more than a bubble.

If you got in early – the price of bitcoin was US$327 on November 20, 2015 – and held on for dear life, you would be looking at a capital gain of 11,521.5 per cent as of January 30. But although bitcoin could be worth US$200,000 by the end of this month, it could also be worth nothing. There is no anchor.

If, through a random convergence of random factors, bitcoin achieves a positive valuation at some point, subsequent valuations must be driven by the arbitrage condition requiring that risk-adjusted returns on different assets be equal. And because zero is always a possible valuation for bitcoin, we can expect wild swings in its price.

True, the same applies to the valuation of central-bank-issued fiat money. Though its use in paying taxes and its status as legal tender give it a leg up on cryptocurrencies, economics falls short when it comes to determining the market value of this central bank liability.

Lacking intrinsic value, it is freely convertible only into itself. And though one can postulate a well-behaved demand function for real money balances, this amounts to assuming the problem away.

Nor does it help to assume that the real stock of central bank fiat money yields unspecified productive services or mysterious uses for households. The best economics has come up with is the assumption that efficient barter is impossible, and that fiat money is therefore necessary to execute essential transactions, like consumer purchases.

But even if we could squeeze a meaningful demand for real money balances out of our intrinsically valueless fiat-money universe, determining the price of money (the inverse of the general price level of goods and services) would remain problematic, because, in a world of flexible prices, there will always be multiple equilibriums.

For example, assume the nominal money stock (the total supply of currency in the economy) and every other relevant factor is kept constant. Even under these simplified conditions, there is nothing to pin down the initial value of the price level.

There is always an equilibrium with a zero price of money (implying an infinite general price level). Moreover, for different initial conditions, there may be rational inflationary bubbles or deflationary bubbles, limit cycles, or chaotic behaviour. There also is a unique “fundamental” equilibrium in which the price of money is held to be positive and constant.

Finally, random transitions between different equilibriums can also be equilibriums in themselves. With irrational behaviour and inefficient markets, the scope for market turmoil increases.

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Neoclassical economics asserts that the fundamental equilibrium prevails, whereas Keynesian economics avoids the multiple-equilibriums conundrum by insisting that the general price level is not a flexible asset price driven by arbitrage.

Instead, it is sticky or rigid. History assigns an initial value to the general price level, which is then updated with a dynamic inflation equation like the Phillips curve (which asserts a stable, inverse relationship between inflation and unemployment). That approach is not great, but I can live with it.

When central-bank-issued fiat currency has value, so, too, do private assets that are confidently expected to be convertible into central bank money on demand and at a fixed price (like commercial bank deposits). And government deposit insurance boosts that confidence even when most assets held by banks are illiquid.

By contrast, stablecoins – digital currencies that are supposedly convertible into dollars on demand at a fixed price – are effectively deposits without the insurance. When and where they are accepted, they can facilitate digital payments.

But they are risky even if the assets held against them have intrinsic value. And if the proceeds from a stablecoin issuance are invested in intrinsically valueless crypto assets, that stablecoin’s stability is bound to be challenged by the markets.


Malaysian police flatten US$1.25 million worth of bitcoin-mining machines with steamroller

Malaysian police flatten US$1.25 million worth of bitcoin-mining machines with steamroller
The current popularity of spectacularly risky, intrinsically worthless cryptocurrencies is hard to fathom, and buyers’ faith in a blockchain’s ability to maintain an unalterable record of transactions may soon be tested by the arrival of quantum computing, creating even more risks.
Moreover, the amount of energy consumed by proof-of-work distributed ledgers – like bitcoin’s blockchain – becomes more massive with every transaction, making the case for proper carbon pricing or, failing that, a tax on cryptocurrency mining.
Finally, the anonymity afforded to cryptocurrency holders raises serious concerns about illegal uses of funds, including tax evasion, money laundering, hiding proceeds from ransomware attacks and other cybercrimes, and financing of terrorism. The issue has become urgent – and regulation may not be enough.
Willem H. Buiter is a visiting professor of international and public affairs at Columbia University. Copyright: Project Syndicate