By Willem H. Butler
The price of Bitcoin has undergone yet another wild gyration, rising from $41,030 on September 29, 2021, to $69,000 on November 10, 2021, before falling back to $35,075 on January 23. That is its second-largest decline in absolute value, though it has suffered larger declines in percentage terms, such as between December 15, 2017, and December 14, 2018, when it fell by 83.8%. More broadly, the cryptocurrency market (comprising some 12,278 coins) was estimated to be worth $3.3 trillion on November 8, 2021, before plummeting to $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 decentralized 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 and “held on for dear life” – the price of Bitcoin was $327 on November 20, 2015 – you would be looking at a capital gain of 11,521.5% as of January 30. But although Bitcoin could be worth $200,000 by the end of this month, it also could be worth nothing. There is no anchor.
If, through a random convergence of random factors, Bitcoin achieves a positive valuation at some point in time, subsequent valuations presumably 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 instead 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.
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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 equilibria.
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 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 behavior. 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 equilibria can also be equilibria in themselves. With irrational behavior and inefficient markets, the scope for market turmoil increases.
Neoclassical economics asserts that the “fundamental” equilibrium prevails, whereas Keynesian economics avoids the multiple-equilibria 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.
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.