Are Bitcoin and Other Cryptocurrencies the Future of Money?

As the market cap for cryptocurrencies crosses $170 billion today, one can’t help but question if this is really sustainable.

The promise of cryptocurrencies sounds great–instant worldwide transactions, low fees, money that can’t be inflated at whim by central banks. A technology platform that would enable these things is fantastic, but whether or not cryptocurrencies are viable currencies in and of themselves is a different matter.

Right now cryptocurrencies are the investment du jour. Even mom and pop investors are starting to put money into Bitcoin, Ethereum, and other alt coins as part of their retirement nest egg. And there’s no denying that money is to be made in the Wild West era of cryptocurrency trading.

However, if cryptocurrencies are to succeed at their aims of becoming actual money, then we’ll need to get to a point where people no longer look at cryptocurrencies as investments. We’ll need to get to a point where people get paid in cryptocurrency, get mortgages in cryptocurrency, and use cryptocurrency as actual money for their groceries, lattes, and other purchases.

To highlight the difference, would you buy Euros or Pounds or Yen to put in your retirement account because you think they will grow in value vs. the dollar over the long term? Of course not. The only time most people buy other currency is when going on vacation.

Let’s take a look at where cryptocurrencies are now and what it would take for them to become viable currencies.

The evolution of money

Before we talk about the future of money, we need to know a little bit about the history of money and how we got where we are today.

The traditional story of money taught in school says that in the beginning people didn’t have a form of currency and traded through bartering.

As people become more specialized in their production and the number of goods in society increases you run into a problem. Let’s say you are a cheese maker and you need a chair. What happens if the chair maker doesn’t need or want any cheese?

Eventually certain goods such as seashells, beads, and precious metals became used as commonly accepted forms of value in the same way we think of paper currencies like the dollar today. Now you could sell your cheese to someone who wanted it for a few pieces of the locally accepted currency, and then spend that to buy a chair. The chair maker in turn could use the currency to buy whatever he wanted.

However, not everything makes for a good medium of exchange. Ideal money is typically listed as having 5-7 different properties. The most relevant to discussion here are: limited supply, portability, durability, divisibility, and–especially–stable value.

Over time precious metals beat out other so called commodity currencies for acceptability because they better satisfied these criteria. Metal can be reshaped and divided into any quantity that you want, it’s nearly indestructible, supply is limited, and increases in the overall supply are very gradual which leads to relatively stable value.

However, precious metals like gold and silver are heavy and difficult to transport, which lead to the advent of paper currencies. Initially banks issued paper currencies as IOUs against their gold or silver holdings. The inherently worthless paper was “worth” something because you could exchange it at the bank for its value in gold or silver.

In a move that still alarms some economists today, government controlled banks eventually abandoned the gold standard. Now paper money is backed by the strength of the governments issuing it–what is known as fiat currency.

What makes money “worth” something?

In the traditional story of money, commodities that became currencies had value because they were also desired commodities to begin with. In other words people wanted gold and silver for other uses than just money, like jewelry. In prisons other desired commodities like cigarettes and, recently, ramen noodles have been used as currencies.

The economists who decry fiat currencies do so because they are not backed by anything of value. The currency is only worth something because the government says it is and we all buy into it. It also gives government the power to print money at will which violates the limited supply property of a good currency. Governments are tempted to do this because it makes it easy to pay off debts, but it comes at the cost of inflation. What some call a hidden tax.

What makes cryptocurrency “worth” something?

According to old school economics, cryptocurrencies are doomed from the start because they are inherently worthless–no one has any desire for an otherwise useless bit of code for any other purpose. And unlike the inherently worthless bits of fabric fiat currencies are printed on, there isn’t even a government backing their value.

But is that the whole story?

Nick Szabo, one of the pioneers of cryptocurrencies, proposes an alternate theory of value that says good currencies have a property called unforgeable costliness. Unforgeable because it is difficult or impossible to make fakes. And costly because it’s scarce and difficult to obtain.

Gold, for example, is unforgeable. People have tried for centuries to convert other metals into gold and failed. Gold is forged in the heart of a dying star going supernova as lighter elements are fused together into heavier elements. Good luck replicating that in the lab!

And gold is costly because it is scarce. In fact, because of the way gold is formed, gold is guaranteed to be a scarce element throughout the entire universe.

The benefit of unforgeable costliness is that people can easily identify the genuine article and transact with high confidence that they are not being duped by fake currency.

Unforgeable costliness is very similar to a concept in biology called honest signals. We desire genetic fitness in a mate because we want mates who will produce strong, healthy offspring. But it’s very difficult to assay genetic fitness directly, so we use proxies. Ask a woman what kind of men she likes and the first thing she’s likely to say is “tall men.” Ask a man and the first thing he’s likely to say is “big boobs.” While in the modern world we’re conditioned to consider height and breast size superficial methods for mate choice, historically tall height and large symmetric breasts were biologically costly to produce and difficult to fake which made them viable honest signals for mate choice that we could easily identify at a glance.

Similarly, unforgeably costly currencies could be said to exhibit honest signals that tell us their value at a glance.

Cryptocurrency replicates the property of unforgeable costliness in two ways:

Clever use of mathematics and cryptography. Transactions are unforgeable because they must be validated by a network of independent computers. This means the cost of hacking the system outweighs the benefit of hacking the system, and you can’t add new currency to the system as simply as editing a cell on a spreadsheet.
Limited supply. Cryptocurrencies have built in, pre-determined supply caps. Bitcoin, for example, has a hard cap of 21 million coins.

Of course the obvious question is, is Nick right? Is unforgeable costliness really the property that gives money its value? Or does value really come from a commodity underlying a currency having desirable properties other than its use as a currency?

Again, to look at gold, I think it’s very difficult to make the traditional desirable properties argument. Sure today gold has various uses in electronics, but gold was used as currency long before we harnessed electricity. Gold’s use is primarily decorative. But why gold instead of other metals? Unforgeable costliness presents a much more compelling argument.

What challenges do cryptocurrencies face?

Recall earlier we said that a desirable property of money is stable value. In fact, stable value is the single most important property. Accordingly, the single largest barrier to cryptocurrencies becoming viable money for everyday use is high volatility.

What if you were paid a fixed salary in cryptocurrency but the price of a cheeseburger was the equivalent of $6 one day, $1,000 the next day, and then $20 the following day. Budgeting becomes impossible. This level of price swing is the reality for some cryptocurrencies.

“But,” you object, “no currencies are completely stable!” Of course, but if one currency changes even 1% in a day relative to another currency on the Forex market, that is a big move. Even inflation in major currencies is relatively predictable which enables banks to make 30 year fixed rate mortgages. If a currency slips in value by even 10% in a year you start to worry that any country using it is headed for serious trouble.

Cryptocurrency advocates are quick to point out that the value change for cryptocurrencies is generally up. In fact, dramatically up over the past few years. A welcome change from fiscally irresponsible governments devaluing their currencies.

Even if we posit that cryptocurrencies are not in a bubble, this is still not a good thing if cryptocurrencies are to become viable currencies for day to day spending. Imagine if a friend lent you 10,000 bitcoins in 2009 and demanded that he be paid back in kind. At the time you’d have about enough to buy a pizza. At the time of this writing you would owe your friend the equivalent of $49,000,000!

Or imagine you want to buy a house and need a mortgage. How could the bank possibly issue you one with a currency that varies wildly? And even if they were willing to, how could you possibly accept the terms of the loan?

Even if we posit that cryptocurrencies have some kind of value via unforgeable costliness, we still need that to be stable value.

Will the value of cryptocurrencies ever stabilize?

That’s the trillion dollar question. Generally as trade volume of a commodity increases, volatility decreases. Eventually demand for any given cryptocurrency may become saturated. Taken together these two things will have stabilizing effects.

As more merchants accept cryptocurrencies as payment this will also help.

I am hopeful. But there is still a large gap from the Wild West cryptocurrency-as-investment speculation phase we are in now to using cryptocurrencies for their intended purpose–as our everyday money.