Finder makes money from featured partners, but editorial opinions are our own.

Why do so many brilliant economists struggle with cryptocurrency?

Posted:
News
least volatile cryptocurrency

Four reasons why even the best economists are having such a hard time getting a grip.

OPINION

Paul Krugman is a Nobel Prize-winning economist, distinguished professor of economics at the Graduate Center of the City University of New York, regular columnist for The New York Times and a prolific commentator on economic issues.

So he probably knows a thing or two about money.

His grasp on crypto-money might be much weaker though, as shown in a recent op-ed in The New York Times, and only as good as all the other highly experienced economists and senior bankers in his preferred echo chamber.

A lot of mistakes seem to be getting confidently repeated inside those illustrious circles.



An immature industry where academic rigour creates an echo chamber

"The enthusiasm for cryptocurrencies seems very odd, because it goes exactly in the opposite of the long-run trend. Instead of near-frictionless transactions, we have high costs of doing business, because transferring a Bitcoin or other cryptocurrency unit requires providing a complete history of past transactions. Instead of money created by the click of a mouse, we have money that must be mined — created through resource-intensive computations," he writes.

"And these costs aren't incidental, something that can be innovated away. As Brunnermeier and Abadi point out, the high costs — making it expensive to create a new Bitcoin, or transfer an existing one — are essential to the project of creating confidence in a decentralised system."

Krugman is referring strictly to the blockchain scaling trilemma in the context of proof-of-work coins. It's a problem, but it's being solved in many different ways.

Not all solutions will work, but it's clearly premature to just point at the scaling trilemma as an unsolvable problem and call it a day.

It's not clear why so many distinguished economists keep repeating this exact same broken argument, but it might be an unfortunate side-effect of academic rigour. There's a huge amount of research pouring into the cryptocurrency space, and much of it is focused on bitcoin and proof-of-work economic theories.

For an economist who's focused on traditional finance rather than crypto, and has better things to do than listen to people earnestly shill scam-coins as examples of a scaling solution, it might seem like proof of work is the only viable game in town and that everything else is just technobabble.

Cryptocurrency looks like a step backwards

If you're a world famous economist, you've been doing this for way longer than bitcoin has even been around. Your experience is focused on organised supplies of government-issued currency, and most forays into barter economies are done only in the context of how they impact the "real" economy going on next to it.

You've probably also had a nice rundown on the history of money, such as Krugman gives.

"First there were gold and silver coins, which were heavy, required lots of security, and consumed a lot of resources to produce," he writes. "Then came bank notes backed by fractional reserves. These were popular because they were much easier to deal with than bags of coins; they also reduced the need for physical precious metals.

"Even so, the system still required substantial amounts of commodity money. But central banking, in which private banks held their reserves as deposits at the central bank rather than in gold or silver, greatly reduced this need, and the shift to fiat money eliminated it almost completely. Meanwhile, people gradually shifted away from cash transactions, first toward payments by check, then to credit and debit cards and other digital methods."

The invention of banking, bank notes and central banking were unarguably some pretty super technological steps forward, and the most experienced economists are probably intimately familiar with that sequence and how each advance improved people's lives.

From that perspective, decentralised cryptocurrencies certainly aren't the next generation of money. They're just a primitive idea with a digital twist, and a pronounced step backwards that's thankfully doomed to fail.

Krugman says as much.

"Cryptocurrency enthusiasts are effectively celebrating the use of cutting-edge technology to set the monetary system back 300 years. Why would you want to do that? What problem does it solve? I have yet to see a clear answer to that question."

A reflexive fixation on the concept of innate value

Cryptocurrencies have no innate value, economists argue.

Neither does fiat currency, crypto-fans argue back.

However, Krugman puts a more tangible value on fiat, pointing out that "Fiat currencies have underlying value because men with guns say they do. And this means that their value isn’t a bubble that can collapse if people lose faith."

Fair point. Although fiat currencies absolutely can collapse upon a loss of faith, at which point barter systems and alternative currencies tend to kick in and those men with guns become quite problematic.

He also points out that gold more closely resembles bitcoin, and that while its perceived value certainly isn't in line with its real-world value, it can at least fulfil some kind of function to help people more easily pretend that it has value.

"Most gold just sits there, possessing value because people believe it possesses value. But gold does have real-world uses, both for jewelry and for things like filling teeth, that provide a weak but real tether to the real economy. Cryptocurrencies, by contrast, have no backstop, no tether to reality. Their value depends entirely on self-fulfilling expectations — which means that total collapse is a real possibility. If speculators were to have a collective moment of doubt, suddenly fearing that Bitcoins were worthless, well, Bitcoins would become worthless."

It's also worth noting that by this point bitcoin does have some innate value. It's not just a currency, but also the world's most widely used decentralised immutability machine. Data can be transmitted on the blocks for uncensorable storage and some projects use the bitcoin's block time "heartbeat" for their own purposes. And it's still a great value for money way of sending funds internationally without getting gouged by fees. Other cryptos might be even cheaper, but bitcoin's liquidity makes it arguably the best choice for the job. It might not be enough to justify the price, but bitcoin still has enough functionality to be more strongly tethered to reality than gold prices are.

Most of all, it's worth emphasising that bitcoin serves a practical purpose as a mining reward, giving the people with a lot of bitcoin and the means to make more a vested interest in keeping prices high. Bitcoin has innate value in the form of a limited set of functions and a lot of cold, hard greed invested in preventing its prices from collapsing. It's not great, but it's certainly not nothing. But you can see how economists would be uninspired by what's essentially a cynicism-backed currency.

Either way, that's just bitcoin and it has nothing to do with cryptocurrency as a whole.

It's not money

One of the main reasons so many economists are grabbing the wrong end of the cryptocurrency stick might be because they're mistakenly thinking of it as a currency equivalent, rather than myriad assets in a universal barter economy.

They keep looking at money metrics like the concepts of innate value, and counting up the number of merchants who accept it and drug lords who evade taxes online rather than with cash, and wondering how on Earth sensible monetary policy is ever going to be maintained with a decentralised digital currency.

Instead, it makes more sense to look at them all as assets circulating in the same economy, with each finding an exchange rate next to each other in different markets – it's all just one big barter economy.

You can already find cryptocurrencies that are very tangibly backed by valuables such as access to commercially useful data, a portion of the human attention span, the right to place bets on a global prediction market, a single Big Mac and much, much more.

And in this sprawling marketplace, you also have currencies backed by less tangible values such as government assurances, sheer greed and a desire to get rich quick or just an IOU from one person. People might hold and transmit value however they want and ideally be able to exchange one type of value for another quickly as needed.

This chaotic-sounding barter future isn't just for the heck of it because it also solves the problem of always needing to use money.

All economies are barter economies, whether you're bartering dollars for donuts or a sheep for a bitcoin.

As Krugman said:

"If you look at the broad sweep of monetary history, there has been a clear direction of change over time: namely, one of reducing the frictions of doing business and the amount of real resources required to deal with those frictions."

Money was invented as a solution to the frictions of a barter economy, but it comes with some frictions of its own. Cryptocurrency offers room for improvement.

In the end, the main reason so many brilliant economists are having trouble understanding it is because it's extraordinarily wild and far-fetched. But so was the invention of money, the creation of bank notes and the first central bank. And now cryptocurrency is shaping up to be the next major fundamental leap forwards.


Disclosure: At the time of writing, the author holds ETH, IOTA, ICX, VET, XLM, BTC and ADA.

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade. Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.

Latest cryptocurrency news

Picture: Shutterstock

Ask a Question

You are about to post a question on finder.com.au:

  • Do not enter personal information (eg. surname, phone number, bank details) as your question will be made public
  • finder.com.au is a financial comparison and information service, not a bank or product provider
  • We cannot provide you with personal advice or recommendations
  • Your answer might already be waiting – check previous questions below to see if yours has already been asked

Finder only provides general advice and factual information, so consider your own circumstances, or seek advice before you decide to act on our content. By submitting a question, you're accepting our Terms of Use, Disclaimer & Privacy Policy and 6. Finder Group Privacy & Cookies Policy.

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.
Go to site