Recent rallies in the price of Bitcoin and similar assets have catapulted cryptocurrencies into public notoriety. Some consider the newfound popularity of these coins a passing fad, akin to the excesses of historical bubbles; others view them as groundbreaking alternatives to fiat currency, with the potential to supplant existing financial systems and central bankers.
Most public discourse has focused on the profitability of trading crypto-assets and, to a lesser extent, the blockchain technology that underlies them. However, there has been relatively little discussion of the underlying economics of the currencies themselves and of the new crop of companies minting their own tokens to raise money. Yet even a cursory analysis of economic history poses some fundamental puzzles to the economic viability and success of these ventures and their initial coin offerings (ICOs). The fact that many cryptocurrencies have fixed supplies precludes the possibility that they could be used sustainably for transactions. Economic history offers an explanation for why this is the case.
The Cigarette Economy
Radford’s “The Economic Organisation of a Prisoner of War Camp” offers an instructive historical analogue. In 1943, American economist Richard Radford, fighting for the Allies, was captured by German forces and kept in a Bavarian prisoner of war (“POW”) camp. Each camp held between 1,500 and 2,500 people and regularly received rations of various foodstuffs and living essentials — milk, butter, biscuits, clothing, cigarettes, and so forth.
A barter economy soon developed. Different groups valued goods differently: Sikh prisoners were willing to trade canned beef for nearly anything, English prisoners sought rations of tea, and so forth. As a result, the relative value of different goods became well-known. Cigarettes, which came in standard units and were relatively durable and portable, emerged as the de facto currency; all goods were quoted in terms of cigarettes. Traders emerged, seeking to profit from price discrepancies. Some speculators would buy foodstuffs with cigarettes on the days that rations were issued (when food and other supplies were plentiful and thus available at lower prices) and sell them at higher prices shortly before the next issue date.
Like cryptocurrencies, cigarettes in the POW economy existed in relatively fixed supply, with periodic additions when Red Cross parcels arrived. As such, the cigarette currency was prone to periodic deflationary periods when new issues were interrupted. In such periods, “stocks soon ran out, prices fell,” and “trading declined in volume”. This makes sense — if there is a shock to or uncertainty surrounding the supply of goods and currency, then one would expect consumers to hoard currencies and cease trading. As cigarette prices increase, speculators and consumers alike are incentivized to collect rather than spend cigarettes, creating a self-fulfilling prophecy that stifles economic activity.
Cryptocurrencies and Cigarettes
The nature of fixed-supply cryptocurrencies are not unlike cigarettes. Consider the recent spate of “companies” raising financing through ICOs. When a company decides to raise money through an ICO, they mint new tokens to sell to investors. The new coins are like equity insofar as they are sold in a public offering. However, that is where their similarities end. Unlike equities, (most) coins are not certificates of ownership in a business or claims to its future cash flows. This being the case, how are investors in new cryptocurrencies actually compensated when they buy newly minted coins?
As with conventional equities, investors in an initial coin offering are rewarded if the underlying platform or product is successful. In any cryptocurrency, as with cigarettes in the war camp, there are two types of buyers — speculators in the coin’s value, who buy the tokens in anticipation of increases in price and “real” users, who buy the tokens in order to use the product. When investors buy a coin in its initial offering, their investment expresses the view that there will one day be enough popular demand for the platform, thereby increasing the token prices. Since the supply of coins in most offerings is fixed, the more popular a platform becomes, the more expensive its coin is. As a result, as with equity offerings, investors are theoretically incented to invest in the companies that they believe will do well.
But if the issuers must fix the token supply in order to attract prospective investors, then the underlying product must be subject to the same deflationary forces as cigarettes. Just as increases in the demand of cigarettes precluded economic activity in the POW camp, when the price of the tokens increase, the cost of using the underlying platform should also increase. This disincentivizes “real” users of the platform. Using the example of a blockchain-enabled version of Uber, why would I want to spend tokens for a ride today if I knew that my tokens would buy me two rides tomorrow?
One may counter that credit — borrowing tokens to pay for an Uber ride — should stimulate usage of the platform by obviating the need to part with my tokens until a later date. However, borrowing also becomes less attractive in a deflationary regime. Consumers who borrow in a currency that appreciates in price are penalized, as interest payments and repaying the principal become more expensive. In other words, borrowing cigarettes to pay for bread may be necessary for those short on cigarettes; however, the borrower may find it more costly to pay back what he has borrowed when the currency itself becomes scarcer.
Another counter is that prices in blockchain platforms could be tied to more conventional currencies like the U.S. dollar. Since cryptocurrencies are infinitely divisible, a blockchain platform could theoretically fix the price of its services or goods to dollar amounts instead of amounts of its token. (This would mean, among other things, that the proponent of digital coins must cede that cryptocurrencies would not be viable replacements to conventional fiat currencies). This is tantamount to suggesting a peg or tether of value.
Tethering the value of the cryptocurrency to a relatively stable asset or currency similarly does not succeed in ensuring price stability in a deflationary regime. The prisoners of war had a similar intuition. By issuing paper marks tethered to a fixed amount of food — say, 45 marks to a tin of milk or a one-to-one mark to cigarette rate — the prisoners of war sought to avoid the problems that emerged when there was a shortage of physical cigarettes. Yet when the camp was bombed and parcels and cigarette were halved, prisoners were reluctant to convert valuable goods and cigarettes into paper. There was a flight from the paper marks back to cigarettes and popular foods, returning once again to the same sort of deflationary problems. The value of the paper mark fell to 4/5ths a cigarette, and the issuer of the marks (in this case, the local restaurant), experienced a proverbial “run on the banks” in which their reserves were drained by the mob of people looking to exchange marks for food and cigarettes. While this may be advantageous to the individual with a large cigarette reserve, such a phenomenon would be detrimental to economic activity.
Analogously, it’s hard to say how cryptocurrencies are crucially different than their cigarette counterparts. Their basic parameters are the same. Like the cigarettes, there is a relatively fixed supply of each type of cryptocurrency (because otherwise, investors would not be compensated for investing), save for periodic new issues through parcels and mining. Like the POW camp, the activities of speculators have a real effect on the price of the coins, and thus, on goods and services.
Further, it’s unclear whether or not there are actually any “real” users of platforms and products raising money through ICOs. At least of this writing, it seems that the increases in the price of newly minted coins can be attributed mostly to the frenzy of far-sighted (or fanatical, depending on your point of view) investors and speculators. Of course, unless there are solid fundamental reasons why the platform should have “real” users who buy the tokens to use the product itself, then the sole basis for cryptocurrency price movements is in the musings of traders. And in fact, by likening cryptocurrencies to cigarettes, I’ve argued that the success of blockchain platforms themselves are negatively impacted by the sharp rallies in their tokens. In theory, this ought to cast aspersions on the long-term viability (and thus, prices) of crypto-assets.
Implications
None of this is to say that cryptocurrencies can’t serve as de facto currencies in some contexts and capacities, or that an enterprising speculator can’t make money from trading them. An arms dealer looking to avoid the scrutiny of law enforcement would be forced to use an anonymous, private medium of exchange. A citizen of a country experiencing hyperinflation may find that the only way to meaningfully transact and store wealth is by using cryptocurrencies. As long as such situations exist, there will always be some baseline value to storing wealth and transacting in cryptocurrencies. Indeed, the crux of the innovative nature of crypto-assets is in their decentralized transaction and database mechanisms, which allow for the transfer of value without error-prone or unscrupulous middlemen.
In fact, technologies like the blockchain may actually enable more effective monetary policy decisions. Cryptocurrencies do not, by nature, need to be fixed in supply. Developers of a new cryptocurrency could program monetary policy to expand or contract the supply of tokens in circulation according to economic activity. Modern-day central bankers make decisions based on lagged and imperfect economic indicators; as a result, policy decisions are imperfect. However, the possibility exists that when all transactions are recorded on a distributed ledger, policy can be truly data-driven. Though such a cryptocurrency may not be particularly attractive for investors in an initial coin offering, it would have the potential to fundamentally advance central banking.
However, questions regarding currency stability as it relates to economic activity are some of the most long-standing questions in the history of central banking. Economists, philosophers, and anthropologists alike have sought answers in vain. As the parable of the cigarette currency and POW economy shows, it remains to be seen whether or not there is a clear solution to problems in monetary policy as they relate to the usage of blockchain platform.