August 22, 2024

By Olav Syrstad

Bitcoin and other cryptocurrencies are generating significant buzz. Proponents of cryptocurrencies use terminology that might lead us to believe they represent the future of money. The most ardent supporters claim that Bitcoin (or other cryptocurrencies) represents a new monetary system where a fixed supply ensures its relative value over time without the need for burdensome regulation and intermediaries. In this blog post, I will examine some of the most popular claims about cryptocurrencies in light of the current monetary system. 

For all practical purposes, current money consists of call deposits issued by banks. These deposits are claims on banks' assets, primarily loans to households, companies, and governments. Such loans are again secured by real estate, production equipment, vehicles, and borrowers' future production capacity. Consequently, our deposits are also secured by these assets. When a bank provides credit, more deposits (money) are created as the debtor initially gets her deposit account credited by the bank. However, as a depositor, you can convert your deposits to other assets, including forms of bank debt or bank equity. All else being equal, when deposits are converted to other forms of bank liabilities, or loans are repaid, the money supply decreases since only call deposits can be used to settle transactions. 

The supply of money is elastic, meaning it follows economic activity (demand and supply of loans) and the population's demand for money (driven, among other factors, by the efficiency of the payment system). By using bank-issued debt claims as money, we have developed an efficient and resilient monetary system. It is efficient because bank debt can easily be divided, transferred, and regulated, and resilient because the collateral adapts to structural changes in the real economy. 

The value of our money is based on trust, which can be divided into two pillars. The first pillar implies that our deposits maintain their nominal value; if you have 100 in deposits, you are guaranteed to receive 100 in nominal value. Several mechanisms are built into our monetary framework to secure the nominal value of money. 

First, depositors must trust that their deposits are safely stored and transferable. Deposits are held in banks, so the first layer of trust relates to these institutions. However, banks may grant loans to unqualified borrowers, and real assets can be overvalued. This may lead to excessive risk-taking, especially when the losses are socialized (as with rescue packages of banks in times of crisis). As a result, authorities have established safeguards to reduce the probability of excessive risk-taking in the banking sector, ensuring trust in banks and, by extension, the nominal value of our deposits. Regulation and scrutiny of banks' activities are the primary means to protect the value of our claims on banks' assets and ensure trust. 

This system is not without flaws. Bank failures and financial crises do occur. To further mitigate the risk of deposit loss, there is a deposit guarantee ultimately backed by the government's ability to collect taxes. As a result, nominal losses of deposits covered by the guarantee are extremely rare. Moreover, to ensure that deposits can be used to settle transactions, they must be defined as legal tender and connected with an efficient and stable payment system. Thus, trust in the nominal value of money is secured by banks' assets, the regulatory framework, the deposit guarantee, and an efficient infrastructure enabling fast and reliable transfers of deposits. 

The second pillar relates to trust that deposits will maintain their real value, meaning the purchasing power of deposits should remain relatively stable over time. Even if the nominal value is secured, deposits may be worth less if the prices of goods and services increase rapidly. In developed countries, the task of maintaining the real value of deposits is typically assigned to an independent central bank that focuses on keeping inflation low and stable. The main tool for achieving this is the short-term interest rate. By setting this rate and ensuring that interest rates on deposits and loans follow suit, the central bank can respond to unexpected and expected price changes. If the price level unexpectedly increases, the nominal interest rate set by the central bank, and subsequently the deposit rate, increases. This way, your deposits will grow by the nominal interest rate to compensate for higher prices. 

How does a cryptocurrency like Bitcoin compare to deposits in terms of ensuring these two pillars of trust? Regarding trust in nominal value, Bitcoin has its own settlement system that enables secure peer-to-peer transactions. If the costs of such transactions are low, this aspect of nominal trust is not problematic for cryptocurrencies. However, there is a notable difference in backing: Bitcoin is not a debt claim and thus has no backing at all. This has important implications. Unlike deposits, which have value independently of being characterized as money, Bitcoin's value is solely based on its function as money. Consequently, Bitcoin's nominal value could suddenly become zero if people find another type of money more attractive. Moreover, since the nominal value of deposits is backed by banks' assets, swapping an unbacked cryptocurrency for deposits is a form of wealth transfer. 

To understand how wealth is transferred, imagine a dictator suddenly decides to introduce a new form of money based on blockchain technology. The dictator issues a cryptocurrency called Bullshitcoin to replace the current deposits in the economy. Bullshitcoin is issued in the exact same quantity as the outstanding amount of deposits. All depositors are forced to swap their deposits for Bullshitcoin – 1 unit of deposits for 1 unit of Bullshitcoin and all goods and services will be denominated in Bullshitcoin. In principle, the old depositors keep their purchasing power in this swap and do not find reasons to complain. If you held 100 in deposits, you now have 100 in Bullshitcoins. All good – right? 

Unfortunately, if we fail to understand that deposits, in addition to being money, are claims on real values, we may not realize that the swap initiated by the dictator is a robbery. The former deposit holders have exchanged claims on real values for something completely detached from the real economy (the dictator does not give up any current or future production). The old deposits, i.e., the claims on banks’ assets, are now in the hands of the dictator. These deposits cannot settle transactions anymore, but the dictator keeps these claims while earning interests and receive the downpayments of the loans. The deposits that before functioned as money are now normal debt claims on the banks’ assets and are valuable independently of being characterized as money or not. 

To illustrate how this wealth transfer unfolds even when the deposits are simply replaced one for one with Bullshitcoin, imagine that everyone with a mortgage loan in the bank (now denominated in Bullshitcoin) borrows Bullshitcoins from the old depositors and uses the proceeds to pay down their original bank debt (that is, the banks are replaced by private borrowers). This means that all borrowers in the economy replace their bank debt with debt issued by the owners of Bullshitcoins. The bank will then receive Bullshitcoins and transfer them to its liability holders – in this case, the dictator. Suddenly, the dictator possesses all the Bullshitcoins. Now, the dictator can buy real assets like real estate, goods, and services. If anyone fails to pay their debt, the dictator will receive their collateral. By swapping Bullshitcoin for deposits, the dictator is secretly extracting real value from the population. This can be viewed as the population being heavily taxed to settle transactions. If the dictator is a benevolent social planner, they will distribute the tax receivables to the population fairly. In contrast, a greedy dictator may use the Bullshitcoins to acquire valuable properties or other goods and services for personal benefit without contributing to the production of these assets. This is analogous to cryptocurrency miners selling crypto for deposits, with the key difference being that no one is forced to buy these cryptocurrencies. 

Now, let's turn to the second pillar of trust: the real value of money. In the current monetary system, there is a risk that the central bank might not fulfill its role and allow inflation to erode the purchasing power of deposits (for instance, to reduce the real government debt burden) by keeping interest rates too low and money growth high. Bitcoin proponents argue that this won't happen with Bitcoin due to its fixed supply, which they claim will not facilitate such price increases. However, it is not necessarily so that a fixed supply of Bitcoin will effectively limit money growth. 

Instead, there's a high probability that a monetary system based on Bitcoin as money will evolve to resemble the system we have today. This includes regulation and a money supply that becomes elastic despite the cryptocurrency's fixed supply. Ironically, blockchain technology makes this more likely. The reason is due to assets other than cryptocurrency, like debt claims, can be used as money. Debt is crucial for a well-functioning economy regardless of the type of money we use. In an economy based on a supply-restricted cryptocurrency, alternative sources of money will likely arise. Since blockchain technology enables peer-to-peer transfers of all types of assets, it becomes even easier to employ other assets as money. 

To illustrate this concept, let's imagine an economy with a finite supply of Bullshitcoins. Otherwise, the society is organized similarly to Western economies today, with a democratically elected government collecting taxes to cover public expenditures. There will be borrowers who want to borrow Bullshitcoins and savers who provide Bullshitcoin loans. This activity creates debt claims backed by real values. These claims, particularly the safest among them, can be tokenized and eventually used as money. In such a case, the money supply is not at all fixed. 

A stylized example may be illustrative. The government issues a token with par value to Bullshitcoin. This government debt-token has a long maturity but pays daily coupons according to some nominal interest rate (interest rate determination in a monetary system like this is beyond the scope of this blog). If this debt is regarded as safe (a fair assumption in many countries), the high-frequency and variable coupon payments ensure price stability relative to Bullshitcoin. The government will start spending, thereby recirculating the Bullshitcoin. With a fixed supply of Bullshitcoin, higher demand for goods and services should lead to a downward adjustment of the price level. However, instead of lowering their prices, merchants may start accepting the government token as payment. To enforce the use of government tokens as money, the government can accept these tokens for tax payments (in this case the government can create money as its own discretion, very much like the central bank can today). 

Obviously, privately issued tokens can play the same role as government tokens. Private institutions may issue tokens to invest in high-quality and collateralized private or public debt. These tokens may also be used to settle transactions. In such a case, it is most efficient for different tokens to be convertible at parity with each other. To enforce this, regulation and clear definitions of who can issue tokens regarded as legal tender (as defined by the government) may be necessary. This regulation would then relate to the risk on the asset side of the institutions issuing tokens to prevent sudden drops in the value of the assets and thereby a loss in value of the token used as money. 

The debt claims used as money in the example above resemble both deposits and near-money assets (like money market shares) in the current monetary system. The best way of organizing borrowing and lending to a large network of heterogeneous borrowers may be through bank-like institutions. To prevent excessive risk-taking, regulation may be necessary – not to regulate money, but to regulate debt. This looks familiar to the system we have today – except that the private issuers of the Bullshitcoin have reaped real value from the rest of us. The important messages are that (i) debt is not limited by the money we choose to use, (ii) debt is the driver of financial fragility, and (iii) debt is an important reason for financial intermediaries and regulation. 

In conclusion, a cryptocurrency like Bitcoin has one of the features needed to function as money: namely, a settlement system. However, since Bitcoin has no backing and blockchain is making competing payments alternatives readily available Bitcoin is much more prone to losing its nominal and real value. The current monetary system, while not perfect, has evolved to address many of the challenges that cryptocurrencies face. It provides a balance between elasticity and stability, backed by real assets and regulated to protect users. While cryptocurrencies offer some interesting technological innovations, they may not be the panacea for monetary issues that some proponents claim them to be.