Mises Wire

Will Cryptocurrencies Pass the Market Test?

On Friday December 8, 2017, the price of bitcoin closed at $15,206– an increase of 28.3% from November. The yearly growth rate stood at 1,474%.

Many economists and financial commentators hold that in the unregulated market of the internet economy, bitcoin is likely to emerge as a new form of money that is going to bypass the central-bank supervision.

Bitcoin, the invention of a person, or group of people, using the name Satoshi Nakamoto, was launched on January 3, 2009.

The basic idea behind bitcoin is to create, by means of a mathematical algorithm, a substance that is scarce and fungible.

Nakamoto devised a software system that enables people to obtain bitcoins as a reward for solving complex mathematical puzzles. The resulting coins are then used for online trading. Nakamoto also arranged that the number of bitcoins can never exceed 21 million.

Some experts maintain that bitcoin will displace the existing fiat money and will usher in a new era of free banking, which will finally put to rest the menace of inflation.

To establish whether bitcoin is likely to become a new general medium of exchange (i.e. money), let us first see how money comes about. The distinguishing characteristic of money is that it is the general medium of exchange, evolved from the most marketable commodity. On this Mises wrote,

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. 

Money is the thing for which all other goods and services are traded. Furthermore, money must emerge as a commodity. An object cannot be used as money unless it already possesses an objective exchange value based on some other use. The object must have a pre-existing price for it to be accepted as money.

Why? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services.

The benefit money offers is its purchasing power, i.e. its price in terms of goods and services. Consequently, for something to be accepted as money, it must have a pre-existing purchasing power — a price.

Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears. The reason for this acceptance is that people now possess previous information about its purchasing power. This in turn enables them to form the demand for money.

RELATED: “Will Eliminating Cash Save the Economy?“ by Frank Shostak

The key to the acceptance is the knowledge of the previous purchasing power. It is this fact that made it possible for governments to abolish the convertibility of paper money into gold, thereby paving the way for the introduction of the paper standard. Again, the crux here is that an object must have an established purchasing power to be accepted as general medium of exchange, i.e. money.

It was through a prolonged process of selection that people had settled on gold as the most marketable commodity. Gold therefore had become the frame of reference for various forms of payments. Gold formed the basis for the value of today’s fiat money.

In today’s monetary system, the core of the money supply is no longer gold, but coins and notes issued by governments and central banks. Consequently, coins and notes constitute the standard money we know as cash that are employed in transactions. Notwithstanding this, it is the historical link to gold that makes paper money acceptable in exchange.

Observe that bitcoin is not a thing as such; it is a unit of a non-material virtual currency — it has no material shape. Thus, it is likely that bitcoin can function only as long as individuals know that they can convert it into fiat money, i.e. cash on demand (see, e.g., Lawrence H. White “The Technology Revolution And Monetary Evolution,” Cato Institute’s 14th annual monetary conference, May 23, 1996).

Given that bitcoin could be transferred rapidly across various locations makes it very useful in this regard, however this does not make it a new form of money but rather a new way of employing existent money in transactions. It is like issuing checks — which still must be cashed up.

Some supporters of bitcoin hold that it is on its way to becoming the general medium of exchange since it has already established a purchasing power. So on this score it is not important whether bitcoin had originated from a commodity.1

We can trace back its purchasing power until the point at which Bitcoin was invented. Certain people really did sell pizzas and other goods against bitcoins in the first transactions. Why did they do so? The reason is unimportant. The point is, they did do so. That gave everybody an objective frame of reference for the market value of bitcoins, which then snowballed to the present day.

One could argue that the fact that bitcoin has an established purchasing power with various goods and services could be an important step towards it becoming the general medium of the exchange. But on this logic, various other goods and services are good candidates to become money given that goods and services that are traded by implication must have a purchasing power.

Note that historically various goods have served as a medium of exchange such as wine, tobacco, gold and various precious stones. All these were participating in the prolonged process of selection until only gold became selected as the general medium of exchange i.e. money.

So from this perspective it is not enough to have an established purchasing power. A particular thing must also pass the market selection process. So far, we do not have much evidence that bitcoin has received general market approval.

Given that the present monetary system displays ongoing signs of instability because of the central banks abuses, we suggest that at some point in time it is more likely that gold could replace the present paper standard. (Note again that given the prolonged historical selection process gold is likely to renew its role as the general medium of exchange i.e. money). The trigger for this could be a severe economic crisis because of a severe depletion in the pool of real savings — the heart of economic growth.

As far as bitcoin is concerned, it is likely to feature along various electronic forms of money i.e. as a particular way of using the accepted medium of exchange.

Nor can the present monetary system cannot be saved by central banks. On the contrary, thanks to the central banks’ prolonged abuse of the monetary system, any further policies of tampering is going to destabilize the monetary system further and will speed up the emergence of the natural i.e. the market selected money. If history is any indication, the private-sector money is likely to just be gold. 

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