Edward Lotterman
With its market price recently passing the psychological $100,000 milestone, bitcoin is making history.
Enthusiasts, including many in Donald Trump’s camp, clamor for the U.S. government to buy the crypto-coins, keeping on until we hold 5% of the world’s supply.
The reason cited is that these coins would “act as a hedge against inflation.” Trump, once sworn in, may introduce legislation to do this. GOP majorities, joined by some Democrats, might well pass a bill. Individual states may face calls to jump on the same bandwagon.
Should we as a nation or as states do this? For a prudent conclusion, start by considering wisdom from the ancient past:
The Preacher in the Old Testament book of Ecclesiastes tells us that “There is nothing new under the sun.” An ancient Greek, perhaps the playwright Aeschylus, recognized that “Whom the Gods would destroy, they first make mad.”
U.S. promoter P.T. Barnum asserted, “There’s a sucker born every minute.” Thomas Tusser, a British poet-farmer from the 1500s, warned, “A fool and his money are soon parted.”
These wisdoms were not born in a vacuum; they are the conclusions of experience.
In other words, the current bitcoin frenzy is just that — insanity. Cryptocurrencies are in a classic financial bubble. All bubbles pop eventually. Enthusiasm always reaches a fevered pitch before disaster. And a rueful, “what the hell was I thinking?” always pervades the survivors while real damage is done to real people.
Those who say, “this time it’s different,” must understand that that assertion has been common in every bubble over recorded history. It’s never different. Those who argue, “bitcoins are going great so far,” need to remember that the I-35 bridge through Minneapolis went great for 39 years — until it suddenly didn’t.
The economics in all this is simple. College freshmen encounter it a few weeks into their introductory macro-econ courses when they learn about “money.” Some college-grad crypto enthusiasts might need a refresher. So here it is:
To be money, something must serve as a:
• “A standard of value” to indicate relative worth of different things;
• “A store of value” to save up value produced in one period for spending in another
• “A medium of exchange” to buy and sell goods and services.
Many things can have great value — Bugatti Royale autos, diamonds, Judy Garland’s ruby slippers, Nobles County farmland, Stradivarius violins. That does not define them as money.
Objects that people value can serve as standards of value for a time — until they are no longer scarce. Lucky Strikes or Spam bought goods and services in many places in 1945. But how many cigarettes or tins of cured meat can buy you a new F-150, pair of pajamas or semester at Carleton in 2025?
Mediums of exchange have varied greatly, salt in Roman military pay, cigarettes in WWII POW camps, bread in Josef Stalin’s gulags. But all have faded away because they were imperfect in this use.
So unless something can fulfill all three functions reliably over time, it cannot function as “money.”
Gold and silver do, although their values have fluctuated more over time relative to a standard basket of goods than many realize. So too, despite temporal bouts of inflation, have fiat currencies such as the British pound, U.S. dollar and Swiss franc. Bitcoin, admittedly, has served this purpose too, especially — by assuring the anonymity of the purchaser and recipient — in enabling online payments for drug shipments or ransomware to be handled consequence-free.
But the key for a cryptocurrency it has to be available and reliable over time. Successful fiat currencies have their values supported by prudent central bank monetary policies, the taxation powers of government and faith in that government’s stability. Corporate stocks are backed the earnings and capital of the companies that issue them. Private bonds are backed by collateral pledged by the issuer and often by cash flows from the facility business expansion financed by the bonds issuance.
In contrast, bitcoin has no such backing, either in assets or cash flows. As with the causes of other bubbles, its value is determined solely by the demand for bitcoin. The bubble bursts when people stop buying it.
So how did this crypto-mania get started?
High inflations hitting all major currencies from the mid-1960s into the 1980s harmed hundreds of millions of people. It especially scourged owners of long-term bonds being paid low, pre-inflation interest rates. People, especially libertarians wary of all government, searched for solutions.
Many economists advocated “rules, not discretion” in monetary policy. Objective criteria should be used to manage money supplies and interest rates, not committees sitting around tables in Washington, D.C., Tokyo or Frankfurt. The “monetarist” and “rational expectations” schools of thought within the economics discipline especially stressed this.
Some argued that “private currencies” could bring discipline and stability. If government’s monopoly on money were revoked and private suppliers allowed to issue currencies, then people would come to prefer whatever money seemed resistant to inflation. They would flock to it. Government money would be shunned.
Computers, the internet, and mathematically-based “blockchain” technologies presented a way to implement such private currencies. Payments using real dollars have long been made electronically between financial institutions and individuals, so who says these payments could not be made with something of consensus value that is not a dollar — something “mined” through a computer?
So as these private, non-governmental transactions became feasible, blockchains could then strictly limit the issuance of new units of any “crypto-currency.” These were transparent and immune to counterfeiting. They could be transferred between “purses” owned by different people or companies. Creating new coins could only be done by solving complicated mathematical problems with hours of computer time.
With control of the quantity of money out of the government hands, even those of supposedly autonomous central banks like the Federal Reserve, crypto would be a rock-solid hedge against government irresponsibility. The most trusted, most popular cryptocurrency would become an international standard of value and a trustworthy store of value. Fluctuating, government-manipulated exchange rates would be a relic of the past. Utopia indeed!
But demand for the new cryptocurrencies, especially bitcoin, rose faster than they could be produced. Their value in fiat currency terms grew, albeit very fitfully. And then, as with tulips in 1630s Amsterdam, South Sea Company stocks in London around 1711 or downtown Tokyo real estate 40 years ago, the urge to buy something simply because many others had the same urge took over. Fluctuations were drowned in an upward surge.
The vast bulk of purchased cryptocoins now are not being used as a better method of buying gas or ordering shampoo online. They are being treated more like a financial security, but without any assets or cash flows nor even the “going concern” status of a corporation or the full faith and credit of a state or city. Moreover, with bitcoin prices varying from near $65,000 this time in 2021, to under $17,000 two years ago, to over $100,000 today, this particular crypto has little use as a stable store of value. Nor is it even a standard of value. What would give the more reliable indication of the value for a section of cropland near Fairmont, Minn., or a truckload of ½” rebar or #2 yellow corn, U.S. dollars or bitcoin?
Other dangers abound.
Bitcoins can only be produced by solving mathematical problems with vast arrays of computers wasting enormous amounts of electricity. But, just as in the hopscotch race between impenetrable tank armor and overpowering tank guns, how can anyone know when a new computer chip or a new algorithm will permit faster bitcoin mining? Discovery of gold at Sutter’s Mill in California drove U.S. prices through the roof in the 1850s, as did the Alaska gold rush and even as did the use of cyanide rather than mercury to separate gold from ore. But as with all commodities, as supply increased relative to demand, price went down.
All manias end. Bitcoin’s end may not be near. But cryptomania will hit a wall sooner than many realize even though the underlying blockchain technology will be of great use.
Don’t waste time emailing me or Warren Buffett, a more famous sensible crypto-skeptic, to explain our blind stupidity. Instead, search out a copy of Charles Kindelberger’s classic “Manias, Panics, and Crashes” to read up on how these events will unfold.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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