In my last post, I argued that cryptocurrencies, such as Bitcoin, have the potential to be competitive with fiat money because individuals’ trust in fiat money is necessarily limited by politicians’ control over its value. But I say potential, because while the Bitcoin is used as a currency in monetarily oppressive regimes, like Venezuela, it does not function as a currency in more established regimes. That, of course, does not mean that people do not hold it in nations like the United States. Some do, but most of these hold it for only small investments and use it to pay for a few items as a kind of hobby. The vast majority hold most of their investments in dollar denominated assets and use cash to pay their day-to-day expenses. For most people, Bitcoin or any other cryptocurrency is not yet a good store of value. It is simply too volatile compared to the dollar, and risk-averse people do not want to hold their wealth in an uncertain unit of account.
Here I sketch what needs to happen for Bitcoin or possibly some other cryptocurrency to gain greater market share against more mature currencies and ultimately against the dollar itself. (A fuller account is given in my paper with Kyle Roche). Cryptocurrency needs to continue to gain in value to attract investors, but also to lessen volatility to attract people who would like to hold it for more general purposes like payment.
For a crypocurrency with a fixed supply, like Bitcoin, these two forces may sometimes be in tension—although speculation may drive up a currency’s value, the inherent volatility that comes along with such upward swings can be destabilizing for a currency. But this may not be a fatal flaw. If Bitcoin comes to enjoy a steady growth in demand, it will be able to maintain an acceptable level of volatility while at the same time reaching a broader market. To be clear, to become more successful and widely used, it does not need to become less volatile than the dollar. There are many less successful currencies against which it could compete and it would gain much value by replacing or complementing gold as the basic hedge against currency devaluation.
There are two important conditions for this success to happen. First, in order for Bitcoin to become an attractive alternative to fiat currency, monetarily-oppressive currencies must grow less stable and ever-more oppressive on the population that uses them. Given the renewed enthusiasm about socialism throughout the world, I am not worried about the fulfillment of this condition. When socialists run out of other people’s money, they print more of it for themselves.
The second condition is more open-ended. There has to be continued strength in the Bitcoin ecosystem. Most people do not have the skills to use Bitcoin directly. Thus, they need cyptocurrency “wallets” and exchanges, like Coinbase. Fortunately these institutions have gotten a lot more professional since the days when Mt. Gox lost hundreds of million dollars worth of Bitcoin. Even more importantly, cryptocurrency needs to enjoy continued growth in the markets that surround it. Future and forward markets make the price discovery process more efficient and help dampen volatility. Permitting exchange traded funds in Bitcoin and other cryptocurrencies will allow more people to hold it as part of their portfolio. That development will thicken the market and have a stabilizing effect.
Note that these wallets, future markets, and ETFs, are not order without law. They are institutions regulated by our law and administrators. Thus, paradoxically, the success of Bitcoin may depend on the state’s willingness to apply the neutral principles of its law to a new form of property that may turn out to be competitor to one of the greatest powers of the state—its fiat money. Bitcoin’s ultimate success would not be rooted only in technological innovation but also in the venerable institutions that protect our liberty—the rule of law and constitutional protection for property.