The future of cryptocurrency sounds liberating. In fact, it was a disaster for everyone.
Earlier this year, Twitter co-founder and Square CEO Jack Dorsey declared that Bitcoin would be the world's "single currency" within a decade. It’s not just the bold predictions that made the comments stand out, but the view that Bitcoin could be useful for things other than speculative investing. After all, while crypto mania has plagued the financial world over the past year, the “money” part of cryptocurrencies has dwindled in importance in the public eye. Bitcoin is currently more of an asset than a currency, as Goldman executives did last year, it's something people trade, like stocks or bonds, rather than something they exchange for goods and services.
This perception reflects reality. The number of Bitcoin transactions (relative to transactions) has not increased much over the past few years, with a recent academic study showing that half of those transactions are related to illicit activity. As a medium of exchange, Bitcoin is today pretty much where it was in 2010: an interesting addition to the existing monetary system, mostly for people interested in avoiding legal authorities or people living in inflation-ridden societies like Venezuela or Zimbabwe).
Still, the dream that cryptocurrencies could replace our existing fiat money system, in which the money supply is controlled by a government-run central bank, remains a key part of Bitcoin’s appeal. The promise is a system where governments cannot manipulate the money supply, and market competition determines which currency people use. But what would happen if this dream came true? How will the system adapt and how will the economy and financial system work if the dollar and euro are replaced by bitcoin?
The simple answer is: not good. Our economies and financial systems are built on fiat currencies, and they rely on central banks' control over money (and the ability of governments to issue debt in that currency) to help manage business cycles, deal with job losses, and deal with financial crises. An economy where Bitcoin is the dominant currency will be a more volatile and tougher economy, governments will have limited means to deal with recessions, and financial panics will be difficult to stop once they start.
the opposite of what you want
To figure out why this is the case, it's crucial to recognize the central bank's key role (the Federal Reserve Bank in the US) in providing what economists call "liquidity" when the system needs it. It's just saying that the central bank can inject funds into the system, either by printing and then lending the funds to the bank (ideas injecting it into the system) or simply buying the asset itself. Providing liquidity is especially important in times of financial crisis, as the crisis causes banks to cut back on lending and savers to withdraw money from banks. At that time, the central bank was the lender of last resort, and it came in as solvent banks struggled to stay afloat and make sure we didn't end a mass bank failure.
In an economy run by Bitcoin, central banks cannot do these things. An important aspect of the Bitcoin protocol is that the total number of Bitcoins is limited to 21 million, after which it will never be released. This makes Bitcoin attractive because something whose supply never increases is more likely to retain its value. The problem is that in the event of a crisis, it is also impossible to add liquidity to the system because you cannot "print" more bitcoins. The central bank might accumulate some bitcoins, and then it might get into the system, but that doesn't do much good because people will know that storage space is limited. Regardless, central bank demand for Bitcoin will drive its price higher,
Bitcoin also makes it difficult for governments to deal with recessions, often employing what economists call countercyclical monetary and fiscal policies. Central banks cut interest rates, as the Fed did after the 2008 financial crisis, by pumping money into the system through asset purchases (so-called quantitative easing). The administration has tried to restart the economy by cutting taxes and increasing spending, often by borrowing money to repay the economy, as in the Obama-era stimulus.
Again, the Bitcoin economy will limit the options for governments. Since the central bank cannot control money, it also cannot control interest rates, and has only a limited ability (depending on the size of Bitcoin storage) to inject money into the economy. Fiscal policy is also powerless. Today, when the government runs a deficit, it allows the Fed to print money and then borrow money from the Fed. This increases the liquidity of the system. In a bitcoin world, governments would have to borrow bitcoin to pay. Again, this would make Bitcoin more valuable and make people reluctant to spend that money, which is the opposite of what you need to deal with a recession.
The good news is that this is an incredible future. While the idea of making Bitcoin a universal currency may have impeccable logic to digital age utopians, in practice, it makes no sense. And the design of Bitcoin is also unimaginable. Since Bitcoins have a limited supply, if demand for them rises, so will their value. But that means if you own bitcoins and you think they're going to become more popular, it's wise to stick with them because they'll be more valuable tomorrow. This makes people less willing to use bitcoin to actually buy things and more interested in using them as a speculative investment, which is the opposite of what you want in a medium of exchange.
This does not mean that cryptocurrencies are useless. Buying drugs, laundering money: These are situations where they can come in handy.
You might think that the supply constraints on gold are the same when the economy operates on the gold standard. But gold supply is not fixed. As people mine more ore, mines start to expand. There is actually some kind of equilibrium, as economic growth increases the demand for gold, making it more valuable, the price increases prompting people to mine it, which brings more gold into the system, which ultimately keeps the dollar value of gold relatively stable. . Between 1800 and 1900, the dollar value of gold gradually increased slightly. In contrast, Bitcoin regularly rises and falls by 5% to 10% over the course of the day, purely because of a shift in speculative sentiment. This volatility diminishes its usefulness as a store of value (one of the other roles of money) and makes it unsuitable for use as an everyday medium of exchange, since no one wants to accept money if it might be worth the distance now 10% reduction for a few hours. In other words, a financial system running on Bitcoin would have all the bad features of the gold standard and very few convertibles.
There are also practical hurdles in making Bitcoin a currency that people can easily use. When demand for bitcoin is high, transaction fees skyrocket as miners raise the price at which they can process those transactions. At the height of Bitcoin madness last fall, each transaction could cost as much as $55. That's fine when people think that their Bitcoin store value will double overnight. But if people want to buy pizza or a new TV with bitcoin, that won't work. More importantly, Bitcoin cannot scale to handle the number of transactions that a modern economy requires. The system is limited to processing 420 transactions per minute. Finally, there is the fact that only a handful of people control a sizable percentage of all Bitcoin in the world. This gives them leverage to manipulate prices.
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We believe in blockchain
Of course, Bitcoin is far from the only cryptocurrency. Depending on how you count, there are now hundreds, if not thousands. Although they are all built on the blockchain like Bitcoin, there are features that seem to make them more attractive as potential global currencies. For example, Litecoin can process more transactions per minute. Monero and Zcash offer true anonymity (in contrast to Bitcoin, every transaction is associated with a given key that can be tracked). Not all cryptocurrencies have a rigid cap on the total number of coins. So maybe different cryptocurrencies could replace the dollar or the euro or the yuan, or, more convincingly, we might end up with a system of many different private currencies rather than just relying on a single medium of exchange.
There is appeal for everyone to choose the currency that works best for them and the idea of cryptocurrencies competing against each other to win the loyalty of consumers and businesses. But in reality, the proliferation of cryptocurrencies we’ve seen over the past few years makes it less likely, not more, that they will eventually replace fiat currencies.
Can China Include Bitcoin?
It's trying. But cryptocurrencies are bigger than any country, even the most popular ones.
The problem with having many different private currencies in the world is that it massively increases transaction costs. With a single fiat currency issued by the government, you don't have to worry about accepting goods and services. You accept dollars because you know you can use it to buy what you want. Commerce flows more smoothly because everyone implicitly agrees to use the dollar.
In an economy with a lot of competing currencies (especially cryptocurrencies without any commodity), it would work very differently. If someone wants to pay you in Litecoin, you have to figure out if you think Litecoin is a real cryptocurrency or just a scam that might close any day. You have to consider who else might accept Litecoin, if you want to spend it, or who will trade your USD (and exchange rates and transaction fees). Basically, the proliferation of money leaves business value behind, making transactions less efficient and more expensive. Any hard-to-use currency is less valuable as a medium of exchange.
Money laundering is still good
This is not speculation. We actually have a historical example of how this works. In the decades before the American Civil War, there was no national currency. Instead, it was an era of so-called "free banking." Individual banks issue bank notes, theoretically backed by gold, which people use as money. The problem is that the further away you are from the bank, the less recognizable (and therefore less trustworthy) bank notes are to people. Every time you make a trade, you must review the note to make sure it's worth what your trading partner says it is. So-called wildcat banks came along, took people's money, sent out a bunch of notes, and closed down, making their notes worthless. To be sure, people have figured out some workarounds, and some dossiers are a banking sort of "show all the banknotes and assess their reliability and value. But the wider consequence is that doing business is just more complicated and slower than others." The same is true in a world where some people use Ethereum, others use Litecoin and others use Ripple.
This does not mean that cryptocurrencies are useless. Conversely, these are still useful for transactions that want to hide from governments (or other agencies). Buying drugs, laundering money, evading capital controls, protecting your funds in a hyperinflationary environment: these are all situations where cryptocurrencies can come in handy. But private cryptocurrencies may soon (or were) a meaningful contender for fiat currency transactions for everyday transactions, which is nothing but a dream. (Source: Hacker Weekly, welcome to share)