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What's the Point of Cryptocurrencies?

10-22-18



I've been thinking a lot about cryptocurrencies lately. The first time I heard about bitcoins was when one of my coworkers announced in casual conversation one day that he was mining bitcoins. "What are bitcoins?" we asked. He gave us a two or three sentence answer. "How much are they worth?" I asked. "About two cents each," he responded. "So, what's the point of that?" I asked. A little flustered, he said that they may not be worth much at that moment, but they could become more valuable later. Then his mining efforts would pay off. If he's kept the bitcoins he mined at two cents a piece, he's a multi-millionaire now. But I still find myself asking, "What's the point of cryptocurrencies?"

The value of any currency boils down to its usefulness in three areas: as a store of value, as a medium of exchange, and as a unit of account (to set the prices of things). Some people make a distinction between money and currency, but for brevity I will ignore that here. By the way, I'm not an economist or a financial advisor. So, don't make any investment decisions based on what you read here. All I'm giving you here are my opinions. And they're worth every penny you're paying for them. Anyway, although the above definition is oversimplified, for any currency to have a point, it has to fulfill at least one of the above needs. Ideally, it would fulfill all three. The problem is complicated immensely by the fact that we humans are very naive. We value a lot of things that we shouldn't. For example, back in the seventeenth century in the Dutch Republic, people thought tulip bulbs were so valuable that they were willing to pay the equivalent of more than ten times the annual wages of a skilled craftsworker for one tulip bulb. Of course the bubble burst, as it had to eventually, when people planted the bulbs and grew more.

This leads to both a mini psychology lesson and a mini religion lesson. Here they are: we often value things simply because we can't have them. When we can have them, we don't value them. For example, cubic zirconia and diamonds look exactly the same and even share many of the same characteristics. But the De Beers Group has managed to limit the supply of diamonds. So, not everyone can have one. We can make as many cubic zirconia as we want. So, diamonds are valuable, and cubic zirconia aren't. The solution to our psychological problem is simple. Stop wanting what you can't have! Herein lies the secret of happiness. So, now that I've given you the psychology and religion lessons, let's go back to talking about money.

The fact is that nothing has intrinsic value. We are the ones that assign value to it. So, whatever we assign a value to and continue to assign the same or greater value to is useful as a store of value. Period. That means that any currency that we value and continue to value can be used as a store of value. And any currency that we don't value or don't continue to value can't.

As far as the other two desirable characteristics of money, usefulness as a medium of exchange and a unit of of account, are concerned, modern technology has solved that problem for us. We no longer have to physically transfer anything, and we can account for anything through the nearly instantaneous communication afforded by computer networks. For years governments and banks have been doing the accounting for currencies on their computer networks behind the scenes. Most people just haven't bothered to take much notice of it. But now, thanks to the internet, a computer network to which we all have access, we as individuals can do the same. So, tomorrow I could invent a digital chicken currency, come up with a method of keeping track of everyone who has digital chickens and how many they have, and provide a method for people to easily communicate about how many digital chickens they are willing to exchange for what amount of other currencies. And viola! My digital chickens are now a medium of exchange and a unit of account! Cryptocurrencies have a built-in method of accounting--a way of keeping track of who has what and how many they have. This method is unique in that by design it doesn't involve governments, banks, stock exchanges, etc. Cryptocurrencies have become a medium of exchange simply to the extent that people and businesses have decided to start using them as such.

If you haven't seen the problem with cryptocurrencies yet, let me spell it out for you. There is ultimately a limitless supply of cryptocurrency. Given that I can use the same technology as bitcoin does to create my digital chickens, and my neighbor Joe can create his digital ostriches, and my other neighbor Tom can create his currency, which he calls "Tomonians" ... You see the problem. When we have a limitless supply of anything, we don't value it. Thus, if we have unlimited currency (a state that often is the result of hyper-inflation), currency looses its ability to act as a store of value. So, what we now have is a potentially unlimited, valueless supply of cryptocurrencies threatening to replace current government-issued fiat currencies.

To make matters worse, cryptocurrencies can plummet in value in a very short time. The reason for this is that they are not backed by anything except what people currently believe they are worth. So, if something happens to make people feel that a cryptocurrency is worthless, then it is worthless. This is true of any "fiat" currency (a currency that isn't "backed" by anything--meaning that we have no reason to know, or even justifiably believe, that we can always exchange a certain number of units of this currency for a certain number of tangible things). Bitcoin, ethereum, the dollar, and the euro are all fiat currencies. A major difference, however, between government-issued fiat currencies and cryptocurrencies is that governments have shown themselves to be at least partially capable of bolstering people's belief in the value of their currencies. I am aware of no mechanism in place to do the same for cryptocurrencies.

So, there are ultimately two solutions that I see to the cryptocurrency problem. The honest solution is to go back to a currency or currencies that are artificially limited in number of units by being backed by something tangible. My thought is that the first currency to do that--be it crypto or other type of currency--and become widely accepted (i.e. become a medium of exchange), will push out all other currencies. This will be true as long as governments don't simply declare this currency illegal, which is the dishonest solution. The dishonest solution would allow governments to go back to using the unbacked system of fiat currencies that they use now. This solution allows them to control, manipulate, and profit from economies the way they do now. By the way, there are gold-backed cryptocurrencies now. They just haven't become a medium of exchange, yet.

The really interesting question in my mind is why governments have allowed this cryptocurrency problem to get started in the first place. Usually when a competing currency comes along, as has happened many times in the past, governments crack down on it immediately. They threaten to prosecute and jail the people involved, and that's the end of the competing currency. Why have cryptocurrencies been treated differently? Is it because cryptocurrencies are not limited by national borders? Is it because governments believe they are incapable of stopping them? Or do governments believe that cyrptocurrenncies have a fatal flaw or flaws, perhaps the ones I mentioned above, which will eventually become obvious to all, so the problem will solve itself. By the way, China has already made it illegal to buy bitcoin with their government-backed fiat currency. And the US government has passed laws to try to remove anonymity from holders of cryptocurrencies.

Aside from cryptocurrencies' questionable usefulness as stores of value, and their volatility, some of the other issues that have been raised about them are related to anonymity, cost of transactions, flaws in the math upon which they are based, and damage to the environment. It once was believed by many that cryptocurrencies allow their holders to be anonymous. The unfortunate fact is that this is not true, simply because cryptocurrencies contain a record that lasts forever of every transaction. So, if the seller is ever successfully identified, and he knows who or where the buyer is, he can be forced to reveal that. And this can happen years after the sale has taken place. Also, the amount of computational power and real power (electricity) that is currently being used to mine bitcoin and conduct transactions is enormous. Bitcoin's annual energy expendeture is now over 73 terrawatt hours. That's more energy than Austria uses! Think how that would grow if bitcoin somehow became the major currency on the planet.

Another general class of problems is that up to now the way cryptocurrencies function in the real world when real people use them has been unpredictable. Take, for example, the cost of transactions. The cost of transactions of cryptocurrencies depend on the underlying method of computing them. The inventor of bitcoin, Satoshi Nakamoto, published a paper in October of 2008 that started the cryptocurrency phenomenon. In that paper he laid the mathematical basis for how bitcoin would operate. However, many details were left out, including how the cost of transactions would be determined. In fact who makes those decisions and how is not specified. Since bitcoin is supposed to be a currency that, according to Nakamoto, provides a decentralized method of accounting which is under the control of no person or organization, one has to ask who is defining the cost of transactions and determining the algorithms that decide how many new bitcoins are created per unit time (neither are mentioned in the paper). Who is writing the bitcoin wallet software? And who maintains the standards that determine whether the wallet software is honest? We have already seen that organizations that provide online bitcoin wallets can mismanage, or even outright steal massive amounts of bitcoins. See also here. My point is that each of the people or organizations that must do these things are subject to intimidation by hostile governments, who could pressure them to make decisions that would effectively destroy bitcoin. For example, they could be pressured to raise the cost of a bitcoin transaction to $1000 (it has been as high as $20 already). While we are discussing real-world unpredictability, I would also like to point out that not everything that Nakamoto predicted about the functioning of bitcoin has turned out to be correct. For example, his paper predicted that the blockchain should not grow by more than 4.2 MB/yr. Right now, it is over 180 GB. According to Nakamoto, that should have taken over 42000 years! Another thing is that, while his paper computes the small probability that the bitcoin blockchain can be spoofed by an attacker, he likely did not have any idea of the vast computing power at the disposal of an organization like the NSA. If they wanted to interfere with bitcoin badly enough, my guess is that they could. Another issue is that about one fifth of bitcoins have been lost forever, because their owners have lost their wallet passwords. These are only some of the real-world problems with cryptocurrencies that no one appears to have seen coming.

But there is something else that bothers me about bitcoin specifically. This is the simple fact that no one knows who Sitoshi Nakamoto is. If he was so confident that bitcoin would work, why hasn't he revealed himself? Did he believe from the very beginning that bitcoin is a Ponzi scheme? If he did, the fact that he hasn't cashed in his huge stake in bitcoin suggests that he is now aware of its flawed anonymity protection and perhaps doesn't want to get caught.

From the tone of this article, it may appear to the reader that I am adamantly against the idea of cryptocurrencies. On the contrary, I am very much in favor of providing individuals with a store of value and a method of buying and selling among themselves without interference, manipulation, or profiteering by banks and governments. However, I do not believe that cryptocurrencies alone, which amount to little more than a new accounting method for more fiat currencies, will provide that. However, I believe they are a good start. I believe that if cryptocurrencies can be developed that deliver on their promise of true transactional anonymity while at the same time being firmly bound to a value basis (whether backed by precious metals or something else doesn't matter), then they have the potential to become what they were promised to be. Then we will all have access to a decentralized method of value storage, buying, and selling that we can actually use. And the corrupt system of fiat currencies that we presently use will be forced out of existence.

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