Technological advances make financial transactions more efficient and should be welcomed. But governments turning a blind eye to bitcoin and initial coin offerings should not forget economic fundamentals; they would be well advised to protect their citizens and financial institutions from risky and potentially socially harmful developments.
The craze for crypto-currencies and their use as a store of value, a fund-raising vehicle or a tool for writing smart contracts continues unabated. The euro value of bitcoin in March 2024 fluctuated between €50,000 and €65,000, to be compared with €5,700 in March 2020 and … €300 in November 2015. What's more, and even if this mode of financing remains marginal, initial coin offerings (ICOs), whereby companies finance themselves by issuing tokens (cryptocurrency tokens newly minted for the occasion), have according to Wikipedia raised nearly $24 billion in funds from 2013 to 2023 (more than 8,000 initial coin offerings were launched during this period). Are cryptocurrencies a threat or an opportunity for our societies? The purpose of this article is to provide some thoughts from an economist on this phenomenon.
Stay alert!
To summarize simply what follows, my recommendation would be to remain alert to certain dangers associated with cryptocurrencies. On the one hand, while I see no problem with sophisticated players betting their own money on the cryptocurrency sector, individual investors need to be informed and fully aware of the underlying business model. On the other hand, any exposure to crypto-currencies by players likely to be bailed out by the state in the event of major losses (banks, insurance companies, regulated pension funds...) must be subject to substantial capital requirements, in relation to the significant risk associated with fluctuations in the value of crypto-currencies.
Blockchain
My skepticism doesn't concern blockchain, the technology behind Bitcoin. Admittedly, many technical problems associated with Web3 have yet to be resolved; for example, validation processes are still costly and security needs to be improved. Nevertheless, this distributed ledger technology is a welcome innovation, with useful applications such as the rapid and automatic execution of smart contracts and the storage of secure information on a public blockchain. This is how we could share our personal data, which we would transport from website to website in a space of trusted partners. This is how 230 billion dollars have been invested in DeFi (decentralized finance) projects, for example to manage swaps or over-collateralized loans with automated execution (where the size of the loan, the amount to be repaid and its phasing, and the collateralization can be updated depending on the economic environment, the evolution of specific projects or the borrower's commercial relations). [See, however, the reservations expressed in the report on decentralized finance by the International Organization of Securities Commissions (March 2022), as well as the opinion of Commissioner Caroline Crenshaw of the Securities and Exchange Commission].
Cryptocurrencies
Cryptocurrencies raise two distinct questions: are they viable? And, assuming they are, do they contribute to the common good? My answers to these two questions are respectively "probably not (but without any certainty: the jury is still out)" and "certainly not in our liberal economies".
Viability
An asset bubble is defined as the difference between the asset's price and its fundamental (or intrinsic) value. The fundamental value is the present value of future cash flows from the asset’s ownership (dividends for stocks, coupons for bonds, rents for rental property, imputed rents when the property is owner-occupied...). To answer the question of viability, a cryptocurrency is what economists call a pure bubble, an asset with no intrinsic value - its price will fall to zero if market confidence in it disappears - in other words, its fundamental is zero. More generally, whether its fundamental is zero or positive, the price of any asset available in limited quantities can reach very high values, well beyond this fundamental, thanks to self-fulfilling beliefs: I'm prepared to pay a high price for an asset if I think someone will buy it back from me tomorrow at an even higher price on average; and this next buyer will hold the same reasoning, ad infinitum. Technically, one must correct for the interest rate on other available assets and for any risk aversion, especially as these bubbles are so volatile. [For the exact conditions under which an asset can become the subject of a bubble, see my two Econometrica articles (1982 and 1985), as well as my article with Emmanuel Farhi in the Review of Economic Studies (2012) on the potential use of bubbles as a store of value by financial intermediaries, generating booms and then crashes in economic activity. The 1985 article also discusses the complex link between the value of an asset as a medium of exchange and the existence of a bubble; even if a pure bubble such as bitcoin can a priori serve as a medium of exchange, the fact remains that its value falls to 0 when confidence disappears].
The risks
Bubbles are generally even more volatile than fundamentals. In the case of crypto-currencies, the uncertainty stems not only from the variability of investors' "sentiments" (using Keynes' expression) and the concomitant possibility of the bubble bursting. It also stems from the behavior of miners (the actors who verify and record transactions on the blockchain, in return for remuneration via the creation of crypto money). No one can prevent a fork, the process by which the cryptocurrency splits into two branches, neither of which is recognized as legitimate by all players (though small minority forks tend to vegetate); the holder of one bitcoin, say, then ends up with two bitcoins: let's call them the "yellow" bitcoin and the "red" bitcoin. The money supply is immediately doubled by the splitting of a single currency into a yellow and a red currencies! Another source of uncertainty is that a consensus may develop if the maximum issuance quantity decided at the outset is challenged as deflationary or insufficient for exchanges, and concomitantly increased.
A lasting bubble?
There are long-lasting bubbles: gold (which has intrinsic value, but whose price far exceeds what it would fetch if treated as a commodity and used for industrial or decorative purposes - i.e., its fundamental value), or fiat currencies (the dollar, pound or euro). Yet the history of financial markets is punctuated by bubbles that end in crashes, from the Dutch tulip bubble of the 1630s and the South Sea bubble of 1720, to countless stock market and real estate bubbles. No one can say with certainty that bitcoin will collapse. It could become the new gold. But I wouldn't bet my life savings on it, and I certainly wouldn't want regulated banks and insurance companies to speculate on its value without sufficient capital, reaping the gains and mutualizing the losses (with the state through a bailout or with uninsured depositors footing the bill in the event of financial difficulty), as the saying goes.
Social value
Risk is part of the market economy and an essential driver of growth. That's not to say that all risks are socially equal. The companies that set out in search of a vaccine against Covid took a considerable risk, despite generous public subsidies. Those that succeeded made substantial profits; they provided immense social value in terms of lives saved, mental health and the avoidance of unprecedented economic costs. On the other hand, and with an important caveat to which I'll return later, the social value of bitcoin seems to me rather elusive.
Seigniorage
Let's start with the question of seigniorage: in the case of a fiat currency, an increase in the money supply traditionally provides the state with additional resources. As is only right and proper, the proceeds of the money issue in this case go to the community. In the case of bitcoin, the first coins minted or money raised in an ICO go into private hands. The newly minted coins in contrast create the equivalent of a race to the bottom. Mining pools compete for bitcoins by investing in computing power (faster and faster specialized servers). Competition takes the form of increasing difficulty every 2,016 blocks. This increase is made necessary by the constraint of maximum total mining (21 million for bitcoin). The fact remains, however, that for the mining community, the expected gains (the value of bitcoins mined) are on average equal to the cost of mining, which means that seigniorage is wasted. Put differently, expenses are proportionate to revenues, i.e. the value of the token obtained multiplied by the probability of preempting other miners. In other words, seigniorage is wasteful when not privatized. [The waste has been reduced in the case of the second most valuable cryptocurrency, ether, which is the native cryptocurrency of the Ethereum system (on which anyone is free to write applications, and even issue cryptocurrencies other than ether). In 2022, ether made the transition from proof-of-work to proof-of-stake].
Another thorny issue is that the electricity consumed by miners is not always cleanly produced. In many modern electricity systems, wholesale prices reflect the local scarcity of electricity, encouraging users to consume electricity when it is plentiful. However, the very low level of carbon prices around the world does not encourage electricity users to consume decarbonized electricity. [Cf. https://www.nytimes.com/2023/04/09/business/bitcoinminingelectricitypoll...
An ecological bitcoin after all?
Bitcoin proponents sometimes argue that bitcoin can promote ecology. The argument goes as follows: the waste gases from oil extraction (usually burnt off for lack of local outlets and means of transporting energy) can be used, as is sometimes the case in North America, to mine bitcoins. The practice of flaring represents a waste of energy and is highly harmful to the environment, as 2-3% of methane, a powerful greenhouse gas, escapes unburned into the atmosphere. [See https:// www.clubic.com/bitcoin/dossier374048bitcoinal assautdumethaneperdu.html .] Bitcoin miners can then team up with the oil company to turn the gas into electricity. The validity of this argument depends on the counterfactual being considered. If the latter is laissez-faire, i.e. no government regulation or pricing of the social cost of methane emissions, any private initiative that avoids them is welcome. However, oil-producing countries (or, if they don't, oil-importing countries) have a duty to tax these emissions. Once they are taxed, it becomes profitable for oil companies to seek outlets for the corresponding energy: they can transport the electricity produced, invite other activities - whether Bitcoin mining datacenters or other uses of electricity - to co-locate with oil extraction, or deal with the problem themselves by storing the gas, reinjecting it into the subsoil or transforming it into methanol.
Criminal risk
Back to the social costs of bitcoin. Bitcoin may be a libertarian dream, but it's a real headache for anyone who, like me, sees public policy as a necessary complement to market economies. Bitcoin is still too often used for tax evasion or money laundering. While some established (if you can call them that) cryptocurrency-fiat currency conversion platforms, such as Coinbase, know the identity of their customers, this is not necessarily the case for other platforms, which may be based in tax havens or rogue states. As a counterpoint, it goes without saying that cybercrime is a much broader topic than cryptocurrencies; even in the absence of the latter, the fight against money laundering and crime requires careful monitoring of banking institutions and, at international level, cooperation between countries sharing the objective of combating these scourges. Of course, the dollar and other hard currencies have always been used for these perverse purposes, but bitcoin's ability to transfer money discreetly and easily to any destination (even the most unsavory) is a cause for specific concern.
The risk of external liquidity
What's more, how could central banks conduct counter-cyclical policies in a world of private crypto-currencies? Of course, we're not there yet. In 2021, El Salvador made bitcoin an officially accepted means of payment: merchants, businesses and the state itself are obliged to accept bitcoins as payment. This initiative by the Salvadoran president (officially to reduce bank charges for emigrants transferring money from the USA to the country!) has met with very limited success, as transaction costs and price volatility (bitcoin lost 65% of its value in 2022) have discouraged players from using this means of payment. [Other countries have chosen or proposed to use the dollar as their official currency, or to peg their currency to it; however, such pegs are not guaranteed, as demonstrated by Argentina in 2001]. Today, central banks can rapidly provide liquidity on a large scale in the event of a financial crisis (the 2008 crisis), a sovereign crisis (the European crisis) or a crisis of another origin (Covid, Ukraine war). This is no longer so easy in a world where liquidity is - in the language of economists - entirely "external" (in the sense of being created by the private sector).
The case of dictatorships
The important exception to this critical view of cryptocurrencies comes from dysfunctional countries. In a country with rampant inflation, or in a country where the state can expropriate part of the savings of individuals or companies by fiat (some Latin American countries come to mind), a more stable and less traceable currency can prevent expropriation (bitcoin is a substitute for the dollar in such countries, with lower transaction and concealment costs). Similarly, it is worrisome when a dictatorial regime observes all private transactions, and in particular is able to see those of political opponents or minorities it oppresses. Indeed, some proponents of bitcoin argue that the government should not have easy access to currency transactions and holdings, any more than the police can search our homes without a rogatory commission issued by an independent examining magistrate. Cryptocurrencies can become useful in an environment where the state is the enemy of its citizens.
Fundamentals are unchanged
While technologies are evolving rapidly (and this is, on the whole, a very good thing), the economic mechanisms remain the same. In this respect, the ICO craze is hardly reassuring. Heralded as a liberation from the power of financial intermediaries, from venture capitalists to banks, the direct issuance of securities to savers neglects the fundamentals of finance: the use of trusted, well-capitalized and reputable intermediaries to oversee projects. Centuries of experience have taught us that it is important for investors to weed out fraudulent projects or those of little economic value, and to have their voice heard in corporate governance. The selection of projects and borrowers, and their monitoring once projects are launched, are "public goods" from the investors' point of view; the free-riding problem makes their provision unlikely in most forms of ICO. Finally, to fund projects through an ICO, backers issue and deliver tokens to investors. These tokens are often compared to shares, but unlike shares, they usually confer no voting rights, and therefore little participation in project governance. What's more, if dividends are distributed in tokens rather than dollars or euros, for example, tokens are once again pure bubbles, and their value can fall to zero regardless of the company's success.
Published in La Jaune & la Rouge, n° 792, February 2024, https://www.lajauneetlarouge.com/magazine/792/
Illustration Photo de Kanchanara sur Unsplash
