The cryptocurrency craze is fascinating to an economist, or at least a student of catallactics, because it is a test of the theory of exchange ratios and prices, which is what catallactics is about.

For this reason, the outcome of the cryptocurrency craze is of great theoretical interest. It is also of interest to students of the psychology of speculation.

Supporters of cryptocurrencies claim they are money. If they are unable to substantiate this claim, then we must conclude that cryptocurrencies are only a medium for speculation, drawing on increasing numbers of the public to maintain their value. For this reason, their validity as money is fundamental to their future. Supporters of cryptocurrencies are certainly very sensitive to accusations that they are not money, presumably for this reason.

Mere opinions do not matter. A critical, detached analysis is needed. The purpose of this article is to test the proposition, that cryptocurrencies are money, from a sound theoretical perspective.

The basis of money

Before cryptocurrencies, there was government money, and before that metallic money, which was gold and silver. Government money evolved out of metallic money, drawing upon it for its credibility, before abandoning all pretence at convertibility when the US Treasury finally abandoned the dollar peg in 1971. The difference between the two is gold and silver are chosen by people exchanging goods in free markets, while government money is imposed on people by their governments.

Catallactics, as a theoretical discipline, investigates the exchange of goods in a free society, and is the basis of classical economics from Cantillon, Hume, Ricardo, Jevons/Menger through to the Austrian school. Government money does not stand up to catallactic examination, because its issuance always subverts free markets by interposing influence from the state into transactions between ordinary people.

The modern justification for government money has its origins in the German historical school of economists, when Georg Knapp declared, on what appeared to be little more than a point of principal derived from the supremacy of the not-long formed federal German state, that the state has the sole right to issue its citizen’s currency.

Knapp’s one book was titled The State Theory of Money, published in 1905. In it, he argued that state money may be recognised by the fact that it is accepted in payment by the state. Money exists according to state regulation and creditors must accept it without being legally entitled to other forms of money in exchange for it.

In his preface to the first edition, Knapp made it clear that he regarded money as a matter for political science. In other words, its existence, in accordance with the tenets of the German historical school, was a matter for the executive setting the law instead of free markets. The first sentence of Chapter One leaves us in no doubt on this matter: “Money is a creature of law”.

The law is horribly deficient. It does not even recognise that the purchasing power of money can change. The law does not compensate those robbed by currency debasement. The law makes no distinction between fiat money and credit money. The law will tax you if you benefit from the wisdom of holding catallactic money instead of state money. The law denies the logic of catallactics entirely, and rules only on state money, irrespective of whether it is backed or convertible into gold. It does not recognise the money chosen by free markets. The law is not equipped to decide on monetary matters.

Therefore, by no stretch of the imagination was Knapp’s treatment of money catallactic. Money issued by the state cannot last beyond the ability of a government to impose it on its people. Knapp died in 1926, three years after his own government’s money had collapsed both predictably and dramatically, disproving his state theory of money.

Today’s state-issued currencies are no different in concept from the currencies that collapsed in the wake of the First World War. With no convertibility into gold or silver, they depend for their purchasing power and validity as money on no more than the rule of law and public faith in the state. Since the Bretton Woods Agreement began to collapse, the dollar lost over 97% of its value measured in gold. These are relative purchasing powers set in the markets between sound money, still accepted as such by most of the world’s population (even though it is not usually used for day to day purchases), and the reserve state-issued currency.

Supporters of cryptocurrencies appear to be more aware than most of the weaknesses of state currencies, particularly when the issuing central banks have stated that their objective is to continually reduce their purchasing power every year as a matter of policy. The collapse in purchasing power seen so far has destroyed nearly all the value of money-based savings such as bank deposits and bonds, a government policy set to continue. Furthermore, there may be an understanding among some cryptocurrency enthusiasts that credit money, issued by the commercial banks, undermines the purchasing power of state money as much, if not more, than the issue of money by central banks.

Is it not better, they argue, for ordinary people to take back control of money from their governments? In their utopian world, we can escape the hidden tax of monetary inflation, and we can keep our ownership of money private. Bitcoin’s founder came up with a formula that would restrict its inflation by making it progressively difficult to “mine”. By introducing new block-chain technology, he created a self-auditing digital version of bearer paper money. Not only is the concept extremely clever, addressing the weaknesses of state money head on, but bitcoin was introduced at a time when central banks have been openly discussing their intention to eliminate physical cash.

Bitcoin has certainly caught the imagination, spawning by the time of writing over 900 other imitations, according to Wikipedia’s List of Cryptocurrencies. Instead of Bitcoin and its imitators being used as money, they have become vehicles for outright speculation. Presumably, supporters of cryptocurrencies hope that at some stage, their monetary characteristics will come to the fore, once the speculation has subsided. However, we can see that cryptocurrencies exist despite the law, and the law barely recognises their validity, even banning them in some jurisdictions. They are not Knapp’s creatures of the law. For cryptocurrencies to be money, they must therefore conform to the characteristics of money demanded by catallactic theory.

Cryptocurrencies fail the regression test

In an exchange of goods for money, both buyer and seller will subjectively value the goods side of the transaction. To do that, both must assume that there is no subjectivity in the value of the money being exchanged. So, while the good, or service, is valued subjectively, the value of money must be regarded as wholly objective, otherwise the transaction descends into the realms of barter.

The regression theorem demonstrates that money in a transaction has its objective exchange value determined by reference to recent experience. We know without question the value of money in a transaction, because of what it bought yesterday. And yesterday, we knew its value from our experience of the day before. By a process of regressus in infinitum, the value of money is traced back to its original subjective value for non-monetary use, before it became adopted as money. In other words, for money to become money, it must have had and must still possess a subjective value as a good.

This is not to say the value of money is based on its use as a good. The purchasing power will be determined by its demand as money, and its value in terms of its purchasing power will fluctuate. When silver was dropped as money in favour of gold in the late nineteenth century, its price fell back towards its use-value as a good.

Even when the purchasing power of money changes, it is still regarded as the objective value in an exchange. Indeed, prices in one centre which get out of line with prices in another centre will correct through a flow of money to the centre where goods are cheaper, from where the goods are expensive. Prices correct by surplus money moving to where there is a deficiency. All the time the purchasing power of money undergoes a period of adjustment, the buyers and sellers of goods assume it is the prices of the goods adjusting, not that of money priced in goods. Money retains its role as money by still being regarded as the objective value in the exchange of goods.

It is of paramount importance that money retains this credibility in all circumstances. As well as passing this test, the money must be durable, reliably stable, and as a store of value, dependable. For all these reasons, gold and silver have long survived the regression test, while the many other commodities and goods used as money over the millennia have all failed.

The state-issued currencies that exist today have generally retained their role as money by being initially convertible into gold and silver, or more lately convertible into a partially gold-backed dollar.i By ditching gold, the abandonment of the last vestiges of the dollar’s convertibility in 1971 led to the loss of its vital regressive quality and most of its purchasing power. All the other state currencies that took the dollar to be their reserve currency have suffered the same fate. And while we all use government-issued currencies, giving them an objective use value today, there are enough examples of state currency failure to confirm that they have a fundamental weakness in not conforming to the regression theorem.

There is no regression in the case of cryptocurrencies, certainly not as money. They were created out of thin air, and are less convincing catallactically than the state currencies that were at least commenced as gold or silver substitutes. While cryptocurrencies can claim a free-market origin, and their creators might think for that reason they are superior to state money, they fail the regression test and so cannot claim to be catallactic.

Can cryptocurrency be used as money?

This does not entirely disqualify cryptocurrencies form being used as money. There is nothing to stop Citizen A coming to an agreement with Citizen B to accept a cryptocurrency in payment for a good. In such an agreement, the cryptocurrency fulfils the role of money. But whether the cryptocurrency will circulate more widely as money is the true test. To answer this question, we need to delve into exchange theory itself.

Money is necessary because we divide our labour, with all individuals specialising in their production to maximise their output. To avoid barter we need a mutually agreed and acceptable medium to acquire the goods and services produced by others. In a free society, where this division of labour occurs without third party intervention, the money that is used to facilitate the exchange of goods is also chosen by the parties exchanging goods and services. The only currencies that have been chosen by free markets, and have survived for millennia, are gold and silver.

The reason gold and silver were accepted is they have a subjective value for alternative uses, in accordance with the regression theorem as described above. Both metals are to this day sold as jewellery and for industrial purposes. Crucially, this is not true of unbacked paper money, and even less so of it in its electronic form.

The history of the failure of unbacked currencies remains unblemished by success, suggesting that it is only a matter of time before today’s currencies will also fail. The purchasing power of today’s fiat currencies is in continual decline, and since the last tie with gold was abandoned in 1971 when they became pure fiat, they have all lost most of their purchasing power, compared with that of the original sound money, gold.

The creation of fiat currencies had their origin in being a substitute for gold. They were redeemable at the currency holder’s option, into a defined weight of pure gold. Earlier, some currencies were convertible into silver, but relative to gold, silver fell into disfavour in the late nineteenth century.

But this was only one of three types of state money. A second form is bank credit, created out of thin air, but expressed in the deposits that resulted from credit being drawn down. This credit money is indistinguishable from money issued by a central bank, an important point when central bank money was convertible into gold, and credit money was not. And lastly, there are base metal tokens in the form of coins, which without conversion into gold or silver, were just that, tokens.

These forms of money are accepted because the subterfuge by which gold substitutes were replaced with pure fiat was achieved without the public being generally aware it was happening. Their money was progressively untied from gold convertibility, so that it could be debased as the state willed.

Both metallic and state money work because their day-to-day values in terms of the goods they buy are stable, with the price of gold expressed in fiat no more volatile than cross-rates between fiat currencies on the foreign exchanges. In their current state, this is not true of cryptocurrencies, which are immensely volatile.

It has been argued that the supply of the first significant cryptocurrency, bitcoins, is limited, in the same way that the new supply of gold is limited, relative to above-ground stocks. Therefore, bitcoins have the same supply characteristics as physical gold. This is undoubtedly true, but it does not make bitcoins money. We must disregard the estimated 100,000 world-wide outlets that claim to accept bitcoin in exchange for goods as not material, because the number is too small, and their acceptance of bitcoins is likely to be either strictly limited, or for speculation instead of money.

Instead, bitcoin and the other 900 or so cryptocurrencies have become purely vehicles for speculation. A Google search for using bitcoin as money yields little more than how it might be used to launder money. Other than its potential for money-laundering and tax evasion, it is hard to see that enthusiasts are interested in using it as a legitimate form of payment for goods.

And no wonder. Bitcoin started in 2008, when the price rose from a few cents to over $3,400 this week. Speculating has become so profitable, that more and more people are being drawn in. Every fall in the price is seen to be an opportunity to buy more. Whatever the outcome, this volatility disqualifies bitcoin from circulating as money, with an objective exchange value, for the exchange of goods.

A spectacular bubble in progress

We know from our analysis of cryptocurrencies that they have no catallactic pedigree, and that their volatility makes them unsuitable for use as money. Therefore, we are forced to conclude they have no monetary credibility, and are solely media for speculation. We can now make one certain estimation, and that is of their eventual demise. That this will happen when the bubble bursts can be firmly predicted, even though the timing cannot.

How it all ends is yet to be revealed. Government intervention, so far, has been restricted to closing cryptocurrency exchanges where there has been evidence of fraud or money-laundering. Some governments ban cryptocurrencies altogether, though it is hard to see how such a ban can be enforced. However, if governments decide to put an end to the cryptocurrency phenomenon, they can probably do so collectively through bank regulation, instructing banks not to open accounts for any commercial entity involved with cryptocurrencies.

International agreement on banking coordination always takes time, but the motives for government intervention are not hard to see. At the top of the list for governments with intractable budget deficits is tax evasion, real or imagined. Money laundering is a second reason, but this is often a cover for the first. Alternatively, it is possible governments will become concerned at the bubble-like characteristics, and wish to contain the financial damage to ordinary tax-payers when the bubble bursts. However, governments are notoriously bad at recognising financial bubbles before they collapse.

More likely, this phenomenon will end the way all bubbles do. The success of the South Sea Company spawned imitators, just like bitcoin today. Speculators late to the party bought into other, lower-priced ventures, diffusing the potential demand for South Sea Company shares. Mostly, they were no more than financial vol-au-vents, whose rapid deflation helped undermine all speculative sentiment. The similarity between pure bubbles over the centuries can be striking, and the cryptocurrency craze is no exception in this regard.

Another parallel is with the tulip mania of 1636-1637, where something as inherently worthless as cryptocurrencies was driven to fantastic heights. But if we seek differences from past bubbles, the cryptocurrency bubble has the potential to be larger than any bubble recorded to date, fuelled by a globally connected population that requires no more than a mobile phone to participate. Furthermore, the expansion of unbacked bank credit has the possibility to fuel the price relationship between cryptocurrencies and fiat currency on a scale hard to imagine. The point reached during the Mississippi Bubble, when the French aristocracy pawned their estates to speculate in the market, is yet to be commonplace with cryptocurrencies.

It’s worth noting that all cryptocurrencies together are worth roughly $120bn, with bitcoin $55bn of that total. This is only a very small fraction of cash and deposits world-wide. Therefore, the point where new money to fuel the craze runs out does not appear to have been reached, and could have much further to go.

But bubbles always collapse in time. If it is permitted to inflate to its ultimate potential, the eventual collapse of this extraordinary phenomenon will impoverish the inexperienced speculating public, who as always, will be left with life-changing losses. The eventual collapse could be significant enough to generate an economic slump on its own, just like the Mississippi and South Sea bubbles four hundred years ago.

For now, the development of this bubble is in the hands of a speculating public, who periodically see manias as a failsafe way to make money. But the answer to the question posed in this article’s headline is that cryptocurrencies are not money and never will be.

iIn the case of the euro, there is an extra step, it being comprised from several currencies that had their origins in gold, or were linked to the dollar through the Bretton Woods Agreement.

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