Rosalie Bull and Katherine Ingram
A developed economy must have a means of facilitating transactions that transcends barter. The modern solution is the bank centered economy. Banks serve as financial intermediaries which lend liquid assets to borrowers, in order to fund their illiquid investments. Banks are able to do this– create liquidity– because a multitude of depositors trust the bank to invest their money in low risk, illiquid assets, such as loans or home mortgages. Banks cannot, however, loan out all of their funds at one time: if a depositor then attempted to withdraw money from their account, the bank would be unable to produce it and depositors would lose trust in their banks. The stability of a bank centered society depends upon deposit insurance, capital requirements, reserve requirements, and the discount window– all forms of regulation which ensure that banks are able to produce liquid cash upon depositor demand.
Banks have not always been successful in this role, however. The 2007-2008 financial crisis, dubbed by many in the economic community as the worst financial crisis since the Great Depression, was caused in part by banks who practiced excessive risk taking, subprime lending, and deleveraging. The Federal Reserve contributed to the crisis by keeping interest rates artificially low in order to sustain the housing bubble. When the bubble exploded in 2008, as depicted in the graph above, many people lost their homes and jobs, and the economy plunged. People lost trust in the banking system, and the idea of a decentralized payment system, or cryptocurrency, was born.
Cryptocurrency operates by means of a universal ledger. Instead of each bank maintaining its own ledger, a universal, distributed ledger is maintained by a blockchain, or thousands of computers which compete to accurately update the ledger every ten minutes. Computers within the blockchain must achieve a majority consensus (50%+) for the update to be included in the ledger. The result is, theoretically, a decentralized payment system operating by means of a globally shared ledger. The system offers several advantageous elements: transparency, accessibility, and efficiency. The ledger is available online, updated frequently, and transactions are authenticated by the rigor of blockchain– thousands of computers simultaneously verifying or denouncing updates as they appear. It eliminates the need for financial intermediaries, and is accessible anywhere with internet. The development of cryptocurrency, blockchain technology, and Bitcoin in particular has proven controversial: some hail it as having the potential to disrupt, or even replace, the global financial institution, while others view it as bogus currency in the middle of a bubble. If cryptocurrency is to replace traditional, bank regulated currency, it needs to function as money. Can it?
Money has three defining qualities. It is a medium of exchange, meaning individuals use it as a means of transferring assets; it is a store of value, meaning it maintains purchasing power over time; and it is a unit of account, meaning it is a yard stick used to set prices.
Cryptocurrency has the largest issue meeting the second criteria. Though there are many commodity currencies like gold that we consider stores of value despite drastic fluctuations, many argue the price volatility of cryptocurrencies like Bitcoin precludes it from being legitimate money. In the past year alone, the value of one bitcoin has ranged from less than $3,000 to $19,000.
So what is it exactly? At the very least, cryptocurrencies are fiat currencies. Like the US dollar, which is no longer backed by gold, Bitcoin has no inherent value. Because cryptocurrencies are decentralized and unregulated, they’re a risky investment. It remains unclear whether Bitcoin can even deliver upon its main promise of reducing transaction costs of banking. In November of 2017, the average fee to process a transaction was $11.38, and miners were able to demand these higher transaction costs due to the increasing value and popularity of Bitcoin.
Bitcoin’s primary advantage, its anonymous and decentralized nature, also serves as its fatal flaw. Cryptocurrencies help facilitate illegal markets, but few reputable businesses accept cryptocurrency because of its risk. Additionally, whereas the Fed controls the money supply and ensures the US dollar maintains value, there is no central entity to prevent Bitcoin’s worth from falling to zero. For the time being, the risk-factor (which could be lessened by regulations and oversight) prevents cryptocurrency from truly entering the mainstream.
McArdle, Megan. “Bitcoin Is an Implausible Currency.” Bloomberg.com, Bloomberg, 27 Dec. 2017, www.bloomberg.com/view/articles/2017-12-27/bitcoin-is-an-implausible-currency.
Iansiti, Marco, and Karim R. Lakhani. “The Truth About Blockchain.” Harvard Business Review, Jan. 2017, hbr.org/2017/01/the-truth-about-blockchain.
Krugman and Wells Macroeconomics Textbook