Bitcoins, cash and tulips

Article written by Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research for Societe Generale, first published in Banque & Stratégies magazine n°366 in February 2018.


Bitcoins generated much excitement in 2017, starting off the year valued at just over $1 000 per bitcoin and closing the year at around $10 000, having peaked at close to $19 000 in mid-December 2017. While the extreme volatility of Bitcoin generates both spectacular gains and devastating losses, it significantly reduces the ability of the crypto-currency to serve as a means of payment; the purpose for which it was originally designed. Indeed, the recent pattern of the Bitcoin price renders it more akin to the speculative mania that engulfed tulip bulbs in 17th century Netherlands, epitomized together with several other speculative bubbles in a 19th century study entitled Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. Tulips are nonetheless still around today, adorning our interiors and generating profits for the producers. Where will Bitcoin be in the future?

Bitcoin is by design a peer-to-peer electronic cash system and like all other fiat currencies, it has no intrinsic value and only derives value from its ability to act as a means of exchange and a store of value; characteristics that both rely on trust. When it comes to traditional currencies, such as the US dollar, the euro or the Venezuelan bolivar, this equates to the trust placed in the government. Trust (or the lack thereof) that governments will (1) protect the value of the currency by making it hard to forge, (2) protect the value by not suddenly turning on the printing press and (3) protect the currency’s status and ease of use as legal tender. Central banks often play a major role in protecting the value of the currency by adopting a policy to security price stability. Trust in the banking system’s ability to keep deposits protected from theft or loss is also an important dimension in this system of trust.

Given that economic history is littered with cases where governments have abused this trust in various ways, it comes as no surprise that proponents of crypto-currencies point to the fact that the system does not rely on backing from any government as one of the major advantages. The blockchain technology, moreover, is trusted to ensure the safety of both Bitcoin deposits (holdings) and transactions; while the anonymity of the system allows users to freely move funds across borders without being subject to any government control. Bitcoin, moreover, is constructed so that only around 21 million coins will ever be created, ensuring a stable money base (this amount is expected to be reached in 2140 with around 17 million Bitcoins already mined).

Bitcoins, however, come with their own security concerns. Albeit easily remedied by backups, there is the simple concern that users can lose their bitcoins by something so commonplace as a hardware malfunction. Reports of crypto-theft by hackers also regularly make it to press headlines; here the quality of the private key password and the eventual crypto-currency platform security are of central importance. Crypto-forgery, luring unsuspecting individuals to unsafe applications, is another issue. There is also the concern that the system could become too centralised with a limited number of miners holding the increasingly powerful computer systems required. Indeed, the security of the system is by design reliant on decentralisation forcing a consensus.

A further security concern is that the anonymity of the system may offer terrorists and criminals a means to move funds around the world undetected and launder revenues from criminal activities. Tax evasion is a further potential concern. Albeit that somewhat ironically, there is a concern that sharing a Bitcoin address equates to sharing information about payment habits. To avoid this requires a somewhat impractical solution of multiple accounts. A final point to ponder is that Bitcoin is not the only crypto-currency in circulation;, an often-cited crypto-currency source, suggests that while Bitcoin is the largest at ($148bn as we head to press), a total of 896 crypto-currencies are currently in circulation with a market cap of around $5380bn. This still fairly modest in size (around 0.4% of World GDP) which means that a crypto-currency crash is unlikely to prove a systemic event at present.

One of the main criticisms of Bitcoin, however, is the energy intensity of the system which raises major questions on the potential for scalability and mass adoption. This is not only a concern for the environment but also a concern when it comes to Bitcoin transaction costs. At the onset, the idea was that Bitcoin would allow individuals to transfer funds across borders as safely and much quicker and cheaper than other traditional providers of payment services. The reality is, however, that the crypto-currency faces a scaling problem that is already now leading to higher transaction fees and slower transaction times, as the miners, who’s role it is to keep the blockchains that sit at the core of the system up to date, quite logically give priority to higher fee transactions. Of course, clever minds are looking for solutions that may one day allow crypto-currencies to operate on a large scale. Given that already today there are numerous crypto-currencies, there is also a need for blockchains to be able to easily communicate between each other to ensure interoperability.

Michala Marcussen Group Chief Economist,

Despite this long list of concerns and technical issues, the potential crypto-currencies and the blockchain technology that underpins them should not just be ignored as a temporary craze. The blockchain technology is indeed already finding use well beyond the world of crypto-currencies given its potential as a secure and swift transactions management tool; and cost efficiency when volumes are moderate.

Returning to crypto-currencies, it comes as no real surprise that governments and central banks alike are showing interest; be it to warn on the dangers of speculative bubbles, seek out ways to tax potential crypto-currency investment gains or to stem any illicit activities. But governments are also pondering whether they should one day issue their own crypto-currencies as legal tender. Imagine for a moment that the various technological issues are solved and that central banks issue crypto-currencies as legal tender. What would that entail?

At present, central banks create base money through their bank balance sheets by issuing notes and coins and generating reserves held by the commercial banks at the central bank. Broad money supply then results from the system of fractional reserve banking, as banks lend out funds to their customers, simultaneously creating a credit and a deposit. Part of this new deposit must then be placed at the central bank as part of the required reserves and the rest can then again be lent out.

Central banks conduct monetary policy through the volume of supply of base money and the price hereof, in the form of central bank interest rates. There is no reason why this system could not continue with crypto base-money and crypto broad-money. One important difference, however, is that it would make it much easier for central banks to impose negative interest rates if so desired and the anonymity of cash transactions would be gone. It is worth note, moreover, that commercial banks are careful not to offer deposits and loans in currencies where they cannot relatively easily gain access to some form of central bank liquidity if needed. It seems highly unlikely that private crypto-currencies could one day fulfil this function, leaving ample space for public crypto-currencies issued by the central bank. Some argue that issuing a crypto-currency would allow central banks to directly provide “safe” central bank money to all citizens and not just to the banking-system. This is true, but if central banks wanted to do so, they could already today offer deposits to their all citizens today in the current fiat currency systems.

Impressive as the blockchain technology that underpins crypto-currencies is, it is worth keeping in mind that a new technological wrapper rarely changes the fundamental function that a good or service meets. I imagine that a 17th century Dutch economist may have pondered tulip mania much in the same way that I do the Bitcoin craze, with a good strong cup of coffee and a few soothing notes of music in the background. Will future generations of economists be paying for coffee with crypto-currencies as they ponder the 2017 Bitcoin craze? My guess is yes, but that they will have been issued by the central banks and backed by governments.”


Article written by Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research for Societe Generale, first published in Banque & Stratégies magazine n°366 in february 2018.