Is digital money a waste?

The roundup last month of Sam Bankman-Fried, who pleaded not guilty to allegations of fraud at FTX, is only the most vivid of recent catastrophes regarding e-money.  Since late 2021, bitcoin prices have fallen off a Dover cliff, as Figure 1 shows.  Pundits are inspired.  “Whatever highfalutin things you might have been told, crypto is only really about one thing: Making a quick buck,” writes Jemima Kelly of The Financial Times.

 

Figure 1: Bitcoin prices since 2015

Source: International Monetary Fund

In reality, digital money (and it really is money, as anyone who has used a debit card at McDonald’s knows) may be a godsend.  We, and the economy, would gain if we could send and get funds as easily as email. Yes, hustlers take advantage, of the ease of digit money, to rob us; but that does not mean that it can never help us. Think of the rapid switch to new-fangled checks from cash payments early in the 20th century. The fact that a scofflaw could kite checks did not make them useless. 

Central banks recognize the promise in digital currencies.  More than 100 countries have “adopted or explored” digital currencies sponsored by their central banks, says the International Monetary Fund. El Salvador and the Central African Republic recognize bitcoins as legal tender.   

Crypto crooks  

Still, digital moneys are prone to fraud, because they are not all regulated.  The value of any form of money depends on the central bank, which controls the nation’s money supply. For example, in the United States, the Federal Reserve sells bonds for dollars and takes the dollars out of circulation. This raises the value of a dollar in the economy—thus fighting inflation, the average increase in prices which reduces the amount of goods that your dollar can buy. (On the other hand, when the Fed wants to create jobs, it sells dollars for bonds, circulating dollars to boost spending.)  The Fed succeeds because it controls the dollar supply. But central banks are still getting a grip on cryptocurrencies.  No one central bank controls them, especially stablecoins, a private money that promises to redeem at a fixed value. 

In principle, cryptocurrencies can be as safe as gold, because technology can limit their supply. To create another bitcoin transaction, the computer must solve a complex problem. But in reality, since no one regulates cryptocurrencies worldwide, little stops an unscrupulous dealer from flooding the money market with bitcoins while falsely claiming that they are fixed in supply (and thus selling them at a high price).  So bitcoins really aren’t as safe as gold: There is a physical limit on the gold supply but none on bitcoins.

Cryptocurrencies look like a good deal because their value sometimes rises sharply on the market. But this is due to a fad. Everyone thinks that cryptocurrencies pay off big, so everybody buys them, which forces up their price. It’s a self-fulfilling prophecy. However, what goes up can as easily come down.  When bitcoins fall in price, everyone will want to sell them, accelerating the price decline.  Glance again at Figure 1. 

Speculative debacles are an old story. When computer-firm startups crashed in 2000-01 due to over-expansion, the US economy went into recession.  In the 1630s, a speculative craze over Dutch tulips suddenly imploded.  Does Figure 2 look familiar? In general, in finance, anything that looks too good to be true, probably is. 

Figure 2: Speculation on tulips raises their price—for a while

Source: Earl A. Thompson, The Tulipmania: Fact or artifact?, Public Choice 130: 99–114. 2007.

If you can't trust the bitcoin a bit, what can you? It's a good idea to put your money in something safe and easy to cash, like US Treasury bonds. (A bond is just a loan to the bond seller.  The Treasury borrows money by selling bonds, which it eventually pays off.) They’re safe because everyone trusts the US government to pay its bills (or has so far), so bonds sell at a stable price. 

Another good place to park your money is a stock index fund, like Standard & Poor’s 500, which reflects the stock market.  It’s fairly safe (though not as safe as a Treasury bond) because the stock market rises and falls with the US economy, which usually grows.  If you’re young, you can speculate just a bit, if you wish, by buying stock in an industry that you understand and by selling when the price is right. (You can speculate because your income will rise over time, covering losses from small risks.) But I wouldn’t stake more than 10% of my money, if I were young. 

"Enough!" you say. (You may know the New Orleans standard written about me, "Oh, didn't he ramble.") "What can I read?" Well, Burton Malkiel’s book on money management, A random walk down Wall Street, entertains and informs.  On cryptocurrencies, the IMF blogs enlighten (img.org). The IMF is an international group that rescues currencies in emergencies.

That’s probably more (or less?) than you wanted to know about digital money. Used with care, they can save us time and grief.  Used without care…. --Leon Taylor, Baltimore, tayloralmaty@gmail.com

     

References

Jemima Kelly. The clowns of cryptoland haven’t given up | Financial Times (ft.com)  January 19, 2023.

Bo Li and Nobuyasu Sugimoto.  Crypto Contagion Underscores Why Global Regulators Must Act Fast to Stem Risk.  imf.org

Andrew Ross Sorkin, Ravi Mattu, Bernhard Warner, Sarah Kessler, Stephen Gandel, Michael J. de la Merced, Lauren Hirsch, and Ephrat Livni.  Sam Bankman-Fried’s “house of cards” teeters.  The New York Times. Dec. 13, 2022  FTX Founder Sam Bankman-Fried’s “House of Cards” Teeters - The New York Times (nytimes.com)

Adrian Tobias and Tara Iyer.  From Crypto to Central Bank Digital Currency, Podcast Tracks Fintech Boom.  From Crypto to Central Bank Digital Currency, Podcast Tracks Fintech Boom (imf.org)  December 21, 2022.

 

Good reading

Thomas Mackay.  Memoirs of extraordinary popular delusions and the madness of crowds.  1841. Depicts Tulipmania vividly (if not always accurately).

Dave Roos.  The real story behind the 17th-century “Tulip Mania” financial crash. History.com . March 16, 2020.  The Real Story Behind the 17th-Century ‘Tulip Mania’ Financial Crash - HISTORY  A fascinating correction to Mackay.