Bitcoin complies with classical economic laws

Case

Bitcoin complies with classical economic laws

Crypto currency may have the future

Is bitcoin, with its strange rate fluctuations, simply a bubble or is it the currency of the future? Cryptocurrencies do comply normally with classical economic laws, as economists have discovered. But not even they can predict whether cryptocurrencies will shortly render the traditional banking system obsolete.

The bitcoin price explosion in late 2017 at first seems reminiscent of the Tulip Mania during the Dutch Golden Age, when the value of tulip bulbs soared so spectacularly that a splendid Amsterdam canal house could be bought for a single bulb. Tulip mania was based purely on speculation, it emerged, following the price crash and its abrupt end in 1637. ‘But bitcoin is quite a different story, its value can be explained logically,’ says economist Albert Menkveld, ten years after the currency’s introduction. ‘Bitcoin is surrounded by more uncertainty than traditional currencies, but does definitely work like a currency.’

Photo Albert MenkveldPhoto: StudioVU/Riechelle van der Valk

The Professor of Finance at VU University Amsterdam worked with fellow economists from France to develop an equilibrium model based on the theories of economist Jean Tirole. They then unleashed it on bitcoin. Their innovative model determines the economic value of a currency by looking at the transactional benefits and the costs. In other words, the ease with which it can be used to buy goods and services is important, but so are the costs that bitcoin owners incur in order to redeem their digital money.

The equilibrium model predicts that the value of a currency rises when transaction costs are high. This is entirely true for bitcoin. By late 2017, the fees paid to “miners” – verifiers of digital currency transactions – had risen sharply due to “congestion” on the blockchain in which pending transactions are recorded. The more the owner paid to the miner, the faster the transaction was processed.
The return on bitcoin also appears to be lower the easier it is to use it to buy goods and services. Menkveld: ‘This can be explained by the fact that the premium for maintaining the currency doesn’t need to be as high. After all, the currency is more attractive as a means of payment.’ A survey carried out by the economists from 2010 to 2011 showed that paying with bitcoins was difficult at the time. And indeed, back then, the return was high. Conclusion: bitcoin prices can be explained using a classical model; there is nothing irrational about it. Legally, cryptocurrencies now have the status only of a means of exchange, but in reality they do indeed function as money – irrespective of the erratic rate fluctuations due to speculation.

Did you know? Bitcoin received a boost when the 2008 financial crisis revealed the mess caused by the banks.

The man in the street

Cryptocurrencies were originally devised as a means of making payments outside the existing institutions, which is cheaper and makes international payment transactions much easier. Bitcoin, the best-known cryptocurrency, received a boost when the 2008 financial crisis revealed the mess caused by the banks. The mood was that the man in the street was being asked to bail out the bankers who had grown wealthy at the expense of ordinary people. So there was every reason to put them out of the game. Similarly, expensive taxi companies were bypassed by Uber, and CD sales collapsed with the arrival of Spotify.

The unusual thing about cryptocurrencies, of course, apart from not involving banks, is that they don’t involve governments either. Who could intervene in an economic crisis if everyone pays for their shopping with bitcoins? A country’s central bank has no control over cryptocurrencies and so, for example, cannot print more money to stimulate inflation. On the contrary: the number of bitcoins is finite. And that makes bitcoin even more interesting to economists, because it holds its value. This is one reason why even hedge funds have pumped a lot of money into bitcoin.

My gut feeling tells me that a scenario in which banks issue an electronic currency is more likely
- Albert Menkveld

Does this also mean that bitcoin is a keeper? Menkveld certainly believes that cryptocurrencies are the future – provided they are not banned. But whether Bitcoin will emerge as the winner on the battlefield of digital payment methods is far from certain, because there are more candidates such as PeerCoin and ZeroCoin. Facebook too recently announced its own cryptocurrency, called Libra. Visa, Mastercard, PayPal, Spotify and Uber are among the companies said to be participating in this project. ‘The involvement of such major companies makes this kind of currency even more promising,’ says Menkveld. ‘But my gut feeling tells me that a scenario in which central banks issue an electronic currency is more likely.’ The traditional banking sector is sidelined in this scenario too. Good news for the consumer and shopkeeper, because the banks’ hidden costs are high.

Banks also cost much more than the miners who give the present cryptocurrency its reliability by using a verification protocol. Whether they will still play a role when central banks take over the issuing of electronic money is debatable. One disadvantage of Bitcoin is the complex cryptographic encryption required to prevent codes from being cracked and bitcoins from being pickpocketed from bitcoin wallets or issued multiple times. This costs not only money, but also computing power and energy. The estimated energy consumption per transaction is as much as 250 kWh: equal to what the average Dutch household consumes in a month. ‘For central banks it takes much less effort to guarantee reliability,’ says Menkveld. ‘Worldwide, central banks are discussing their own “Bitcoin Plus”, an electronic currency that can potentially be linked automatically to economic variables such as Gross National Product and price levels. Sweden and Australia are already taking concrete steps. I believe it is closer than most people suspect.’

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