Will Bitcoin ever replace fiat money?

Can cryptocurrency replace euros and dollars?

Since the introduction of the crypto currency Bitcoin in 2009, there has been heated debate about whether crypto money will replace currencies such as euros or dollars in the future. Facebook's plan to create the Libra cryptocurrency has fueled this debate. The approximately 2.5 billion active Facebook users would then have access to an alternative payment system.

In addition to numerous technical, legal and political problems, the fundamental question is whether a cryptocurrency system can function economically. From the point of view of the monetary economy, at least six reasons speak against cryptocurrencies being able to take over the functions of conventional currencies.

In the following analysis, cryptocurrency is understood to be a digital system, the rules of which are defined in a protocol. A decentralized database records the largely anonymous transmission of digital units between the participants. These units can be purchased as so-called tokens in exchange for conventional currencies. Since the system is based on the decentralized interaction of a large number of private actors, it can do without a central bank or state supervision and regulation. A kind of "private" money, withdrawn from government access and therefore more stable in value, is to be made possible.

1. Cryptocurrency insufficiently fulfills the basic monetary functions

All objects used in history as money fulfilled the function as a generally accepted means of payment, as a stable store of value and as a unit of account for determining the price of a good. Currently, only a very small proportion of all economic transactions are carried out in crypto currencies, which is why we cannot speak of a generally accepted means of payment. Due to the high price volatility, stable storage of values ​​is not possible. Even within the crypto universe, values ​​are typically given in dollars or euros. Microeconomically, cryptocurrencies do not work as money. The arguments below suggest that this will not change in the future either.

2. Crypto money cannot replace the monetary policy of a central bank

Each crypto currency must specify rules for controlling the supply of digital "monetary units" in its protocol. Typically these are rigid rules that are independent of economic developments. With Bitcoin, a steadily flattening growth in the amount of tokens is planned up to a certain maximum amount above which no more new units are issued.

A central goal of central bank policy is to create price stability. In addition, however, central banks are free to assess the respective economic situation and use monetary policy instruments as best as possible to achieve this goal. The human judgment of experts is essential here. In addition, the monetary policy framework is constantly changing as the economy itself is constantly changing. Monetary policy must therefore constantly realign itself flexibly. Optimal monetary policy cannot be linked to the mere growth of the money supply.

The old monetarists had placed stable growth in the money supply at the center of their monetary policy recommendations - however, these recommendations were rejected decades ago as not being economically expedient. The rules for the growth of the amount of tokens, which are mandatory in the protocol of a cryptocurrency, are also far too rigid. A supply of liquidity to the economy that is desirable from a monetary policy point of view could not result from this.

3. Crypto money does not allow liquidity injections in financial crises

In times of crisis, rigid rules for expanding the supply of money work even worse than normal. Because in a financial crisis, the need for liquidity in the financial sector increases by leaps and bounds. Customers withdraw their liquid assets. Markets make the provision of external liquidity more expensive or refuse. Financial institutions would collapse if they had to sell their assets to raise liquidity in falling markets. In such a situation, a central bank as the "lender of last resort" can prevent the collapse of the financial system and, subsequently, the real economy by making large amounts of liquidity available to the financial system at short notice.

A rigid supply rule of a cryptocurrency system does not allow the flexible creation of crisis liquidity, nor are the special circumstances of a financial crisis predictable, so that effective rules for creating crisis liquidity can be anchored in the protocol of a cryptocurrency in advance. The financial system of a cryptocurrency would therefore be crisis-prone and not permanently stable.

4. Crypto money does not allow monetary policy tailored to individual countries

Cryptocurrencies such as Bitcoin or Libra claim to create a globally functioning new monetary system. Internationally, however, national economies vary widely. In economic terms, they do not represent an optimal currency area, as they are subject to different developments - so-called asymmetric shocks. Goods markets, labor markets and capital markets are too little integrated to justify the creation of a common currency. Fiscal equalization mechanisms such as a common unemployment insurance system do not exist. National monetary policy and adjustable exchange rates therefore lead to much better economic results. Since the world is not an optimal currency zone, the economic system would not work under a global cryptocurrency.

5. Crypto money cannot prevail against established monetary systems

Monetary systems can be understood microeconomically as networks. Consumers and companies jointly inquire about the services of a monetary system for making payments. The more companies offer a certain payment system, the more attractive it becomes for consumers to use. The more consumers use a payment system, the more likely companies will accept this system. As the size of the system increases, so does the benefit for all participants. Conversely, small systems have a chicken-and-egg problem if they try to establish themselves next to a large system. Because the consumers do not use the system, the companies do not offer it. And because the companies don't offer the system, they don't use it.

Smaller systems such as cryptocurrencies only stand a chance if their performance is sufficiently different from that of larger systems. It can be argued that Bitcoin, for example, offers advantages over conventional currencies in illegal transactions or in an unstable country like Venezuela. In the case of bulk payments in a stable country with a functioning currency, however, a pure currency token will hardly ever get beyond a niche existence.

6. Crypto money would undermine the monetary and fiscal sovereignty of states

If governments allowed private monetary systems to emerge on a large scale, they would surrender an essential element of a country's monetary sovereignty. The monetary dependence on a non-transparent group of private actors, some of which are not domiciled, would be problematic.

In addition, the use of cryptographic processes to create anonymity is a central element of many crypto currencies. It is possible to make payments anonymously without being personally identified. This is not only a problem from the point of view of money laundering and the financing of illegal activities. It is also becoming much more difficult for tax authorities to control transactions and collect taxes. This would also undermine the fiscal sovereignty of states. In view of the impending loss of essential elements of their economic sovereignty, it is therefore not surprising that most states are reluctant to reject the development of crypto currencies as a substitute for established money. In any case, massive political resistance is to be expected.

The future of crypto lies in services beyond the established monetary system

If you look at the six arguments listed above together, the replacement of established currencies with crypto money appears very unlikely. Presumably, the development opportunities of crypto token systems are only marginally affected. Even if cryptocurrencies are unlikely to prevail against established currencies in fulfilling classic monetary functions, they have great future potential due to the diverse design options in other areas. Starting with the possibility of reliably and publicly storing data on a blockchain, through the numerous applications from "smart contracts" to "corporate tokens", many new areas of application are conceivable. Evolution will show which of the many concepts currently being discussed and tested are sustainable in the long term. Even if the euro and dollar persist, there could also be exciting new cryptosystems that may fundamentally change the economy and society. However, the monetary functions of these systems will not be in the foreground. (Guido Schäfer, January 14, 2020)