Why Cryptocurrencies Don’t Work as Currencies

by Benjamin Studebaker

I’ve been surprised lately by the number of people who have brought up or asked me about Bitcoin and other cryptocurrencies. It’s moved me to take a minute to point out why many economists and political economists don’t get excited about them.

If you talk to a Bitcoin enthusiast, chances are they’ll draw your attention to the technical aspects of how the cryptocurrency works. It’s decentralized! It works through a peer-to-peer network! Transactions are recorded in a blockchain! You can mine them! It’s open-source! They’re untraceable! But none of this really matters, because none of it really has anything to do with what currencies are for. There are two big things that make a currency socially useful:

  1. It provides a stable medium of exchange.
  2. You can pay your taxes with it.

These cryptocurrencies do neither. Let’s say a bit about each.

Stable Medium of Exchange

When a currency is rapidly decreasing in value, it’s inflating. When it rapidly increases in value, it’s deflating. Everyone can see the obvious problem with inflation–why would you want a currency that becomes significantly less valuable before you get a chance to spend it? But deflation is also ruinous. If your currency deflates, you have no incentive to spend it because you can expect that it will get more valuable the longer you hang onto it. A currency can’t act as a medium of exchange if people aren’t exchanging it. In economics we sometimes talk of the perils of a “deflationary spiral” in which deflation disincentivizes everyone from spending money. Because everyone hangs onto their money, demand collapses. Because demand collapses, firms can’t find anyone to buy the stuff they make. So they cut production, which means they cut jobs, which means wages and incomes fall, which means people have less money to spend, which means they spend less, which means firms lower their prices, which means more deflation, and so on:

When a cryptocurrency like Bitcoin’s price is increasing rapidly, it’s not acting as a stable medium of exchange. Most of the people who own Bitcoins aren’t spending them, they’re holding them in the hopes that they will increase in value. You don’t do that with a working currency, you do that with a commodity, like oil or tulips.

This isn’t just a matter of speculators breaking these currencies. Deflation is sometimes built-in. In Bitcoin’s case, the supply of the currency is meant to taper off and eventually become fixed. A fixed money supply sounds appealing to those who pine after the gold standard. But we left the gold standard for a reason–if the money supply is fixed, it can’t keep pace with a growing economy. When the economy grows faster than the money supply, economic growth pushes prices down, as we try to support more purchases with the same amount of currency. That means that once again the currency deflates. Central banks set modest inflation targets to guard against deflation–a little inflation encourages people to spend their money, while a little deflation can kick off a nasty recession. Bitcoin is rigged to deflate, which means it’s rigged to fail as a currency. Indeed, the Bitcoin algorithm means that even before the supply of Bitcoins becomes fixed, the rate at which the supply expands will be fixed, which means the supply can’t adjust to changes in the size of the market that uses Bitcoin. We need some control over the supply of our currencies so that we can adjust the monetary supply to fit the needs of our changing economies. But Bitcoin takes this control away from us by design. It’s set up to fail.

Paying Taxes

One of the reasons we use the currencies we use is that our governments insist that we pay our taxes to them in national currency. If we are paid in foreign currency, or in the form of some other set of goods or commodities, we still have to pay taxes on that income as if we had earned that income in national currency. So for instance, if you’re an American living in the United States and you accept Bitcoin as payment for goods or services, you’re still legally obligated to pay tax on that income as if you had been paid in dollars or engaged in bartering. The relevant income valuation for tax purposes is the Bitcoin’s value in dollars at the time of the exchange. This means that in combination with Bitcoin’s price instability, the tax liability on a Bitcoin transaction rises and falls spectacularly depending on the timing. When it comes time to pay taxes you have to pay in national currency. If all you have is Bitcoin, you have to sell off some of your Bitcoin to pay the tax bill, and there could be a large discrepancy between the value of the Bitcoin at the time you pay taxes and the value of the Bitcoin at the time you received the income. If the value of Bitcoin increases, you pay capital gains on that. If it decreases, you eat the loss. The state has Bitcoin users between a rock and a hard place.

So if it’s not a stable medium of exchange and you can’t pay taxes with it, what’s the point of Bitcoin? To some extent it works like a Ponzi scheme–if you get in early, you can make money by talking other people into buying Bitcoin and raising the price. The earlier you get in, the more you make. Beyond that, there are some who are interested in it because they think they can use it to launder money and cheat the government. If only small handfuls of people use cryptocurrencies to commit tax evasion, it might go unnoticed. But this would give the cryptocurrencies a relatively small black market user base and wouldn’t justify large valuations. To have a large valuation, you’d need a large black market user base, and a large black market user base will draw the attention of law enforcement. Already, the IRS is gearing up to extract user information from Coinbase, the digital currency transaction hub. Once it has this information, it can audit and investigate anyone and everyone who trades cryptocurrency. This is how the IRS went after Swiss bank accounts a few years back. Like Coinbase, the Swiss banks promised to protect user anonymity, and the US government made them eat their words. The closer cryptocurrencies come to succeeding as black market exchange mediums, the greater the incentive for the IRS to tear them limb from limb. And if you can’t use them to launder money, what on earth is the point of them? Some cryptocurrency users will tell you they have nothing to fear, that the technological sophistication of their currencies makes them invulnerable to the state. These people are openly bragging about using cryptocurrencies to break the law. They’re poking the bear.

None of this is to suggest that there’s any specific point at which the Bitcoin bubble will burst–if I could predict that, I’d be rolling in cash. But it’s clear that decentralized non-state cryptocurrencies can’t perform the functions which state-backed currencies perform, and for that reason their use (and consequently their real social value) will always be limited. If we take into account the fact that cryptocurrencies make the most sense when you’re trying a break the law, their social value may be negative, and that means users are living on borrowed time. Sooner or later, the state will come for them. Like Ben Franklin said, nothing in life is certain except death–and taxes. You can fight the law, but you know how that usually goes: