Bitcoin, the cryptocurrency, has soared against the dollar more than 1,600 percent over the past year. Other cryptocurrencies such as ethereum are up even more. Public curiosity about digital currencies has soared twentyfold, as gauged by Google trends.
An industry has sprung up to try to capitalize on this new technology, bringing a mix of savvy investors, prospectors, and hucksters. Staid companies such as 130-year-old Eastman Kodak have added cryptocurrency-related lines of businesses, and have seen their stocks soar.
Dogecoin, a cryptocurrency launched in 2013 as a joke playing off a popular meme featuring a Shiba Inu dog, this month saw the dollar value of its “coins” exceed $2 billion.
Huge price gains. Major public excitement. A media frenzy. Envy of the early adopters who are now, at least in the crypto world, billionaires. All tell-tale signs of a bubble, as listed by economist Robert Shiller, who won the Nobel Prize for his work on financial bubbles.
One last mark of a bubble, according to the checklist Shiller laid out in 2013, is the belief in theories that the economy has entered a “new era” to justify price increases that have no precedent or basis in underlying business.
On that score, bitcoin is the ultimate example.
Bitcoin’s biggest proponents believe, and have believed from the day the peer-to-peer, digital currency was hatched, is that the invention could replace most of our financial institutions. That includes the dollar, the Federal Reserve, and the banking system.
That possibility, however fantastical, is ultimately driving the bitcoin run-up. And it is closer today to actually fulfilling that promise than what could have been imagined just a decade ago. The current mania only helps, because the more people know about bitcoin, the more likely they are to consider the idea seriously of buying or selling and using it.
Yet, Washington appears to be asleep at the switch. The federal government as a whole is unprepared for what amounts to an attempt at a hostile takeover of its currency monopoly. The prospect that bitcoin could threaten the dominance of the dollar, or at least force changes at the Fed, is a topic that has not even been broached on Capitol Hill, even as anarchists and libertarians who first backed bitcoin see their plan unfolding as they foresaw it.
Written into bitcoin from the beginning
Bitcoin’s creator, or creators, were fueled by skepticism of government-run currency.
“The root problem with conventional currency is all the trust that's required to make it work,” bitcoin’s creator, the pseudonymous Satoshi Nakamoto, wrote in a 2009 post in a peer-to-peer cryptography forum, in which Nakamoto developed the concept. “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”
Fiat currencies refer to those that aren't backed by physical objects, like gold, and are deemed valuable by a government.
Nakamoto, whose identity has never been established, proposed the concept of bitcoin in a white paper posted to the forum as a way to cut out the middleman in transactions.
Rather than requiring a trusted authority, such as the Federal Reserve, to maintain what is essentially a large ledger to allow parties to make payments to each other, Bitcoin would allow buyers and sellers to transact directly with each other using an online ledger. Transactions on the ledger would be verified through a cryptographic process, rather than being maintained by a third party.
In the first iteration of that ledger, the so-called “genesis block” that created the first bitcoins, Satoshi included a reference to a headline from that day, Jan. 3, 2009, published in The Times of London: “Chancellor on brink of second bailout for banks.”
Satoshi can only have meant the line as a criticism of the monetary system that prevails in Britain, as well as in the U.S. and most countries today.
The key features of that system are fiat money issued by a central bank, and a fractional reserve banking system that multiplies the money supply. Today, “money” is generally understood to include cash and bank deposits.
Bitcoin is meant to loosen the government’s grip on money. It was developed by cryptographers and libertarians and first adopted by people looking to stay beyond the government’s reach, such as online drug dealers and gamblers.
Many libertarians have long called for ending the government’s control of money, usually in favor of a gold standard. Ron Paul, the former congressman and author of End the Fed, for years campaigned on replacing the central bank with a gold standard. (Paul has expressed skepticism about bitcoin because its value is not defined in terms of a commodity.)
Now, the broader public, not just libertarian diehards, is becoming aware of cryptocurrencies. In bitcoin backers’ eyes, their attention is welcome even if they are craven speculators or merely curious bystanders. Bitcoin needs recognition to become a widely accepted means of payment.
“More people are becoming familiar with crypto, and realize that money, like all goods, is better provided by the market rather than by monopolistic government,” said Erik Voorhees, the CEO of ShapeShift, a cryptocurrency exchange. “Obviously, much of the interest is speculative, but that’s true in any new industry, and with each wave of new users, a portion of them become permanently interested in the technology.”
Voorhees is a prominent entrepreneur within the cryptocurrency industry. Before venturing into business, he blogged prolifically on the case for taking control of the money supply away from the government. “My hope is that within a generation, people will realize how silly it is to use money that is continually debased and manipulated by politicians and banks,” he said. “Bitcoin represents the separation of money and state.”
An older pedigree
The technology for public digital ledgers known as blockchains is new, but the idea of private currencies has captivated libertarians for decades.
In 1976, Friedrich Hayek proposed ending government monopoly of currency and allowing private issuers to step in.
Hayek, later a Nobel Prize winner and a leading figure in libertarianism, didn’t buy the conventional justification of the government’s control over the monetary system.
He didn’t believe that a central bank is needed to maintain an elastic supply of the currency, providing more money in the case that more is demanded, such as during a downturn when businesses and households want more cash on hand because they're scared about the future.
Instead, he reasoned that if private banks were allowed to provide their currencies, they would have every incentive to ensure that the currency remained stable, relative to a basket of goods, which is the same basic goal that the Fed has for the dollar. They could produce currency that served as a reliable medium of exchange and a store of value. If they didn’t, customers would take their business to a different bank, one with a more stable currency.
In the end, banks would offer reliable and stable currencies for the same reasons that gas stations provide high-quality gasoline. Furthermore, ancillary industries would pop up to fill the other needs created by private currencies, such as providing conversions at the point of sale in shops. “[S]heer desire for gain would produce a better money than government has ever produced,” he concluded.
From Hayek’s point of view, a system of private currencies would cure a variety of economic ills. It would rule out the possibility of unexpected inflation or deflation, and smooth out business cycles.
But it would be most desirable because it would stop the growth of government. “Nothing can be more urgent than that we dissolve the unholy marriage between monetary and fiscal policy,” Hayek wrote.
The libertarian intuition behind Hayek’s statement is that the government’s control of money allows it to finance programs and military operations by issuing itself loans at favorable terms or inflating away debts that it has already incurred.
Take away the government’s right to print money, the thinking goes, and the gravy train slows to a halt. Politicians wanting new spending would be forced to tax the voters who elect them, rather than hiding it via a stealth inflation “tax.”
Precedent for private currencies
When Hayek wrote about private, competing currencies, he could not have imagined the growth of the Internet, let alone the emergence of cryptocurrencies.
Nevertheless, history offers examples of the private currency systems he favored. For instance, Scotland from 1716 to 1845 featured several competing banks offering currencies, and had relatively good monetary stability. Canada did not have a central bank until 1935, and didn’t suffer from bank collapses during the Great Depression.
A digital currency system would be more radical than those examples. In the past, banks served as currency issuers because they were at the center of the payments system, making it easier to introduce currency into circulation.
Cryptocurrencies, however, would loosen the historical connection between banks and currencies by allowing individuals to transact directly with each other, not needing any financial institution to facilitate the payment. Bitcoin, in effect, serves as a kind of digital gold, a synthetic commodity, but one that doesn’t need to be weighed or stamped by any authority to verify its value. The total number of bitcoins that will be produced is capped by its underlying algorithm.
Cato Institute monetary scholar George Selgin points to one fairly recent example of something like a synthetic commodity being used as money. Before the 1991 Gulf War, sanctions prevented Iraq from restocking the supply of dinars printed in the U.K. Although Saddam Hussein condemned the paper currency and tried to replace it with his own money, the old stock of dinars continued to circulate in the Kurdish regions of Iraq. The currency didn’t work very well as money, in part because the notes began to fall apart after they exchanged hands again and again without replacement, but the system wasn’t a complete failure. It did work.
Satoshi Nakamoto appears to have wanted, and many of his fans want, to force a similar system on today’s economies. They don’t want to ask the government for change; they simply want to impose it without asking permission, through the blockchain.
The government isn’t prepared
Official Washington has not yet prepared for, and is still not responding to, the challenge or threat of losing its monopoly on currency.
Article I of the Constitution gives Congress the power to coin money and regulate its value. But most members of Congress aren't even aware of the idea that blockchain technology could threaten the institution's control of money.
One excuse is that Congress delegated monetary policy to the Fed in 1913 via the Federal Reserve Act. With the Fed and its presidential appointees responsible for the stability of the dollar and monetary policy, representatives and senators are not often forced to debate, campaign on, or otherwise think much about the currency they ultimately control.
The panels and subcommittees with oversight of monetary policy haven’t held hearings on the possibility that cryptocurrencies could provide competition to the dollar.
Congress has, however, taken the first steps in reacting to other possible effects of cryptocurrencies, beginning in late 2013 when bitcoin first made news for hitting $1,000.
But those hearings and interventions have mostly related to the potential that cryptocurrencies create for money laundering, fraud, or tax evasion. Not money provision.
Nor has the Trump White House responded, apart from a few throwaway lines from National Economic Council Director Gary Cohn, who has suggested he believes in cryptocurrencies’ potential.
Some agencies have been forced to reckon with bitcoin, because the industries involved in it have grown and demanded their consideration. For example, the Commodity Futures Trading Commission has paved the way for Bitcoin futures. The Securities and Exchanges Commission has warned investors of the dangers in buying cryptocurrencies. The Treasury monitors the use of Bitcoin for money laundering.
Treasury Secretary Steven Mnuchin said Friday that the super-group of regulators he chairs, the Financial Stability Oversight Council that is empowered to subject businesses or industries to financial regulations, has formed a working group to study cryptocurrencies. The aim of the group, he suggested, would be more to examine the possible use of bitcoin for money laundering and to protect consumers swept up in the current mania than to determine whether it poses a threat to the dollar.
Most importantly, the IRS has issued guidance that cryptocurrencies are assets for tax purposes. In making a purchase with bitcoin, users might realize a taxable capital gain, assuming that the value of that bitcoin has risen since its purchase.
Owing taxes on bitcoin sales would be a huge impediment to its adoption as a currency. The dollar, too, would obviously be hard to use if every purchase entailed tax implications.
“What Congress can and should do is protect consumers that use cryptocurrencies in their everyday life from being unfairly taxed,” said Rep. Jared Polis, D-Colo. Polis has co-authored a bill that would allow consumers to make cryptocurrency purchases of under $600 without facing reporting requirements.
He and Rep. David Schweikert, R-Ariz., is chairman of the Congressional Blockchain Caucus, a group of lawmakers aiming to develop the regulatory framework for blockchain businesses.
Although a proponent of cryptocurrencies, Polis views them as playing only a limited role in the monetary system. “So far, cryptocurrencies fill a limited role compared to fiat currencies like the U.S. dollar,” he said.
More important than regulations for specific blockchain businesses, though, is the overall regulation of currency, a job that is up to the Fed.
For the most part, high-ranking Fed officials versed in monetary economics have simply brushed off the idea that bitcoin could really be a currency.
“I would simply say that bitcoin at this time plays a very small role in the payment system,” Chairwoman Janet Yellen said at a December press conference. “It is not a stable source of — store of value, and it doesn’t constitute legal tender.”
“I don’t see bitcoin as a credible competitor to the dollar in the United States of America,” Federal Reserve Bank of Minneapolis President Neel Kashkari said in a public appearance in January.
Kashkari, though, acknowledged that it is too early to say what cryptocurrencies might become. “We’re in the earliest days of trying to figure out what virtual currencies are going to mean for the U.S. or for developing nations,” he said.
The challenging economics of privately-issued currency
Yellen and top officials have other issues besides the rise of cryptocurrencies on their minds. But individual researchers scattered across the sprawling Fed system have been examining the blockchain and wrestling with its economics since it began being traded.
Recently, a researcher affiliated with the Philadelphia Fed and a University of Pennsylvania academic co-wrote a paper looking into the feasibility of Hayek’s idea, and whether currency competition involving bitcoins could work. They came to a mixed conclusion.
The researchers used a standard model of monetary economics and plugged in the possibility of entrepreneurs issuing their own currencies, such as cryptocurrencies.
They found that, in some cases, it would be possible for the market to produce a system of currencies with stable prices. But most of the time, the experiment wouldn’t work.
Jesus Fernandez-Villaverde, the Penn economist who co-wrote the paper, explained that markets for money won’t produce the reliably good outcomes that would be expected from other markets because of the unique nature of money. “The market for money is incredibly different from the market for, say, potatoes,” he said.
The underlying issue is that money itself is used to address a major “friction” in markets, namely the difficulty of trading for all the necessities of life in the absence of money. For example, a book publisher would have a hard time trading books for housing, food, clothes, and so forth. Economists call this the "double coincidence of wants." Money, as a medium of exchange, smooths out that “friction” by allowing anyone to convert the fruit of very specialized work into something that can be traded for anything — a medium of exchange.
But because money itself is geared toward easing an underlying market friction, it is not itself amenable to market competition, Fernandez-Villaverde suggested, attributing the insight to one of the great libertarian economists, Milton Friedman.
Specifically, the problem is that currency providers would get conflicting signals from the market about what the value of the currency needs to be in order to satisfy all the different coincidences of wants in the economy.
The Nobel Prize winner did lay out reasons for a government monopoly of money in a 1959 lecture. Later in his career, Friedman would suggest with his co-author Anna Schwartz that private currencies could work in theory, but that it wasn’t realistic or worthwhile to try to get the government out of the business of producing money. The two left the door open, however, to the possibility of evolutions in technology they couldn’t foresee. Friedman died in 2006.
Influential even if it doesn’t ‘work’
Even if cryptocurrencies are not a legitimate rival to government currencies, they could still force the Fed or other central banks to change the way they do business.
Fernandez-Villaverde’s research suggests that alternative currencies could keep bad central banks in check, effectively imposing “market discipline” on them.
For instance, if the Fed allowed a return to the days of the Great Inflation of the 1970s, the public might turn to cryptocurrencies with stable values.
A lot of smaller countries have seen far worse management of the money supply than the U.S. did in the 1970s. In Venezuela, suffering from an inflation rate in the thousands and strict currency controls, residents have reportedly turned to bitcoin in higher numbers to pay for regular transactions.
In theory, the blockchain “makes it possible to move money beyond the reach of a terrible government,” said Will Luther, an economist at Kenyon College and a scholar for the Cato Institute's Center for Monetary and Financial Alternatives.
Citizens wouldn’t even have to adopt alternative currencies to force the government to improve its own currency, Fernandez-Villaverde noted. The mere threat of a shift could force the government to clean up its act. The fear of losing control of the currency to an algorithm would be a powerful motivation.
In fact, the blockchain doesn’t necessarily have to produce a viable currency at all to threaten to upend the currency system.
David Yermack, an NYU finance professor who has researched cryptocurrencies, views bitcoin as a poor medium of exchange and store of value, even after its recent successes. But he believes that central banks could introduce their own digital currencies.
By processing payments through a blockchain, the Fed could cut out the middleman of banks. Everyone could have a deposit account directly with the Fed via the blockchain, allowing for faster payments and far greater control of prices by the central bank. “If that occurs, the fractional reserve banking system may become a thing of the past,” Yermack said.
Government’s eventual response
If cryptocurrency were ever to threaten the Fed’s control of money, the assumption is that the government could undercut it with new laws.
"When bitcoin becomes a threat, they'll take whatever action" they need to suppress it, former Fed Chairman Ben Bernanke said at an October event hosted by a blockchain company.
The evidence is on Bernanke’s side.
The government has in the past batted down private currency issuers. In 2007, for instance, federal agents raided and shut down Liberty Dollar, a small company that provided private currency.
A handful of countries have declared it illegal to transact in bitcoin or for banks to exchange the cryptocurrencies.
Yet, it would be difficult for any one government to stamp out a cryptocurrency entirely, for the same reasons they would struggle to stop trading in gold. Bitcoin is maintained by an online network distributed all over the world, and is accessible wherever there is Internet access.
Government restrictions could make bitcoin less appealing. But the better it works, or the worse the government manages its own money, the more likely it is that people will want to use it anyway.
“Governments will not give up their control of money willingly,” Vorhees said. “They will likely impose all manner of restriction and regulation down upon new competing currencies, but for now, they suffer from hubris and don’t really believe their fiat paper could ever be threatened.”