Stability determines who wins the crypto war

It would be difficult for anyone to imagine that a "currency" that often fluctuates 20-30% in value in a few days could gain widespread use as money. That is Bitcoin’s long-term problem.

The wild rise in the price of Bitcoin and other cryptocurrencies have certainly got investors – both private and professional – to sit up and take notice. In fact, in some sense we can say that to survive as an investment object for gamblers there is a need for price fluctuations. But the consequence of that is also wild fluctuations in the implicit purchasing power of the cryptocurrency, which certainly is not a warranted feature of any currency.

Bitcoin's strength is its biggest problem

The reason anyone wants to buy a Bitcoin is that the amount of Bitcoin in existence, at least in principle, is fixed and cannot be changed. There is no central bank that can arbitrarily decide one day to double the amount of Bitcoin in circulation. That gives considerable credibility.

But this quantitative limitation is also Bitcoin’s biggest problem, as larger or smaller fluctuations in demand create huge variations in price. We have all been able to observe this kind of volatility recently.

While such price fluctuations may well make Bitcoin attractive to speculators, it also makes Bitcoin virtually worthless for everyday use as a common currency.

The solution: elastic money supply

It is possible that Bitcoin’s price volatility will decrease over time. But more likely, it suffers from the same ‘design error’ as the old gold standard, which also had a quasi-fixed money supply, giving rise to large fluctuations in the currency’s purchasing power.

This in my view makes it rather likely that Bitcoin, sooner or later, will be superseded by other cryptocurrencies, which will be designed to provide far more stability in their implicit purchasing power.

The way to ensure this stability is to think of a cryptocurrency where the amount of ‘coins’ is not fixed, but to a greater or lesser extent varies with demand. Thus, the money in circulation rises when demand does.

To ensure the credibility of such a cryptocurrency, the technology used in Bitcoin must be applied in a more sophisticated model. Coin production would still have to be strictly limited by a computer algorithm that cannot be changed. But stability also requires a better ‘monetary policy’ rule than the one that now controls the production of Bitcoins.

Relatively stable cryptocurrencies already exist, but they do not enjoy Bitcoin’s popularity. However, it is likely in my view that they – or something similar – will be Bitcoin’s future replacement.

Bitcoin started as an alternative to the money issued by central banks around the world. Quite soon, there will probably be more attractive options available. Yet the competitive challenge that Bitcoin offers to the “established” currency system should be welcomed. The currency that wins will be the one that best protects purchasing power. It hardly matters whether it is money issued by a central bank or generated by a computer algorithm.

PS we are presently considering to launch a new publication in 2018 on the cryptocurrency market. The idea presently is to do fairly regular commentary on cryptocurrency related issues from the perspective monetary theory and monetary history to give participants in the cryptocurrency markets a better understanding of the monetary issues driving the markets. The publication will on the other hand not be investment advice.