how cryptocurrencies are trying to perform an act of economic necromancy
Cryptocurrencies are — and I have to handle this metaphor carefully because it’s an antique — the gold rush of the 21st century. Would-be tycoons across the world are mining away, hoping to get rich quick with what they believe is the future of all money. But years into the experiment started by bitcoin, questions about the long term viability of digital currencies are mounting. Can the technology behind them scale to meet the needs of global commerce? Is the algorithm used to create and track them really the way forward or is it a solution in search of a problem? And will it lead to a massive waste of electricity, sending millions of utility bills skyward?
But before we address these questions, it makes sense to get a basic grounding in what a cryptocurrency is. It’s not money in the same way that a dollar, or a euro, or a dinar are. It’s not a valuable commodity like gold, silver, or palladium, although it frequently behaves like it. (Keep that last part in mind because it becomes very important later on.) It’s kind of like a token that can be exchanged for currency in a more conventional sense, but with far more complex rules behind how this exchange works and who issues these tokens. Perhaps the most cautious and comprehensive primer on cryptocurrencies right now comes from John Oliver’s deep dive, which should get you acquainted with the basics of both the technology and terminology.
Now, one of the things you may have noted is that everyone seems very excited about the word and concept of a blockchain, the fundamental underpinning of every cryptocurrency. There are definitely things to like about it if you’re operating in legal and financial spheres. It makes money laundering exceedingly difficult and tracking transactions a breeze, which is why last year’s hot takes on how Russia could use them to possibly escape sanctions were so off the mark. It also streamlines complicated transactions like purchasing real estate or settling a large, convoluted corporate merger by creating a non-reversible “proof-of-work” that money changed hands or the paperwork was signed and recorded in a single, easy to inspect block.
This is why so many companies are looking at developing internal blockchains for keeping track of many moving parts. It’s faster and easier, and it can be decentralized to make it harder for hackers to attack and corrupt, and help develop even more complex supply chains in the future. However, once we step outside the walls of a single organization or a small cluster of partners in the same venture, we run into serious problems with applying the blockchain to our daily lives across the globe. And the biggest issue is ramping it up to the required scale.
Current investors are feeling the brunt of this problem directly in their wallets. In 2017 there were an estimated 522.4 billion electronic financial transactions worldwide with a typical transaction fee of between $0.20 to $0.30. Meanwhile there were 104 million bitcoin transactions, or three orders of magnitude fewer, yet transaction fees exploded from a typical $0.10 to an average of $28 per transaction by December. Those fees have fallen back down to less than a dollar as panicked companies optimized payment blocks and people started making fewer transactions among other steps to relieve network congestion. Unfortunately this is just a temporary solution and preventing future fee pile-ups is still an ongoing problem.
With almost 726 billion electronic transactions expected in 2020, a more than 28% increase in just two years, blockchain experts will need to figure out a way how to handle even one percent of that without transaction fees exploding again. This is a big ask and the crypto communities are still trying to figure out a long term solution, which is complicated because so many players have to agree on a way forward that’s not just suitable to the vast majority of users, but one that’s backwards-compatible with previous technologies from which users can’t be forced to upgrade if they don’t want to, adding an extra layer of challenges.
Then there’s also the question of how many resources it takes to host a cryptocurrency node. If we take bitcoin as an example, since it’s the furthest along in dealing with scalability issues, the current transaction size is hovering around 640 bytes. If by 2020, all electronic transactions were in bitcoin, the ledger would add almost 422.6 terabytes that year and since every node has to have a copy of the ledger, each node would take a six figure budget to run and another six to seven figures every year to handle the anticipated 10% annual growth in transaction volume.
This means large organizations would now be responsible for managing the future of bitcoin since they would be the only ones with the budget to maintain nodes, an anathema to the ideas behind cryptocurrencies. The data they would collect would also be an invitation to greater regulation which can very adversely affect the miners since governments would want to scan the ledgers for any evidence of illegal activity such as money laundering and black market purchases, as well as have a heavy hand in combating fraud which already costs the crypto market $9 million every day and is bound to explode if crypto volume rapidly grows.
And that surge in volume will come with expensive growing pains since nodes will have to mine, or compete to solve a complex mathematical problem when packaging new blocks of recorded transactions first to generate more currency. The cost and energy involved in crunching the numbers is rising fast and miners are traveling to remote small towns to find low energy costs to make a profit running a node, which can be a huge problem for the towns. At this point, bitcoin mining is consuming almost as much energy as all of Vietnam and with the difficulty in mining rising exponentially, the energy costs will also skyrocket as entire countries may need to find new ways to generate electricity. Depending on what’s used to generate the energy being consumed, it could be a major environmental disaster.
Likewise, cryptocurrency mining takes place all over the world, and as Chinese miners have been told to move their operations out of the country, it will move into even more countries since China used to account for 60% of all mining. This means that a massive enough increase in bitcoin and other crypto transactions will invite not just national governments to regulate, but set up an international framework. While this may make crypto transactions safer and more reliable for the typical end user, it also opens the door for complicated taxation schemes as bureaucrats see opportunities to balance tight budgets or pay off long-standing debts.
Now, so far this sounds like all gloom and doom and a whole lot of time, effort, and money to make cryptocurrencies the future of payments. But will it be worth it? Will the benefits outweigh the costs? It seems unlikely, even if we assume that there will be wealthy organizations able and willing to finance the mining and maintenance of nodes, the crypto community will deal with regulations and investigations into currently widespread pump and dump and ponzi schemes, we’ll figure out the fiendishly complicated taxes, and keep the transaction fees at least on par with today’s credit cards. Why? Because if we look back at how and why the cryptocurrency trend took off, we’ll see that they’re just a new package for an old economic idea we’ve outgrown.
There’s a reason why cryptocurrencies are “mined” and in the case of bitcoin and 18 other currencies, have a fixed limit of so many millions of coins. In many ways, the still mysterious inventor of bitcoin, Satoshi Nakamoto, wanted to replicate the gold standard. This is why the currency took off under many anarcho libertarians who believed that the gold standard is the one true monetary system while all others are nothing more than printing money on nothing more than the bankers’ whims.
Consider that bitcoin debuted in January of 2009, the peak of the financial crisis that triggered the Great Recession. At the time, the Treasury was talking about a complex network of loans and write-offs they called quantitative easing, something Jill Stein would later refer to as “a magic trick” that could be used to erase a trillion dollars worth of student debts by just printing however much money was needed to cover the outstanding total.
Despite this notion being completely wrong, libertarians, already skeptics of the current fiat system at best, looked at it in much the same way. Instead, they wanted to promote what they were convinced was a better way forward, certain that the gold standard never got its fair shake despite being the dominant monetary system for thousands of years.
You see, if all you were concerned about is stopping hyperinflation, a massive devaluation of a currency due to the government printing more money than economic performance and national assets suggest is warranted, the gold standard is the way to go. Since the currency is tied to the price of gold, you can’t issue more money without also having more gold to back it. But the problem is that the value of gold, or any other precious commodity to which you’d peg the value of your currency is arbitrary. As the supply of gold changes so does its price, which can lead to wild swings in prices for just about everything.
Volatility and fluctuations that can happen within milliseconds mean you’re never sure exactly how much something costs until your transaction goes through. It’s one thing when you’re just trading hyper-volatile commodities, it’s something entirely different when you’re paying your rent. A frequent example of this is a purchase of two pizzas for 10,000 bitcoins in 2010. At the time, it seemed that Laszlo Hanyecz was paying for dinner with monopoly money worth about $41 outside a crypto exchange. In today’s terms, with each bitcoin valued at nearly $6,475 as of this writing, that pizza cost him over $64.7 million. By not keeping those 10,000 coins, he effectively lost two multi-generational fortunes.
How willing would you be to buy anything, knowing that over the long haul you may be missing out on a retirement, or a down payment on a house, or a college tuition for your kids if you did? For an economy to function and grow, money needs to change hands. The slower that money moves and the more prices fluctuate based on arbitrary behind-the-scenes valuations, the slower the economy grows and the smaller its value. The fiat system allows us to inject money in the form of loans into the financial system so necessary goods can be manufactured and required research financed. That money is paid back with interest and by changing key interest rates we can control how easily this process can happen.
With an arbitrarily limited currency, this kind of growth becomes pretty much impossible. Yes, proponents of the gold standard and its spinoffs argue that’s not true but their justification for this will be pure numerology. They’ll correlate certain cherry-picked inflation rates. They’ll try to compare manufacturing output ignoring waves of technological advancement, the switch to a services-driven economy, and the rise of offshoring. In their dogma, fiat currency isn’t just the least worst monetary system on which we’ve settled, it’s the root of virtually all evil because it allows us to print new money or increase monetary supplies by issuing loans which can, and sometimes do, lead to hyperinflation
For them, fear of hyperinflation trumps all other considerations, but if you’re in a position in which your government is printing new money not like, but because it’s going out of style, you have fundamental problems that cutting off the money spigot would only worsen. Your banks owe everyone sums they can’t repay and your economy has broken down because no one will trade with you. Consider that we already tried fixing market crashes with a commodity-backed currency and the result was the Great Depression which helped the seeds of World War 2 fully germinate. Why would we ever want to repeat the mistakes of the past just because they have a shiny new wrapper called crypto?
And that’s really the biggest problem with cryptocurrencies in the long run. The blockchain technology that powers them can be adopted by existing financial institutions to better handle both simple and complex transactions, and fight fraud and money laundering alongside government regulators. But the actual cryptocurrencies and the economic rules they dictate are very unlikely to be more than commodities traded with current fiat, government-backed money. We spent many decades finding a monetary system and policy we can steer without slamming our heads into arbitrary walls, and we’re not going to give them up just because a group of tech-savvy enthusiasts resurrected the gold standard and poured cyberpunk buzzword sauce on it.