Digital assets on the mind

I was somewhat surprised to see in the paper this morning (Feb. 17, 2021) that bitcoin, the predominant digital currency (or “crypto”) among the most popular alternative digital currencies such as Ether and Litecoin, has reached a mind-blowing value of nearly $49,000 per coin (For perspective, the price of a bitcoin was around $1000 at the beginning of 2017). This doubling in value in less than two months represents a gain of nearly 70% for the “currency” in 2021. This appreciation in value has led to an unprecedented public interest in bitcoin in recent years. Bitcoin’s gradual increase in value is partly attributed to the facts that major corporations such as Tesla. BNY Mellon and Mastercard have recently revealed their interests in digital currencies. Bitcoin is also thought to possess many advantages over fiat currencies (such as the dollar).

I have been asked on numerous occasions by a number of friends and students about investing in cryptocurrencies and whether bitcoin could successfully serve as an official currency. Though not being a monetary economist (one who specializes in Monetary Theory – a subspecialty in Macroeconomics), I am familiar with this line of research as it is intimately related to my own academic research in Financial Markets & Institutions. Let me take this opportunity to give you my thoughts on the subject and, hopefully, help you make more informed decisions on this controversial issue.

My short answer to the first part of the question is that, at least based on academic studies to date, no one knows if investing in bitcoin will generate higher returns than index-investing (such as buying the component securities of a specific market index). Since crypto’s inception in 2009, there have been a very few significant empirical studies examining this issue and no definitive conclusions can be drawn thus far. Theoretically (using a mathematical model), a case can be made against the adoption of cryptocurrencies. For those of you willing to explore this issue further (and do not mind studying PhD-level applied math and theoretical models in Monetary Economics), I suggest that you check out the five most recent articles on cryptocurrency published in the Journal of Monetary

Economics since 2020. It should be noted that, as of today, researchers in this field still do not really know the answers to questions such as “Will crypto deliver price stability?, “Will digital currencies coexist with fiat currency?, “Will the market provide the socially optimum amount of money?, or “Can crypto and a government-issued/fiat money compete?”, without being willing to accept the enormously unrealistic model assumptions. One of the main reasons is that it is nearly impossible to conduct research on crypto due to its decentralized nature (where intermediaries or banks are not involved), making it difficult to obtain reliable sources of data.

With regard to the second part of the question, my opinions are as follows (which also help answer why crypto is unlikely to become a widely adopted currency of the future). Firstly, introductory ECON 101 suggests that, for a financial instrument to serve as money, it must fulfill at least three of the primary functions, namely a “medium of exchange”, a “standard of deferred value” and a “store of value”. It can be argued that crypto fails on those three counts, in practice. To serve as a medium of exchange, it must be a generally accepted means of payment. However, due to the nature of its execution (for instance, the buyer has essentially no recourse if he/she transfers the bitcoin before receiving the product and the seller fails to ship it to him/her), interested parties would have to think twice before engaging in a transaction involving crypto – limiting its appeal as a medium of exchange. This is probably one of the reasons crypto is hardly used by the masses. Relatedly, crypto does not appear to be a great “store of value” or “standard deferred value” as its price volatilities are well documented in the popular press (recall that the price of bitcoin on an exchange was about $1000 in early 2017 and suddenly increased to nearly $20,000 by the end of the year. The price unexpectedly declined to less than $7000 two months later. Similar fluctuations took place in subsequent years). Secondly, and in my opinion the most damning feature of crypto, terrorists and criminals (there’s been some published evidence of their activities) love to conduct their businesses with crypto due to its anonymity which helps its users avoid a paper trail. With crypto it is also not difficult to hide income from tax authorities – leading the Internal Revenue Service, for example, to issue new reporting requirements. Lastly, crypto may impede a central bank’s ability to conduct monetary policy. To stimulate the economy during the current pandemic, for example, the Federal Reserve Bank (central bank in the US) manipulates the money supply in circulation by lowering its interest (federal funds) rate. Crypto, being a competing currency, can interfere with the Fed’s operations by lowering the demand for the Fed’s (fiat) currencies. Like most things in Economics, however, this is debatable and depends on whether you are a “fresh-water” or “salt-water” macroeconomist – a topic for another day due to space constraint and, by the way, one of the primary reasons many people including myself have left Macroeconomics entirely, opting for positive issues in Financial Economics instead.

In summary, bitcoin or other alternate cryptocurrencies are a novel and complex topic that requires significantly more research in order to make any valid inferences. Investing in crypto appears to be a rather risky business. Be prepared to take on the risks as there ain’t no free lunch!