Yesterday on Facebook, someone asked an interesting question on cryptocurrencies and inflation. One of the attributes that, to some degree or another, makes gold currency stable is that gold is in strict supply. It’s costly to mine, and there is a limit to how much there is available to mine. Monies that don’t have a similar constraint have to establish alternative institutions, such as the inter-bank clearing mechanism in George Selgin’s theory of free banking. Cryptocurrencies don’t have the same physical scarcity as gold — a new firm (which I will use as a catch-all term for individuals, groups, hackers, coders, whatever…) can introduce a new algorithm, and with it a new cryptocurrency —, and sophisticated institutional constraints have not yet arisen. Does this mean that cryptocurrencies are destined to an inflationary demise?
Different currencies are imperfect substitutes to each others. There is some degree of brand discrimination, in that people oftentimes prefer one over another. Different cryptocurrencies are different goods, and the marginal value of one is not the same as the marginal value of another. The broad implication is that the overall supply of all types of cryptocurrency does not determine the marginal value of the individual brands. These are determined by their own supply and demand schedules, even if these curves are inter-related. For example, suppose that the “GoogleCoin” firm issues an excess supply of its currency, dramatically reducing the value of the marginal “GoogleCoin.” If we hold all else equal, this doesn’t mean bitcoin’s marginal value will fall with “GoogleCoin’s.” In fact, individuals may want to reduce their “GoogleCoin” balances and increase their bitcoin holdings, implying an increase in demand for the latter (and a corresponding increase in its marginal value).
The same idea holds true with modern currencies. Hyperinflation in Zimbabwe does not cause, all else equal, similar effects on the U.S. dollar or the euro. The marginal value of the two latter currencies are determined by their own supply and demand schedules. In fact, the hyperinflation of the Zimbabwe dollar shifted the demand curve for currencies like the South African rand to the right, because individuals were looking for a more stable currency. We can conceive of a situation where several paper monies are quickly loosing value, because of, say, hyperinflation, while another paper currency elsewhere — benefiting from effective institutional constraints — remains relatively strong and stable.
What matters for a currency to be stable is that there are limits to how many units can be issued. Bitcoin’s approach to this issue is to include an asymptote to its money supply function. I’m sure other cryptocurrencies are similar. If cryptocurrency markets get more complicated, more sophisticated institutions might be necessary to help ensure monetary stability, but for the time being these kind of built-in limits to supply essentially mimic the relevant natural attribute of gold: physical scarcity.
Throughout this discussion, I’ve assumed that there are established cryptocurrency monies. Currently, this assumption may not hold. I don’t generally follow the cryptodebate, but I believe it’s contested that bitcoin is really money. The guidelines to what is money and what isn’t are somewhat ambiguous, because the overarching quality of money is its liquidity. But, there is a continuous range of liquidity (or, borrowing from J.P. Koning, moneyness) that a set of assets can lie on. Money is generally considered the most liquid asset, but different currencies can certainly have different degrees of liquidity (the Rothbard dollar may be accepted over a larger geographic area than the Mises peso).
The supply of money is always determined by the demand for money. When something is already money, supply can create its own demand. Without strong institutional constraints — something that creates a quick process of reflux —, an excess supply of money raises the price level and may induce individuals to increase their desired cash balances. But, new cryptocurrencies are not automatically money. They have to earn that liquidity by being widely accepted as a unit of exchange. Their moneyness depends on the demand for its liquidity. The implication is that any new brands that are money candidates cannot be supplied in excess, because changes in their supply are determined by changes in the demand for them as money. If bitcoin were already a widely traded general medium of exchange, and if there were no constraints on its supply, an excess supply of them may create its own demand, but there are built-in constraints to its supply. Further, since bitcoin is in a relatively competitive environment, dramatic changes to its marginal value may drive individuals to get rid of their bitcoin and increase their holdings of alternative currencies.
If existing cryptocurrencies are unstable, it’s not necessarily because of a lack of constraint on their supply. The majority of, if not all, cryptocurrencies are not money, they’re just non-money assets (valued for whatever reason). They are volatile assets, because the source of their demand is volatile. And, they are just as prone to bubble behavior as any other financial asset: false profits leads to malinvestment, and all of that.
If cryptocurrencies do catch on and they begin to be valued for their liquidity (that is, as money), I don’t see any obvious reason for instability. This may change as the financial system adapts to these cryptocurrencies — depending on the institutions that develop along with it —, but the built-in rules that limit the supply of different brands of cryptocurrency mimic the physical scarcity of gold.