What cryptocurrency investors get wrong about economics

While digital currencies have always been a highly unusual asset class, it won’t stay that way forever

Representations of the Ripple, Bitcoin, Etherum and Litecoin virtual currencies. While cryptocurrencies have been a highly unusual asset class for their entire history, they won’t act like an unusual Show more

Last week I argued that cryptocurrency is here to stay. Now, I would like to explain to some of my cryptocurrency friends why parts of the mainstream economics and financial world do not take them more seriously. To put it bluntly: Many of you do not understand monetary economics very well.

There are two common mistakes.

First, the dollar is not on the verge of collapse, nor will it be replaced by a cryptocurrency asset. The US is one of the world’s two largest economies and the centre of the English-speaking world. It has the power to tax, the strongest network of alliances and the most powerful military. Yes, it has printed a lot of dollars since 2008, but it also has taken steps to lower the speed at which those dollars circulate.

Rates of price inflation are likely to be higher for the next two years or so but already some of the immediate inflationary pressures are abating; lumber prices, for instance, are now plummeting. Over a 10-year time horizon, the US government can borrow at a near-zero real rate of interest, hardly a sign of a doomed empire.

Nor is the US government about to go broke or on the brink of resorting to hyperinflation. The US debt-to-gross-domestic-product ratio may well hit 200 per cent but the poorer and smaller nation of Japan is doing OK with similar debt levels.

Keep in mind that national wealth, while difficult to estimate, may run as much as six to eight times higher than GDP. So, a 200 per cent debt-to-income ratio could mean a debt-to-wealth ratio as low as 25 per cent. That is hardly the end of the world. Think of how comfortable you would be if you paid off "only" 75 per cent of your mortgage.

If anything, cryptocurrencies are more likely to hurt the currencies of countries that are doing very poorly, such as Venezuela. Fiat currency won’t just go away, so over the long run cryptocurrencies could actually boost the value of the dollar by stifling the rise of potential competitors.

A second point, often neglected in the cryptocurrency community, is that cryptocurrency prices won’t continue to go up forever at high rates. It does not matter whether money supply deflation is built into a cryptocurrency system, or that new and valuable uses will be discovered each year.

At some point, the market will figure out the value of cryptocurrencies and incorporate that information into a high level of price for those assets. From then on, expected rates of return will be – dare I say – normal.

Compare the cryptocurrency market to the art market, which for a long time did not grasp the potential value of an Andy Warhol painting. For years, prices went up a lot. At this point, however, a liquid market remains and the expected value of an investment in Warhol is not necessarily better or worse than the value of an investment in other well-known works of art.

It is an entirely defensible (albeit contested) view that the market still has not appreciated the full value of cryptocurrencies. This state of affairs may yet endure for some while, but it will not last for decades.

The irony is that so many of the arguments made by cryptocurrency types imply especially low pecuniary rates of return on digital coins.

To the extent cryptocurrencies are useful as collateral or for liquidity purposes, people will be more willing to hold them at lower pecuniary rates of return, just as they are willing to hold cash, or just as the collateral uses for US Treasury bonds raise their price and lower their expected rates of return.

If we eventually arrive at a world in which equities are expected to rise by, say, 5 per cent to 7 per cent a year, and Bitcoin by, say, 1 per cent, then that will be a sign that cryptocurrencies have made it.

The more general point is that while cryptocurrencies have been a highly unusual asset class for their entire history, they will not act like an unusual asset class forever.

• Bloomberg