With the advent of cryptocurrencies into the mainstream financial system, it’s not strange anymore when you can see that the front page of a business newspaper contains the headlines, “Bitcoin is the best asset class of 2020,” “Investors flock to Dogecoin after Elon Musk’s tweet” or “Tesla will now accept Bitcoins as payment.” A combination of various financial constraints and favors as well as the support of a mighty few have helped in lifting up the price of these currencies to unprecedented heights. While writing this, Bitcoin is just shy of reaching an all-time high of 50,000 US dollars, which I believe, it can easily touch given the current euphoria continues on. But does the current mandate of many investors that provides cryptocurrencies such high valuations justifiable, or is it just another bubble ready to burst? In this article, I will try to declutter some of the mist and present the true scenario. So, let’s get started.
Before we know how Bitcoin or cryptocurrencies as a whole are intertwined with the economy, it is prudent to understand how Bitcoin works and how it is created. Basically, Bitcoin is based on blockchain technology. In simple terms, it’s kind of like a network where the data shared or transaction details between any two nodes of the network are stored in the form of blocks. These blocks are then connected by chains or links, which shows the continuity between the blocks. These blocks are decentralized, and hence it is not stored at a particular node or location. When Satoshi Nakamoto created Bitcoin or the blockchain network as a whole, certain protocols were implemented, which ensures that the transactions in the blocks can never be altered, and the issue resolving mechanisms would ensure that there is no inconsistency between the transaction information in one node with the other. Hence, the transactions done through a blockchain are immutable, irreversible, and safe. Now, new Bitcoins enter into the system via Bitcoin mining. Certain nodes in the network have to perform the function of verifying the transactions within the network. In order to verify the transaction, a mathematical puzzle is to be solved, which requires a lot of computing power and energy. These nodes are then rewarded with new bitcoins for every block that is verified or created. This is known as bitcoin mining.
The price of a bitcoin has risen by about 800% from its low in March 2020. Since then, it has not turned back and has been continuously increasing at an unbelievable rate. Well, it reminds me of a similar story in 2017, where the price of a bitcoin rose by about 1500% in a single year. But then, in early 2018, a huge fall of 65% wiped out most of the value from the currency. It took almost 2 years for the price to reach the highest level from 2018, and now after breaking all resistances, is still continuing on its northward trajectory. One major difference between the rise of 2017 and 2020 is that Bitcoin has now received backing from established investors from Wall Street and beyond. Hence, retail investors are more than willing to confidently invest in Bitcoin as an asset class. Billionaire Elon Musk who is quite optimistic about the future of cryptocurrencies has added fuel to this optimism by even promoting currencies such as “Dogecoin,” which was created only for fun as a meme. But one of the profound thing which worries many is that most of the people are buying these cryptocurrencies as an asset class and not as a means of transaction. This means that people are either only trading in these currencies as speculation and technical analysis or are viewing it as gold for a long-term investment. However, most of the transactions in bitcoin or other cryptocurrencies that are being done are usually for illegal activities like child trafficking, illegal arms sale, terrorist activities, etc. Since the government or the central bank does not control the transactions in bitcoins, it is usually viewed as a safe haven for such criminal transactions. However, bitcoin has been able to detach itself from the stigma as the criminal coin by making itself accessible to the masses and with the ease of transaction by the crypto exchanges.
Now, the question which arises is this “Will the governments of different countries allow the bitcoin to take the place of fiat currency?”. Will it be a currency that will be completely out of control of the government and the central bank and, as such, will be regulated only in terms of demand and supply as must be for an ideal capitalistic society? Well, the possibility that any government will give away its sovereignty to only market forces and, as a result, rescind its power of regulating the financial and economic aspects of the world is highly unlikely in the near future. According to the protocols set by bitcoin’s founder, there can only be a fixed number of bitcoins i.e., 21 million, that can ever exist in this world. This is regulated by decreasing the rewards given to the bitcoin miners every year. Now, since the supply of bitcoins is limited and the demand for it is ever increasing, ceteris paribus, the value or price of bitcoins should definitely shoot up. Many renowned economists are comparing bitcoin with gold. Well, there are indeed many parallels between gold and bitcoin. Both are appreciating assets, as the demand for them is ever-increasing, but the supply is limited.
Many economists have pointed to the return to the Bretton Woods system, which existed from 1944 to 1971, where every country was required to maintain gold reserves, which were equivalent to the currency in circulation. This was helpful in the way that it prevented the countries from printing an unlimited supply of money. This even helped the US dollar to become the world’s reserve currency while other countries could work on rebuilding their economy. Hence, bitcoin or any other cryptocurrency can act as gold in this case which will be pegged to the currencies of different countries. However, in 1971, US President Nixon unilaterally announced the suspension of the convertibility of the US dollars with gold, and then the US dollar became a free-float currency. Other countries followed suit, and the Bretton Woods system came to an end. This, however, gave unilateral power to the government or the central bank of a country to print money according to their will and even devalue their currency for their own benefits without having to worry about maintaining a gold reserve. The whole currency conversion rate was based on demand and supply as well as the government’s decisions. This system has worked until now, but there is a growing suspicion among many economists and financial experts about the government’s decision to print money according to will and then accumulating an insane amount of debt by issuing government bonds.
Last year, because of the Covid-19 pandemic, the Federal Reserve decided to pump in almost 3 trillion dollars into the economy by supplying new money. This money is usually in the form of debts or securities that the Federal Reserve buys from the government or other private entities. However, this has provided a steroid to the ailing economy and artificially flooding the market with new dollars. As a result, the newly created dollars have pushed the Dow Jones Industrial Average and S&P 500 to all-time highs, even though the economy and the earnings of the companies do not substantiate such a rally. But still, the dollar has maintained its relative stability. If other countries would have tried to print such an insane amount of money, it would have caused inflation and a huge drop in the value of their currency. Since the US dollars is the world’s reserve currency and because of the trust in the stability in the US government, the US can accumulate such an insane amount of debts and still not face any immediate repercussions. Many countries are buying up dollars from the open market as foreign exchange and artificially increasing the value of the dollar. This leads to a decrease in the supply of dollars in the market and hence the value of the dollar increases. Countries like China, Japan, Switzerland, Russia, and India have huge foreign reserves denominated in terms of dollars. Since the value of the dollar shoots up, it leads to a devaluation in the currency of the other countries. As a result, it becomes cheaper to produce goods in that country, which leads to an increase in the export of such goods.
There have been recent talks of currency manipulation and warfare. Now, many countries have been stocking up dollars. If somehow, any country decides to release these dollars into the market, a huge fall in the value of the dollar would occur and would disrupt the whole economic system as we know it. But an action such as this will also harm the country which released the dollars unless they have devised some method to shield their own currency from the fallout. Now, back to cryptocurrencies. Hence, many economists are of the notion that since the cryptocurrencies are created by algorithms, and hence we can predict the amount that will be created at a given stretch of time, it will lead to the countries becoming more responsible and hence withhold themselves from printing huge amount of money and also prevent economic warfare between countries. Like bitcoin, the supply of gold was limited, but the amount of gold that could be mined could never be predicted accurately. This created an advantage to the countries which had huge gold reserves, as they are the ones who may control the whole money flow in the world.
Jumping back to an asset-backed monetary system would mean that the people are also willing to bear the consequences. This will read to a decrease in the freedom of the central bank to implement strict and immediate measures when the economy is in turmoil or recession. In 2020, even though many countries went into recession and it was thought that it will have a lasting effect, the central bank came to the rescue. With the decrease in the interest rates as well as the increase in the supply of money, the central bank was able to do all these without having to worry about maintaining a reserve of gold which may have to be imported from some other country.
Now, what if we replace the dollar and instead use bitcoin as the international currency for inter-country transactions? This may seem to be a good prospect for many bitcoin investors, but any international currency must have two important features. First, it should be relatively stable, and we all know how stable bitcoin is. Any person working in the export-import business as of now will ever come into a contract whereby he or she may not even be sure of the actual amount that will be received if the payments are delayed by a month. Second, trust. The US dollar is used for almost all international transactions because of the trust that the people around the world have in the US government. They believe that the US government and economy will never allow itself to go bankrupt, or even will not undertake any mischievous actions. But look at bitcoin, we do not even know who the founder actually is. We have nowhere to go if something fraudulent happens with us. We have no one to blame and no one to regulate. For bitcoin to be successful, we all have to trust each other. But, the regulating action of the central bank is also put into question when people think about the 2008 financial crisis. But still, the central bank came to the rescue during both 2008 and 2020 to lift the economy back on its track.
Many countries, including India, have begun to mull to ban private cryptocurrencies and are thinking of a cryptocurrency of their own. Blockchain as a technology can completely revolutionize the banking industry. India has begun thinking of creating a digital currency which may implement blockchain technology. The NPCI (National Payments Corporation of India) has already introduced the platform “Vajra,” which is based on blockchain distributed ledger technology for safe transactions. China has also begun to issue “Digital Renminbi” currency which will be pegged to the physical renminbi but it will be issued by the central government. However, this currency will be centrally controlled like that of the present currency and will not implement blockchain technology. Countries like India and China will not easily give away their autonomy. Hence, it’s very unlikely that bitcoin will be used as a legal tender anytime sooner in these countries. However, these countries may implement blockchain technology to facilitate transactions.
While concluding it, I would like to say that bitcoin as of now, with its relative instability will not be regarded as a currency for international transactions or even act as a reserve currency. However, if the governments of different countries unite together to create a cryptocurrency that will be relatively stable and also be trusted, then there is a hope that one day, this currency may replace the US dollar as the world’s reserve currency. Private cryptocurrencies may be accepted in the developed countries as a means of transaction because of the ever-decreasing yields from other asset classes, but the governments in developing countries will not allow private cryptocurrencies to become legal tender money. However, the governments in these countries may allow trading and investing in these currencies via registered crypto exchanges because it will just act as an asset class that has been given value by the people who believe in it. In the future, the governments will definitely adopt the blockchain technology for different purposes, but it will ensure that the ledgers in the network are registered and trusted but may deter from accepting cryptocurrencies as a whole.
By the time I finished writing this, bitcoin has already touched the $ 50,000 mark. Let’s just hope that it isn’t just another Souk Al-Manakh story.