The price of a Bitcoin has skyrocketed from about Rs50,000 a year ago. It is close to Rs10 lakh now. In fact, the appreciation is even higher in several other cryptocurrencies. What is going on?

Assets like gold and fiat money derive their value basically from factors like status as legal tender, convention, and confidence. Now cryptocurrencies are, in principle, quite like gold and fiat money in this respect. So they can have value even if there are no underlying assets. It is true that Bitcoins have appreciated too much too fast. This may suggest possible short-term volatility but this by itself does not imply that a bubble is present; it can be that the assets were hugely undervalued to begin with.

What can explain the possible demand among actual users of cryptocurrencies in future? Very high and volatile inflation is still present in some countries in Africa and Latin America; it may persist in future as well. More important, the ratio of public debt to taxes, if not the ratio of public debt to gross domestic product (GDP), is very high in many developing and developed countries. So, public authorities may tolerate, if not engineer, high inflation for short periods and/or sustained inflation at a “moderate" level for several years. This can happen despite inflation targeting (flexibility in the policy regime can provide an excuse in various ways for high inflation in future). So, “traditional" currencies can lose value over time, and there can be good demand for cryptocurrencies, which are different.

When there is a financial crisis, there is a need for safe havens. Earlier, it was metals like gold that were useful in this context. In future, there can be cryptocurrencies as well. There are other issues like the high costs of transfer of funds; this is particularly true of international remittances. So, there is, prima facie, considerable scope for more cryptocurrencies.

All this suggests that cryptocurrencies can be indeed very valuable assets. However, there are some counter-arguments.

It is possible that due to competition from cryptocurrencies, policymakers and financial institutions will be compelled to mend their ways, and traditional methods of payment will improve. Then, there will be little demand for new currencies. There can also be little demand if people just do not feel comfortable using cryptocurrencies for various reasons. Furthermore, though cryptocurrencies have been running well for a few years, there is hardly any guarantee that there will be no technical glitches in future. If there are, the high and rising prices of cryptocurrencies can collapse. This conclusion is in sharp contrast to what we saw a little earlier. So, we do not know for sure if a bubble is absent or present in cryptocurrencies.

If a bubble in cryptocurrencies does exist, then prices will fall sooner or later, and the story will end there. But what if there is no bubble in cryptocurrencies?

Cryptocurrencies will compete with assets like gold, “traditional" currencies, demand deposits, and money market mutual funds (MMMFs). Observe that in the aggregate, the demand for cryptocurrencies and such other assets has a cap; this follows simply from the premise that people have limited purchasing power and that money (affluence) does not grow on trees in the real world. This is a simple, general and useful principle in identifying bubbles per se (rather than identifying when a bubble will end, which is a far more difficult task). If the demand for cryptocurrencies goes up considerably, then this implies that there will be a fall in the demand for some other assets in future.

It is true that much of the demand for gold is not as a “financial asset"; it is instead as jewellery, as an asset in places of worship, or as part of the reserves of central banks. However, even this main demand for gold is somewhat rooted in the belief that gold is a good store of value. So, if there is competition from cryptocurrencies as a store of value, then the demand for gold and, accordingly, the price of gold, can come under pressure in future.

The demand for “traditional" currencies can keep falling due to competition from cryptocurrencies if the latter are increasingly used for payments. So, the seigniorage income can fall for central banks and their owners, that is, governments. If there is a difficulty in raising taxes to make up for the fall in income, then government borrowings can go up, and, accordingly, the yields of government bonds can rise.

The popularity of cryptocurrencies could also adversely affect the demand for demand deposits in banks as these too are used as money. Profits and the market capitalization of banks could fall. Also, there could be an adverse effect on asset management companies that derive good income from MMMFs, which are also used as money.

It is true that there has been hardly any discernible fall in the prices of other assets even when prices of cryptocurrencies have skyrocketed. Why? Despite the huge rise in prices of cryptocurrencies, the level of market value is still very small; it was just about $316 billion on 30 November 2017 the world over. In sharp contrast, as per the latest estimates, the US currency alone is $1.58 trillion, and the value of gold in the world is $7.8 trillion. So, even if there is a shift of demand to the tune of a few hundred billion dollars, the warranted percentage fall in prices of other assets would be small. In other words, there would be a small bubble in the prices of other assets if cryptocurrencies became more widely acceptable among actual users. Though small at present, this bubble in other assets can be significant going forward if the demand keeps shifting to cryptocurrencies.

Published with permission from Ideas For India, an economics and policy portal.

Gurbachan Singh is visiting faculty at the Indian Statistical Institute (Delhi Centre) and Ashoka University. Comments are welcome at theirview@livemint.com

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