Active Stocks
Fri Jul 12 2024 15:58:30
  1. Tata Steel share price
  2. 168.70 -0.18%
  1. Wipro share price
  2. 560.05 4.81%
  1. ITC share price
  2. 459.00 0.07%
  1. NTPC share price
  2. 377.25 0.00%
  1. Kotak Mahindra Bank share price
  2. 1,830.05 -0.77%
Business News/ Opinion / Columns/  Cryptocurrencies in the day and age of renewed inflation fears

Cryptocurrencies in the day and age of renewed inflation fears

Private cryptocurrencies are best treated as risky investment assets rather than actual currencies

Photo: iStockPremium
Photo: iStock

The age of cryptocurrencies dawned in 2008. In October that year, Satoshi Nakamoto wrote his famous proposal for a new form of peer-to-peer payments that would bypass the traditional financial system: Bitcoin. The use of blockchain technology for a payment system is without doubt one of the most exciting new developments in finance. I had argued here in December 2017 that Bitcoin is likely to function poorly as a currency. Also, it is not clear that a financial system based on private money will have the ability to generate liquidity in case there is a payments crisis. “The idea of a private, frictionless payment system with 2.6 billion active users may sound attractive. But as every banker and monetary policymaker knows, payment systems require a level of liquidity backstopping that no private entity can provide. Unlike states, private parties must operate within their means and cannot unilaterally impose financial obligations on others as needed. That means they cannot rescue themselves. They must be bailed out by states, or be permitted to fail," Katharina Pistor of Columbia Law School wrote in an essay published in 2019.

The immense volatility in cryptocurrency prices makes them poorly suited to be either a medium of exchange or a unit of account, especially for the long-term contracts that underpin the modern economy. A volatile asset can be used to buy a pizza, but is hardly useful when it comes to employment or supply chain contracts that firms sign over the years. Recent years have seen attention focused on ‘stablecoins’ such as Facebook’s Libra (called Diem now). These are backed by either sovereign currencies such as the dollar or physical assets such as gold, and are designed to be used for payments in the traditional financial system as well.

One of the key attractions of Bitcoin was that there would be a permanent limit on the number of units in circulation. That limit was 21 million. Nakamoto wrote in his proposal that Bitcoin would be free of inflation once the entire supply had been mined for internet use. It is important to remember that the original proposal for the new financial instrument was released at a time when there were fears that a sharp increase in the supply of traditional fiat currencies—aka quantitative easing—would unleash high inflation across the world. Global inflation has been muted since then, and much of the recent fear about resurgent inflation is more rooted in supply-chain disruptions than excess money supply.

It is perhaps not surprising that Nakamoto mentioned inflation in his original proposal. The monetary base of major developed economies has outpaced their growth in output since then. The pandemic has unleashed a new round of expansion in the balance sheets of the US Federal Reserve, European Central Bank and Bank of Japan. Each has broadly increased by seven times since September 2007. The central bank balances sheets of the two largest emerging economies, India and China, have also expanded sharply. Much of this is widely known. But what has happened to the supply of cryptocurrencies?

There are now 18.73 million Bitcoin in circulation, or nearly 90% of all potential supply. However, even if the supply of a single cryptocurrency is tightly controlled, the supply of all possible cryptocurrencies is not subject to any control. The reason: There is no way to prevent other private cryptocurrencies from joining the party. There has been a veritable explosion of cryptocurrencies in recent years. Many of the later variants have more flexible supplies than Bitcoin. Also, while much attention is now focused on the price of individual cryptocurrencies against a traditional monetary standard such as the US dollar, far less attention has been paid to how they are priced against each other—their relative prices, in other words.

Ethereum, currently the second most important cryptocurrency after Bitcoin, has no supply limit written into its design. There are nearly 116 million units of Ethereum in circulation currently. And there are 129 billion units of Dogecoin available right now. The website currently lists 5,145 cryptocurrencies being traded. Nineteen of them have a market capitalization of over $10 billion. A global economy with contracts written in thousands of volatile private cryptocurrencies will face transaction costs that could bring economic activity to a standstill.

Cryptocurrencies are better suited to be investment assets, though they are susceptible to roller-coaster rides, since there is no way the supply can adjust to swings in demand. We have seen a lot of this in recent months. The antics of Dogecoin are only the most stark example. Private cryptocurrencies should ideally be treated as risky investment assets rather than currencies, even as central banks begin work on using blockchain to issue a new form of sovereign money. Many cryptocurrency enthusiasts see them as protection against the high inflation that central banks tend to unleash on the world. However, cryptocurrency prices have soared during a decade when much of the world was battling deflation rather than inflation. In case the recent inflationary momentum picks up, it will be worth seeing which way cryptocurrency prices move. There will be a useful lesson in that.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

3.6 Crore Indians visited in a single day choosing us as India's undisputed platform for General Election Results. Explore the latest updates here!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 18 May 2021, 08:56 PM IST
Next Story footLogo
Recommended For You