by Alasdair Macleod, GoldMoney:

The cryptocurrency craze is fascinating to an economist, or at least a student of catallactics, because it is a test of the theory of exchange ratios and prices, which is what catallactics is about.

For this reason, the outcome of the cryptocurrency craze is of great theoretical interest. It is also of interest to students of the psychology of speculation.

Supporters of cryptocurrencies claim they are money. If they are unable to substantiate this claim, then we must conclude that cryptocurrencies are only a medium for speculation, drawing on increasing numbers of the public to maintain their value. For this reason, their validity as money is fundamental to their future. Supporters of cryptocurrencies are certainly very sensitive to accusations that they are not money, presumably for this reason.

Mere opinions do not matter. A critical, detached analysis is needed. The purpose of this article is to test the proposition, that cryptocurrencies are money, from a sound theoretical perspective.

The basis of money

Before cryptocurrencies, there was government money, and before that metallic money, which was gold and silver. Government money evolved out of metallic money, drawing upon it for its credibility, before abandoning all pretence at convertibility when the US Treasury finally abandoned the dollar peg in 1971. The difference between the two is gold and silver are chosen by people exchanging goods in free markets, while government money is imposed on people by their governments.

Catallactics, as a theoretical discipline, investigates the exchange of goods in a free society, and is the basis of classical economics from Cantillon, Hume, Ricardo, Jevons/Menger through to the Austrian school. Government money does not stand up to catallactic examination, because its issuance always subverts free markets by interposing influence from the state into transactions between ordinary people.

The modern justification for government money has its origins in the German historical school of economists, when Georg Knapp declared, on what appeared to be little more than a point of principal derived from the supremacy of the not-long formed federal German state, that the state has the sole right to issue its citizen’s currency.

Knapp’s one book was titled The State Theory of Money, published in 1905. In it, he argued that state money may be recognised by the fact that it is accepted in payment by the state. Money exists according to state regulation and creditors must accept it without being legally entitled to other forms of money in exchange for it.

In his preface to the first edition, Knapp made it clear that he regarded money as a matter for political science. In other words, its existence, in accordance with the tenets of the German historical school, was a matter for the executive setting the law instead of free markets. The first sentence of Chapter One leaves us in no doubt on this matter: “Money is a creature of law”.

The law is horribly deficient. It does not even recognise that the purchasing power of money can change. The law does not compensate those robbed by currency debasement. The law makes no distinction between fiat money and credit money. The law will tax you if you benefit from the wisdom of holding catallactic money instead of state money. The law denies the logic of catallactics entirely, and rules only on state money, irrespective of whether it is backed or convertible into gold. It does not recognise the money chosen by free markets. The law is not equipped to decide on monetary matters.

Therefore, by no stretch of the imagination was Knapp’s treatment of money catallactic. Money issued by the state cannot last beyond the ability of a government to impose it on its people. Knapp died in 1926, three years after his own government’s money had collapsed both predictably and dramatically, disproving his state theory of money.

Today’s state-issued currencies are no different in concept from the currencies that collapsed in the wake of the First World War. With no convertibility into gold or silver, they depend for their purchasing power and validity as money on no more than the rule of law and public faith in the state. Since the Bretton Woods Agreement began to collapse, the dollar lost over 97{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} of its value measured in gold. These are relative purchasing powers set in the markets between sound money, still accepted as such by most of the world’s population (even though it is not usually used for day to day purchases), and the reserve state-issued currency.

Supporters of cryptocurrencies appear to be more aware than most of the weaknesses of state currencies, particularly when the issuing central banks have stated that their objective is to continually reduce their purchasing power every year as a matter of policy. The collapse in purchasing power seen so far has destroyed nearly all the value of money-based savings such as bank deposits and bonds, a government policy set to continue. Furthermore, there may be an understanding among some cryptocurrency enthusiasts that credit money, issued by the commercial banks, undermines the purchasing power of state money as much, if not more, than the issue of money by central banks.

Is it not better, they argue, for ordinary people to take back control of money from their governments? In their utopian world, we can escape the hidden tax of monetary inflation, and we can keep our ownership of money private. Bitcoin’s founder came up with a formula that would restrict its inflation by making it progressively difficult to “mine”. By introducing new block-chain technology, he created a self-auditing digital version of bearer paper money. Not only is the concept extremely clever, addressing the weaknesses of state money head on, but bitcoin was introduced at a time when central banks have been openly discussing their intention to eliminate physical cash.

Bitcoin has certainly caught the imagination, spawning by the time of writing over 900 other imitations, according to Wikipedia’s List of Cryptocurrencies. Instead of Bitcoin and its imitators being used as money, they have become vehicles for outright speculation. Presumably, supporters of cryptocurrencies hope that at some stage, their monetary characteristics will come to the fore, once the speculation has subsided. However, we can see that cryptocurrencies exist despite the law, and the law barely recognises their validity, even banning them in some jurisdictions. They are not Knapp’s creatures of the law. For cryptocurrencies to be money, they must therefore conform to the characteristics of money demanded by catallactic theory.

Cryptocurrencies fail the regression test

In an exchange of goods for money, both buyer and seller will subjectively value the goods side of the transaction. To do that, both must assume that there is no subjectivity in the value of the money being exchanged. So, while the good, or service, is valued subjectively, the value of money must be regarded as wholly objective, otherwise the transaction descends into the realms of barter.

The regression theorem demonstrates that money in a transaction has its objective exchange value determined by reference to recent experience. We know without question the value of money in a transaction, because of what it bought yesterday. And yesterday, we knew its value from our experience of the day before. By a process of regressus in infinitum, the value of money is traced back to its original subjective value for non-monetary use, before it became adopted as money. In other words, for money to become money, it must have had and must still possess a subjective value as a good.

This is not to say the value of money is based on its use as a good. The purchasing power will be determined by its demand as money, and its value in terms of its purchasing power will fluctuate. When silver was dropped as money in favour of gold in the late nineteenth century, its price fell back towards its use-value as a good.

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