Learning about cryptocurrencies has been an interesting lesson in the history of economics and money.

 

The more you go down the “rabbit hole” of crypto, the more you find yourself revisiting the fundamental principles of micro-, macro- and international economics. I’m sure that if crypto existed when I took these courses in university, I would have been a much better student.

Whether you’re for or against cryptocurrencies, it nonetheless represents an interesting real-time economics experiment worth paying attention to.

Presented below are some thoughts on the cryptocurrency phenomenon. It is not intended to be a black-and-white view on crypto being good or bad. Rather, an attempt to digest cryptocurrencies in the context of classes I took in university.

[1] Crypto and the history of money

Money is a protocol for keeping track of value that is exchanged in an economy.

Before the first forms of what we would recognize as modern day money, the economy was based on barter. Barter economies depended on the direct exchange of goods and services, and suffered from a number of short comings. It relied on the coincidence of wants, having no standard unit of account, and having a limited ability for subdivision, to name a few.

Money came into existence — be it in the form of physical commodities, commodity-backed paper, or government-backed fiat — to address these issues. Each successive iteration of what we as a society recognize as money, has had both pros and cons. Money today, in the form of government fiat, is no different.

Government fiat is a useful tool for influencing the economy during booms and busts, and providing a basis for collecting taxes. At the same time, there are risks. The supply of fiat currencies are controlled by a very small handful of people — i.e. central banks. Monopoly market structures tend to have a higher risk of market failures — intended or not. Central banking may not be immune.

Cryptocurrencies reverse this concept. Rather than having the protocol for money controlled by a handful of institutions, it expands the number people who can make decisions around the money supply. At worst, cryptocurrency systems will take longer to make policy-level decisions. But at best, it provides an alternative monetary protocol (not replacement) to keep government fiat in check.

[2] Crypto and the (re)definition of an economy

In its simplest form, an economy is a collection of individuals who co-ordinate to produce a set of goods and services. Modern day economies are governed by geographic borders (“vertical economies”), which have a number of common features.

• Governance: Vertical economies have a centralized governance model (e.g. a government).
• Monetary policy: Vertical economies have their own monetary policy to decide what’s best for the economy.
• Enforcement: Vertical economies use a combination of economic incentives and the military to enforce rules.

This type economic setup works well for moderating goods and services that are not entirely fungible across borders. Things like the production of certain commodities, food and agriculture, and real estate.

As the world is becoming increasingly interconnected, there will be more goods and services that naturally cut across borders (“horizontal economies”). This includes things like computing power, global stores of value, scientific research, and prediction markets.

Horizontal economies have similar features as vertical economies, but have one important difference: there is no obvious trusted party to oversee enforcement. As a consequence, horizontal economies need to be designed differently.

• Governance: Horizontal economies require a decentralized governance model — e.g. A governance model that doesn’t rely on a trusted central party.
• Monetary policy: Horizontal economies, like vertical economies, requires a fit-for-purpose monetary policy.
• Enforcement: Horizontal economies can only rely on economic incentives to drive intended behaviors and enforce rules.

The last point is the reason for why cryptocurrencies may be necessary. A cryptocurrency acts as a point system and unit of value for a decentralized economic network. In short: it is a mechanism for incentivizing people to act in the network’s best interests.

[3] Crypto and valuation

Cryptocurrencies that mediate the exchange of value across a decentralized economic network may be better understood through monetary supply equations (e.g. MV = PQ), rather than cashflows and present values.

• P(t) is the price at time t
• M(t) is the supply at time t
• V(t) is the velocity or turnover of the currency at time t
• Q(t) is the quantity of good and service at time t

Without getting into the complexities of convertibility of goods and services into a fiat-equivalent, inspecting the above equation provides clues for understanding the price of a cryptocurrency. Note that there are others developing more complex crypto valuation models.

For the majority of cryptocurrencies today, the supply equations are algorithmically fixed. Therefore the key variables to monitor are velocity (V) and quantity (Q). The relationship across these two variables explains most of the price movement of a cryptocurrency, as well as its adoption.

• Case 1: If V/Q is greater than 1: All else equal, more people are transacting in the currency, but since goods/services that can be purchased aren’t growing as fast, price is driven (up) by speculation.
• Case 2: If V/Q stays at ~1: All else equal, transactions and the goods/services that can be purchased are at parity. This suggests good adoption of the currency. Volatility may be dampened as network effects kick in positively. Prices should be stable.
• Case 3: If V/Q is less than 1: All else equal, usage of the currency is shrinking. When V/Q falls less than 1, there could also be an accelerated collapse in price as network effects unwind.

In the earliest stages of a cryptocurrency’s life, we’re almost certain to see V/Q >1 (Case 1). Whether it persists and endures for the long term depends on if it can get to Case 2 before Case 3.

In conclusion

Contrary to the media hype and headlines, cryptocurrencies present an interesting natural experiment unfolding in economics.

In many ways, much of what’s happening in crypto today parallels economic events of the past. It wasn’t that long ago that the world collectively decided to re-define money (e.g. Bretton Woods) or create a new currency across geographic boundaries (e.g. the Euro).

Looking beyond the calls for crypto as a scam, or rocket ship to the moon, hopefully this post has provided some food for thought around the potential role for cryptocurrencies in our society.

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This post was originally published on Medium by Andrew Wong in February 2018.