Welcome to another edition of the Mueller Report!
This week’s edition on cryptocurrency will likely be of intense interest to some of you and (seemingly) irrelevant to others. Either way I hope it is informative and thought-provoking.
Cryptocurrencies have vaulted into the limelight over the past six months. Tesla bought over a billion dollars worth of bitcoin in the fall and was accepting payment for their cars with bitcoin (they recently stopped because of concerns about energy usage). One bitcoin trades for between $50k-$60k. Seven or eight years ago it traded for around $250. Ten years ago it traded for around a dollar. Ethereum has jumped from under $1000 a year ago to around $4000 today. Many other cryptocurrencies have seen large increases in their dollar value.
I confess that I sometimes have a fear of missing out (FOMO). If only I had bought Ethereum three months ago. If only I had bought Dogecoin two months ago. If only… Let me tell you why this is unhealthy thinking. First, get rich quick schemes rarely work and often fall apart. Second, the mentality of getting rich quickly can also be destructive. It makes us discontent with our current state. It makes us anxious when our wealth is not growing as quickly as we like. And it can make us envious as we feel like we need to keep up with people who seem to be getting rich quickly.
One more quick note I want to make here about avoiding FOMO is that making decisions out of a fear of missing out tends to distort our thinking. We rush to jump in before it is too late. We think more about the potential upside than the potential downside, and we don’t understand what we are doing as well as we should.
So, let’s try to understand the crypto world a little better.
The Nature of Money
By way of background, we should answer the seemingly innocuous question: “What is money?” We all use it every day, so you would think we would have a pretty good handle of how it works. But like so many other things we use every day, our cars, toasters, dishwashers, sinks, elevators, smartphones, most of us don’t really understand in any detail how the things we use operate or how they work.
Money is a commonly accepted medium of exchange. Many goods have served as money in the past: sea shells, tobacco, salt, cattle, nails, and of course precious metals like gold and silver. If you want to learn more about the origins of money, you can watch my lecture on the subject.
Good money has certain qualities. It is easily divisible, homogenous, a store of value, a unit of account, portable, and widely accepted. Anything can serve as money, as a medium of exchange, but not everything can be a good medium of exchange. Currency is a form of government-issued or at least government-defined money - the dollar, the pound, the euro.
And currencies can serve as good or bad money depending on whether they embody the qualities just mentioned. Some currencies fail because they cease to be a good store of value. When governments print too much money (almost always to finance exorbitant spending), the value of that money declines. This is inflation, or in extreme cases hyperinflation. As a currency loses its value, people opt for other mediums of exchange.
Many countries experience “currency substitution” where people regularly transact in currencies or money other than the formal national currency. In extreme cases, other currencies replace the national currency altogether. For example, the U. S. dollar replaced the national currencies in Ecuador, Panama, Cambodia, Zimbabwe, and a few other places. They were “dollarized.”
Milton Friedman, a Nobel Prize-winning economist who wrote extensively about money and monetary institutions, highlighted some interesting recent historical examples of unusual media of exchange. By the end of WWII, the German currency was worthless. The allies replaced it with a new currency but they still had a problem with inflation which they tried to address through price controls. But the mismatch between the value of the currency and the legal prices meant that relatively little exchange took place in public. Instead most exchanges took place privately using cigarettes for small transactions and cognac for large transactions. Cigarettes were also used as a form of currency by Americans in German POW camps during WWII.
Let’s return to the question of what money is. Most of our money (dollars) are electronic rather than physical. Banks do not hold trillions of dollars in physical cash in their vaults, even though they have trillions of dollars on their balance sheets. When you make purchases with a debit or credit card, or with a check, money moves between various bank accounts, sometimes within the same bank, sometimes between banks. These transfers (which involve trillions of dollars every day) occur electronically either via Fedwire, The Fedwire Securities Service, or the National Settlement Service. All three are run, operated, and overseen by the Federal Reserve System (the U. S. national bank).
Let’s face it: almost all of your money is already digital.
Our current monetary arrangement is governed by the computer algorithms and protocols set up by the national banking system in conjunction with commercial and investment banks. These institutions have spent a great deal of time and energy developing and building their systems of electronic fund transfers. They have also focused on being user friendly - you don’t have to know anything about Fedwire, interbank clearing, overdraft protection, etc. to send money to friends or to have your employer deposit money in your bank account.
Another important element of our current monetary system is that the dollar is legal tender - meaning that businesses and banks across the country are required to accept it as payment for goods, services, and for repaying debt. It is also important to note that the Federal Government requires payment in dollars for taxes or fines.
Cryptocurrencies are affected by the same criteria as the dollar or the pound in terms of whether they make good money. Are they divisible, portable, a store of value, homogenous, and a unit of account? Right now, they are more divisible and more portable, in some dimensions, than dollars. However, there is a large question around whether they are as good a store of value - which also affects whether they are a good unit of account.
Suppose your monthly rent is $750. Three years ago, that price in terms of bitcoin would have been ~.1 BTC per month. Two years ago it would have been ~.1 BTC. One year ago it would have been .078 BTC. Today it would be .015 BTC. Bitcoin has gone from the equivalent of about $7,500 to a little over $50,000 in less than two years. This is great if you own bitcoin (more on that later) but not great if your rent is fixed in terms of bitcoin. If it had remained fixed at .1 BTC, then your monthly rent today would not be $750 but $5000.
Some Considerations of Cryptocurrency
And now we come to a few big questions.
Why are cryptocurrencies valuable?
Should I buy, hold, invest in, or learn about cryptocurrencies?
Let me give the usual disclaimer that I am not offering investment advice. I am sharing how my perspective on cryptocurrencies.
Cryptocurrencies are valuable because people want them, are willing to pay for them, or will accept them in exchange for dollars, goods, and services.
Some people have asked me: why are cryptocurrencies valuable? Why do people want them? Well, there are a lot of reasons. Here are a few important ones.:
Cryptocurrencies tend to be a great form of remittances. Many immigrants around the world work in wealthy countries and send support back to their family and friends in their country of origin. Sending money through banks is costly and slow. Mailing cash is dangerous. Most cryptocurrencies transcend national borders and the banking system. Transfers can be made directly to the recipients. Many fees are avoided. It is much safer than mailing physical cash. And it can often be done anonymously or at least pseudonymously.
Cryptocurrencies only require certain information and an internet connection.
It has nothing to do with geography.
That means that when you move, your money moves with you. No opening new bank accounts or closing old ones, no currency conversion, no regulators, bankers, or tax officials to satisfy (at least not in the way that transferring large or even modest sums of money out of a country would normally entail).
Cryptocurrencies tend to have a lot more privacy than bank transfers. Your credit card company has a record of everything you buy. Your bank “sees” every dollar moving in and out of your bank account. Not only is this data often available to private companies to buy (part of “big data”), but it is also subject to the spying eyes of government agencies (domestic or foreign) or terrorist hackers - which have been in the news a lot recently.
Advantages
The cryptocurrency world offers several advantages to dollars:
It is better integrated with the internet and e-commerce. The biggest reason I am bullish on cryptocurrencies in general is because they are being designed for an electronic world. They are built to sync and integrate with phones and computers and websites and browsers and games. This is part of why there is a tremendous amount of programming and engineering going into the design of their protocols and their integration with normal life activity.
They tend to be difficult to hack. Financial institutions are too, but technically many of these cryptocurrencies are almost entirely immune from hacking and they are beyond the control of any individual - eliminating the all too common human error that creates the opening for massive security breaches.
They tend to be limited in their supply, unlike national currencies which can be increased at the whim of a central government (another couple trillion in infrastructure and childcare spending anyone?)
They can provide greater control and flexibility over one’s money.
They are not as easily stolen by thieves, hackers, or governments.
Disadvantages
There are serious disadvantages too:
Governments do have some power, perhaps a great deal of power, to curtail or limit the use of cryptocurrencies - especially at points of sale or points of converting the cryptocurrency into a domestic currency. If the U. S. government were to outlaw the sale of large objects like houses for cryptocurrency, and were to go after banks or exchanges where people tried to convert cryptocurrency into dollars, it would have a chilling effect, to say the least, on the adoption and valuation of these cryptocurrencies.
Uncertainty: the value of cryptocurrencies in terms of national currencies has been extremely volatile. Yes, some of the major cryptocurrencies like Bitcoin, Ethereum, Bitcoin Cash, and Litecoin have appreciated a huge amount in the last year. But other cryptocurrencies have gone close to zero or disappeared entirely. If you convert dollars into cryptocurrency, there is a risk that the value of that cryptocurrency in terms of dollars could decline, potentially a lot.
Difficulty: there is a somewhat steep learning curve for using cryptocurrency. You have to set up private wallets on your phone or computer, you have to keep track of your private keys and passwords, and there are still hackers out there who will try to get information from your phone or computer, or from whatever crypto-service provider you use. This is less of a challenge for younger people and there is increasing energy being put into making cryptocurrency easier to use and manage.
At the end of the day, cryptocurrencies have exciting potential. They offer real value for real people. They also represent a potential revolution in how things are bought and sold in the electronic world - which is growing in importance and potentially seeping into the world of physical things. From a monetary standpoint, I am fascinated by the possibilities of holding a medium of exchange that is appreciating over time. With a fixed supply, if there is steadily increasing demand over time (a big “if” granted), there is nowhere for some of these crypto currencies to go but up.
To return to the initial theme of this post, you shouldn’t buy cryptocurrency because everyone else is or because you are afraid of missing out on tripling your money overnight. That is unlikely to occur and it is possible that some or all of these cryptocurrencies are “overvalued” at the moment relative to their long-run potential. Instead, take some time to figure out the cryptocurrency landscape. How does it work? How interested am I in being an earlier adopter versus coming late to the party?
Buying tech stocks in the middle of the dotcom bubble was a bad idea and many people lost a lot of money. But tech was not a bad idea. Nor would investing money in the years after the bubble burst in tech companies, especially FANG (Facebook, Apple, Netflix, Google), have been a bad move.
The question, of course, is how analogous our current situation is to the example I just gave. I think it could be quite analogous, but there is a lot of uncertainty.
What got me into bitcoin over six years ago was the claim: “Look, 1 bitcoin could eventually be worth a million dollars. It could also eventually go to 0. The latter is more likely than the former. So don’t dump all your money into bitcoin. But maybe consider putting 1 percent of your wealth in it. Yes, you could lose it, or you could see it increase dramatically in value over time.”
I thought (and still think) that advice was sound. The place to start is small, not large. A year from now we’ll have a better sense of whether this is a temporary phase or bubble, or if cryptocurrencies really are the next stage in the evolution of money and banking.
Judge accordingly.
Talk to you next week!