On Cryptocurrencies

Why cryptocurrencies have value? What is the fundamental problem they are solving?

Our reality consists of three types of phenomenons: objective, subjective and intersubjective. Objective phenomenon exist independently of our consciousness. Subjective phenomenon exist only in the mind of a single individual. But the most interesting of all are the intersubjective phenomenon. The intersubjective phenomenon are neither subjective nor objective but rather exists in the combined consciousness of many individuals. Religion, mythology, astrology, money are examples of such intersubjective phenomenon. Their meanings are constructed purely by people in their interactions with each other.

Most fiat currencies today can be categorised as intersubjective phenomenon. Fiat currencies are not backed by gold, silver or other commodities but rather they have value because we all believe that these notes have value. But, what if one day we start believing that these fiat currencies have little value or no value at all? Implicitly, we put trust in the issuer of these notes (typically central banks) to keep the supply of these notes under control. Failure to do so, results in inflation and major loss of value of that currency. Lets consider the governmental incentives for inflation…

If we examine the state of the current monetary systems around the world, we can find several problems. First, most of the countries around the globe are in debt with concerning proportions compared to their GDP. This raises the concern if they are able to meet their debt obligation honestly (without inflating their currencies). Second, there is a prevailing economic theory that currency devaluation increases exports since the goods produced at home become cheaper outside. In order to stay competitive and export more goods, governments have the incentive to continue devaluing their currencies. China is perhaps the prime example of a country which continues to devalue its currency. Third, inflation causes nominal prices to rise which in turn means governments can collect higher taxes in nominal value.

Money by definition has three primary functions:

  1. Money is a store of value.
  2. Money is unit of account.
  3. Money is a medium of exchange.

It seems there are currently too many incentives to distort the first function of money.

Now lets look at cryptocurrencies. Cryptocurrencies are also intersubjective phenomenon. They also have no intrinsic value other than our joint belief that they do have value. However, the difference for now seems to be the fact that they fulfil the first function of money better than the traditional fiat currencies.

Most cryptocurrencies have algorithmically determined supply which is often limited and predictable. This makes the coins a scarce and limited asset. In an environment where the fiat money supply is increasing continuously and at unpredictable rate, the cryptocurrencies can be used to hedge against the risk of inflation.

Cryptocurrencies are also open-sourced projects. Anyone can clone their source code and start their own coin. However, agreeing that a coin is valuable to mine, use and exchange is a timely process. Anyone can create a coin, but everyone has to agree that the coin has monetary value and fulfils the primary functions of money. In a global environment with a lot of competing forces, the most fairly distributed, most secure, most adaptable, most resilient coin is bound to come on top.

Will cryptocurrencies ever replace the current fiat monetary system? I don’t know. They don’t need to. Their primary function for now should be to induce honesty and transparency from our governments and central bankers. They should know that even though they still rule our intersubjective reality, there are other substitutes out there. If they fail to fulfil their promise and distort the primary function of money as a store of value, there are other solutions to the problem they helped create.