Hayek Explains Cryptocurrencies

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“When one studies the history of money one cannot help wondering why people should have put up for so long with governments exercising an exclusive power over 2,000 years that was regularly used to exploit and defraud them.”

This can be explained only by the myth (that the government prerogative was necessary) becoming so firmly established that it did not occur even to the professional students of these matters (for a long time including the present writer!) ever to question it.

But once the validity of the established doctrine is doubted its foundation is rapidly seen to be fragile.” — Friedrich Hayek in The Denationalization of Money.

Since 2008, there have been debates between different economic theories on how best to pick up the pieces after the worst financial disaster for generations. A lot of attention is often focused on theories from Keynes and Marx. The general trend appears to be that mainstream corporations and governments favour Keynes (e.g. cheap monetary policy and QE resulting in inflation) whereas populist movements favour a redistribution of wealth and we find many movements invoking Marxist ideals (just look at Jeremy Corbyn).

But the mass media tend to overlook one school of thought, probably because his ideas are considered radical. This is 20th century Austrian economist Friedrich Hayek.

I was fascinated by his proposition of less government control and more decentralisation. This is contrary to theories from Keynes and Marx. In this article we are going to explore one of Hayek’s most radical ideas.

How Crypto is Sabotaging Legacy Banking

First we need to consider the recent crypto news, in January we saw a massive correction in the markets across all crypto assets. By “chance”, this happened just a few days after the World Economic Forum in Davos. Coordinated FUD and inaccurate news was rife in the media, together with scare-mongering and negative comments from central banks, all with one message — warning against cryptocurrencies. I don’t believe that this was a coincidence, I think this was manipulation by the banks.

So this got me thinking about the macro impacts that cryptocurrencies were now having on the legacy banking system.

The technology behind cryptocurrency is going to be, and already is revolutionary and with the rise of cryptocurrencies, a redistribution of wealth and economic autonomy for people excluded from our current system seems imminent.

But what does this actually mean for crypto in our society and why does it scare the banks so much?

To understand how crypto fits in, I delved deeper into old-school economic theories to see where this could go. This is where Hayek comes in.

The Denationalisation of Crypto

Hayek is all for free markets and letting things regulate themselves, in effect less centralisation. In my research, I came across his (1978) pamphlet, The Denationalisation of Money. This is where things get very interesting.

In his pamphlet, Hayek’s proposes privately issued, competing currencies. That is, Hayek proposes that individual firms issue currencies that are not backed by any production or consumption good. Hayek wanted to privatise central banking. As you can imagine, this was completely radical at the time. But not anymore…

Hayek argued that if government obstacles were removed, the free market would provide the optimal quantity and variety of monetary products. Just as the forces of competition lead to low prices and superior quality in other market sectors. It then follows that competition in the “fiat money industry” would lead to currencies that were better than their government produced counterparts. For example, a private company creating a “good” currency would factor in the following traits:

• Stable purchasing power
• Harder to counterfeit and cheat
• Be available in more convenient denominations

These “good” currency traits are starting to sound a bit familiar.

The Ducat

Hayek’s central point in Denationalisation of Money is that there is no solid reason for governments to have a monopoly on money via central banks. Currency can be privately issued and subject to the laws of competition.

He conducts a thought experiment using a hypothetical currency which he calls the ducat. The ducat is backed by two things:

1. The ducat is nominally backed by government currency (e.g USD, Euro, Yen, etc).
2. The issuer promises to keep its purchasing power stable relative to a basket of commodities (e.g. a basket of food goods or oil or steel etc).

So how would this hypothetical currency keep its stability relative to the chosen basket of commodities?

1. When the price of the ducat exceeds the desired purchasing power, more ducats are printed and sold until the price drops to the promised purchasing power.
2. Likewise, when the price of ducats drops below the desired purchasing power, the company buys back notes until it is back at the desired level or purchasing power.

The competition of the free market will ensure that this is carried out. Because if one company falls behind another in terms of keeping its ducat purchasing power stable, it will ultimately lose out to the competition.

“The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process…only competition in a free market can take account of all the circumstances which ought to be taken account of.”

What’s more, companies could change the commodity baskets to allow customers to choose what is important to them. For example, some people may not care about the price of eggs and bread, and would prefer a currency that had stable purchasing power in terms of a basket of aluminum, platinum, oil etc. Different companies could fill different niches.

After reading all of this, I couldn’t help but draw many parallels with cryptocurrencies. Regardless of Hayek living in a time way before we had advances in technology to create cryptocurrencies. The main point here is that the discussion about private currencies is age old and still has the same main recurring points. Crypto is already subject to the laws of free market competition, which ensures that companies and developers strive to create the best cryptocurrencies. We are also seeing many crypto projects fill in market niches which has a visible demand from the public.

Problems with the Ducat

Let’s take a look at some problems that have been raised about Hayek’s proposal for private currencies:

1. All money, even government fiat currency, must ultimately derive its purchasing power from a historical tie to a commodity. Fiat money although not backed by real commodities is backed by the central authority.
2. Any company attempting to circulate its own currency would go bankrupt. Due to the fact that it would have to keep buying back its currency to maintain purchasing power as government fiat inflates.
3. In the world Hayek proposes, there would be no single currency, so the benefits of a common medium of exchange would be diminished.
4. A private company, just like its government counterpart, will find it most profitable to inflate. For example, if 1 Ducat can be exchanged for a basket of goods, why not print up two billion of them and buy as many goods as possible? This would cause the public to abandon the currency, but so what? You would still get your goods.

The Ducat vs Cryptocurrencies

Now let’s look at each of the cases above and see how these problems are mirrored in Cryptocurrencies:

Purchasing power derived from a commodity

Cryptocurrencies have value tied to the product or services that they allow you to access (depending on what type of utility it has). But more fundamentally, the value is tied to the freedom of use and the fact that the code and mathematics behind it keeps the initial integrity of the currency intact. It cannot be tampered with.

The company circulating the private currency will go bankrupt

A company that issued cryptocurrency could indeed go bankrupt, but it would be for conventional reasons, not because they would have to buy back the currency.

Cryptocurrencies have written in code, from their creation, the rules for how they will behave (the purpose of the coin) and how many will exist. This cannot be changed. Furthermore, the very nature of cryptocurrencies, being decentralised, would mean in theory, it can continue to operate without a centralised company.

Imagine if Vitalik and his team went bankrupt, could Ethereum still operate? If there are still nodes on the network and computers carrying out PoW then of course Ethereum can just keep on operating as normal.

Yes, the original point of bankruptcy is brought about by the company striving to keep purchasing power of the currency. Some might say that the volatility of cryptocurrencies doesn’t allow it a stable purchasing power. But remember, because there is a unchanged upper limit of cryptocurrencies, it will retain purchasing power. One bitcoin will always be equal to one bitcoin no matter which year. Ether will allow you to use the Ethereum network in the same way this year as it will next year. Your purchasing power cannot be stolen via inflation.

Common medium of exchange will be diminished

We’ve already seen a cambrian explosion of competing currencies, but has this diminished the use of a cryptocurrency as a medium of exchange? I don’t think so. Firstly, we can very easily exchange different currencies on exchanges making the market more liquid. Secondly, when we get development upgrades such as atomic swaps, scalability upgrades and decentralised exchanges, this will just make the marketplace even more fluid.

Private companies seeing it as more profitable to inflate

Sure, a private company can try to inflate their currencies to buy more goods before anyone else, but this can’t be done with cryptocurrencies. Again, the rules of the cryptocurrency are written in the code from the start and is available for everyone to see and scrutinise. Most cryptocurrencies have a capped supply limit written into the code that cannot be changed or inflated. This level of transparency gives users trust in the currency that they decide to use. If the company does not have this transparency and its currency lacks “good” traits, then it will lose out to the free market competition.

Conclusion

Banks and central banks in particular are always going to be resistant to cryptocurrencies because fundamentally, cryptocurrencies threaten their businesses. Not only that, governments that insist on iron grip control over their populations will be against the economic autonomy that cryptocurrencies offer.

Some governments, which tend to be least free (e.g. China, Russia, Saudi Arabia), have acted to ban cryptocurrencies altogether. This is due to misguided rhetoric and a resistance to allowing an individual’s economic autonomy. However, the free market has punished them by denying them the advances of the technology and they will have to play catch-up. Nevertheless, other countries, which had the foresight to allow cryptocurrencies (e.g. Japan, UK, Switzerland) have been rewarded with further technological innovation and new budding business sectors.

This explains the hostility from the majority of institutions at the World Economic Forum. In particular, the hostility from the central banks which currently hold a monopoly on currency.

Hayek saw that there would always be resistance to private currencies:

“The older generation of bankers would probably be completely unable even to imagine how the new system would operate and therefore be practically unanimous in rejecting it. But this foreseeable opposition of the established practitioners ought not to deter us. I am also convinced that if a new generation of young bankers were given the opportunity they would rapidly develop techniques to make the new forms of banking not only safe and profitable but also much more beneficial to the whole community than the existing one.”