A common criticism of bitcoin and other cryptocurrencies is that they have no real value. Just because people have agreed that they do have value doesn’t mean that they do. And because they are not backed by central banks and governments they are volatile at best and illegal at worst.

How true is this? And how do government and central bank-backed fiat currencies compare with this standard?

This is a lay person’s look at these questions. It reflects some ongoing debates and opinions and is not meant to be an economic treatise.

Crypto — does it have value?

Bitcoin is said to derive its value from two sources:

· As a medium of exchange

· As a store of value (an asset that maintains its value, or can be expected to retain some value even if there are fluctuations)

One opinion is that a cryptocurrency can only be regarded as a store of value if it first has utility as a medium of exchange. If it is not accepted as a medium of exchange, it has no practical utility. In the absence of any other intrinsic value, it can then not be regarded as a store of value.

This is somewhat of a circular argument. Many might say that a coin or token must first demonstrate that it has some utility (this is what most Whitepapers and ICOs are trying to do). The failure of so many hundreds of tokens and coins probably is because they have no utility that people can discern and therefore they are not seen to be legitimate mediums of exchange — and then they have no value.

The lack of interest in these coins and tokens on the crypto exchanges is evidence of this. The coins and tokens with the least utility value are probably the riskiest. According to Coinidol, the best chance of success may be in “projects exteriorizing the real needs of cryptocurrency wallet owners, like convenient payment solutions, blockchain platforms and infrastructure, as well as investment and trading tools”.

Comments from the International Monetary Fund about crypto assets as “commodity money” may have relevance here:

“Economists continue to debate the origins of money, and why monetary systems seem to have alternated between commodity and credit money throughout history. If crypto assets indeed lead to a more prominent role for commodity money in the digital age, the demand for central bank money is likely to decline.”

“We cannot rule out the possibility that some crypto assets will eventually be more widely adopted and fulfill more of the functions of money in some regions or private e-commerce networks.”

Monetary Policy in the Digital Age. IMF Report, June 2018

For the skeptics, the comment from Christine Lagarde, MD of the IMF, may be added:

“Not so long ago, some experts argued that personal computers would never be adopted, and that tablets would only be used as expensive coffee trays, so I think it may not be wise to dismiss virtual currencies.”

At the end of the day, value seems to be in the eye of the beholder. Even now when all cryptocurrencies are taking something of a beating, the crypto exchanges continue to operate. Total market cap may have fallen to around $220 billion, from over $800 billion in January 2018, but there are still people willing to trade billions of dollars per day for the individual coins.

Fiat money vs crypto

Many people are not even aware of the term “fiat” money. Money is surely just money?

The Investopedia definition of fiat money is:

“Currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material from which the money is made.”

Fiat money has no intrinsic value. It is not linked to physical reserves. Until the 1970s, the American dollar was commodity-backed, linked to gold. Every dollar issued by the country was backed by a supply of gold, most of it stored in Fort Knox. Today, the country’s balance sheet is the backing. The value is based on the faith and credit of the economy.

What does that mean? In essence, it means that this money has value because the government of a country has said that it does, and has taken some steps to support it, usually via central bank controls. It is underpinned by the balance sheet of the country underwriting it.

Alternatively, it has value because the two parties agree that it has. So, this would be reflected in the relative value of the money on the exchange markets, and in people’s willingness to trade it for goods and services.

That sounds very much like what gives cryptocurrency value: two parties agree that it has value, and they are prepared to exchange it, either for other currencies or for goods and services. The missing part — by design — is government control. Much of crypto’s value lies in it being immune from debasement and control by central banks.

What gives fiat value — opinions from Quora

Quora is a question-and-answer site where questions are asked, answered, edited, and organized by its community of users in the form of opinions.

The responses on Quora to the question “What gives fiat value?” are as entertaining as they are diverse:

· Fiat currencies have no intrinsic value. All they are is pieces of paper with photos of dead politicians on them. But, in the USA, they are guaranteed by the government, as shown by the signature of the Treasury Secretary on them. So, the value depends on two factors: solvency of the federal reserve and the federal government.

· The word of governments gives fiat its value. Ultimately, it is the taxpayers of that country that are the guarantors of all the fiat money in issuance.

· “Value” has different meanings: purchasing power for goods and services; the exchange rate against other currencies; the interest rate you can get on it. If value means the purchasing power for common goods and services, then a fiat currency has value because the central bank and/or the government promise that inflation won’t go up beyond a certain number.

· Productivity defines the value of fiat. Too many dollars/euros/units chasing too little productivity leads to inflation and a reduction in the currency’s value. Too few units chasing too much productivity leads to deflation and an increase in the currency’s value.

· All money has value because of debt. We need some means to pay for the things we need — our mortgage, groceries, etc. The demand for payment on liabilities drives the currency. A dollar, whether in the form of a paper currency or a bank deposit, is not money. It is a form of credit, i.e. a debt.

· Value is driven by the salience of its acceptance. You accept a fiat dollar because you fully expect it to be accepted by someone else if you want to make a purchase from them.

So next time you are asked to please explain exactly how cryptocurrencies work, you might be comforted by the realization that people don’t do a great job of understanding and explaining traditional currencies either!

The crash of fiat money — examples

The big risk to fiat currency, when the economy and the balance sheet become suspect, is hyperinflation. When a country’s economy crashes, the fiat currency crashes with it. Some examples of this are Hungary and Yugoslavia in the 1940’s and 1990’s, Zimbabwe in the early 2000’s and Venezuela right now.

The following are very extreme examples of how fiat currencies can collapse, often as a result of poor government and risky central bank actions.

Obviously, this will not happen everywhere, but the examples serve to highlight the point that fiat money has no intrinsic value, other than the value assigned to it by governments and by people’s willingness to trust it.

The problem is that when people lose trust in a fiat currency, its value is lost.

Zimbabwe

Investopedia gives a clear description of how hyperinflation happened in Zimbabwe:

· Economic conditions declined in the 1990’s, with inflation reaching 17%.

· The position was exacerbated in 2000 when government expropriated farms and gave them to people with no farming skills. As a result, export revenue declined sharply.

· The central bank started to print money to pay the country’s debts and offset higher prices caused by the agricultural shortfall.

· Inflation skyrocketed, reaching between 230 and 500 billion percent in 2008. Prices kept rising, with bags of money being needed to buy basic items.

· The value of the Zimbabwe dollar in relation to other currencies crumbled. A trillion Zimbabwe dollars was worth about 0.40 USD. At one point the central bank was printing 100-trillion dollar bank notes. Each one was enough to pay for one week’s commute to work.

· Eventually the Zimbabwe dollar was scrapped and replaced with the USD.

Hungary and Yugoslavia

A similar meltdown of the Hungarian pengő happened in 1946. The pengő was replaced by the forint, with a conversion rate of 400 octillion (4 followed by 29 zeros) pengő to one forint. In effect, Hungary cut 29 zeros off its unit of account.

In 1994, the monthly inflation rate in Yugoslavia reached 313 million percent. Between 1990 and 1994, the government kept issuing new dinars to replace previous ones and cut 27 zeros off the value of the currency.

Venezuela

The recent collapse of the Venezuelan economy and the bolivar paints a bizarre picture of a government trying to control fiat currencies.

The once-rich South American country has implemented policies that have collapsed the economy. Hyperinflation during 2018 reached more than a million percent. Rather than simply abandon the bolivar and replace it with the USD or some other currency, as Zimbabwe was eventually forced to do, Venezuela’s president Nicolas Maduro has made some interesting decisionsabout how to salvage the economy:

· The bolivar has been devalued by 95%.

· It has been replaced by a “sovereign bolivar”. The conversion rate is 100,000 old bolivar to 1 sovereign bolivar. This has wiped 5 zeros off the value of the currency.

· One sovereign bolivar (or 100,000 old bolivar) is currently worth 0.15 USD.

· Venezuela has also launched its own cryptocurrency– the Petro — backed by the country’s oil (50%), gold (20%) iron (20%) and diamonds (10%).

· The Petro has been declared a new currency, to be used to buy goods and services.

· In technical terms, the Petro is a “security token” or a “stable coin”, backed by real-world assets.

· Because of this commodity backing (albeit that this is oil and metal still in the ground), the president has declared that each Petro is worth $60.

· He has also declared that the new sovereign bolivar will be linked to it. Each Petro is worth 3,600 sovereign bolivar.

· He has registered 16 crypto exchanges in the country in hopes that they will list the Petro.

· To date, there is no sign that they or any other exchanges have listed it. Instead, there have been rumblings that the Petro is illegal, that it is simply a copy of the Dash technology, that there is no guarantee of the backing by commodities.

What’s the takeaway from all of this?

While many may point to cryptocurrencies as risky and open to reckless behavior, the same can be said for fiat. And when a country’s currency crashes, millions of people are affected by it and have no defense.

So, it’s no surprise to learn that many people in both Zimbabwe and Venezuela have turned to bitcoin and other cryptocurrencies as the only way to somehow salvage some of their wealth.

Which is best — crypto or fiat?

At the end of the day, public opinion and trust play a surprisingly important role in defining the value of a currency — both fiat and crypto.

Proponents of fiat may derive a sense of security from knowing that governments and banks are “in control”. Proponents of crypto derive their sense of security from knowing that governments and banks are not in control.

It would seem that both will continue for now. It remains to be seen whether cryptocurrencies will stand the test of time.