By Jonathan Laird

Originally published on The Block, July 22, 2019

Quick Takes

• Economists generally describe money as a medium of exchange, a unit of account, and a store of value.
• In order to perform those functions, money needs to be fungible (interchangeable, like how two five-dollar bills equal one ten) and inimitable (unable to be counterfeited).
• Cryptocurrencies have the key properties of fungibility and inimitability but struggle to perform the functions of money.
• As adoption increases, cryptocurrencies will likely stabilize in value and function more regularly as money.

The nature of money is a complicated and obtuse subject. In daily life, most people use money without truly considering what it is. Money simply works. Cryptocurrencies, however, offer an unusual and distinctly twenty-first-century perspective on money. The cryptocurrency world often invokes monetary terms, yet looking at cryptocurrency news reveals that economists, technologists, politicians, and entrepreneurs frequently take strong and opposing stances on whether Bitcoin and other cryptocurrencies are a new form of money or simply the digital equivalent of fool’s gold. Many commentators focus on whether the value of Bitcoin relative to fiat currencies is justified. A more practical approach, however, lies in understanding what makes anything useful as money.

Three Functions of Money

Economists typically describe money as something that performs three basic functions. Money acts as a medium of exchange, a unit of account, and a store of value. A store of value is a key basis for the other functions. If people consider a currency valuable and that value remains fairly stable over time, then individuals can safely store wealth in it. A stable currency can be used to price goods and services, serving as a unit of account, and then people can buy those goods and services using that currency as a medium of exchange.

These three principles of money, however, do not explain what money must be in order to perform those functions. The functions of money all depend on value, but value is a subjective measurement. Most people consider gold to be intrinsically valuable. It is beautiful, with many artistic and industrial uses. But gold alone provides no nourishment, no warmth, and no protection from the elements. Gold has historically been used as money because it has two key properties that many other objects lack: fungibility and inimitability.

Two Key Properties of Money

Fungibility is the property of being interchangeable. In monetary terms, a one-ounce pile of pieces of pure gold would be worth the same as a single one-ounce nugget of pure gold. Most fiat currencies function the same way. Borrowing a twenty-dollar bill from a friend implies that you will pay back twenty dollars, not return the exact same bill. The aggregate value is important, not the individual units of currency.

Inimitability is the inability to be duplicated. Gold is difficult to counterfeit because its elemental properties are difficult to imitate. Governments prevent counterfeiting be adding features that are difficult or costly to copy, such as watermarks and microprinting. If anyone could print convincing fake bills at home, the value of the real currency would quickly drop. Therefore, inimitability also implies some measure of scarcity.

Evaluating New Money

Whether cryptocurrencies are a new form of money depends heavily on whether one focuses on the functions of money or the core properties of money. Bitcoin, since it has the greatest market penetration, is closest of all the cryptocurrencies to performing the three functions of money. Many items are priced in bitcoins and can be purchased with them, but Bitcoin struggles with being a stable store of value. Its highs and lows over the last ten years certainly demonstrate that fact.

But Bitcoin is inimitable in ways that no fiat currency is. Bitcoin is cryptographically impossible to duplicate, and by longstanding and distributed consensus, it is a deflationary currency. With a maximum supply of 21 million coins, Bitcoin cannot suffer from hyperinflation like the fiat currencies of the Weimar Republic, Zimbabwe, Venezuela, and many other nations. In this regard, Bitcoin is better at being money than any fiat currency.

Bitcoins are also generally treated as fungible. However, the design of Bitcoin and most other cryptocurrencies still makes censorship possible. Because transactions are publicly viewable, every bitcoin has a history which makes it unique and therefore not truly fungible. (As an aside, the concept of a bitcoin as a discrete unit is a bit of a skeuomorph, but it is easier to conceptualize.) Some altcoins are objectively fungible, so the problem is certainly not insurmountable. Monero, for example, uses an obfuscated blockchain to ensure that every coin is interchangeable, while MimbleWimble coins like Grin essentially erase a coin’s history with every transaction. Second-tier scaling solutions like the Lightning Network can also help increase practical fungibility for Bitcoin.

Stability and the Future of Cryptocurrencies

The current instability of cryptocurrencies relative to most fiat currencies is the major economic hurdle that the industry faces. But this instability should not be unexpected. Any new currency should be expected to be unstable in its early years, and unlike government-issued fiat currencies, Bitcoin and most altcoins do not have central planners to artificially manipulate the value, nor do they have the force of a government to compel use. Most cryptocurrencies are experiments in truly free-market money.

The debates over whether cryptocurrencies are money will likely continue for the foreseeable future. But many find the idea of independent digital money compelling, especially in developing nations with unstable fiat currencies and poor access to banking. Since cryptocurrencies have the basic fundamental properties of money, adoption will likely continue to increase for the foreseeable future. As adoption increases, stability should also increase. Expect to see Bitcoin and some of the altcoins function more regularly as money.