It was a legendary dispute between two monetary economics titans of the twentieth century. The question is whether “challenger currencies” can ever replace traditional, government-backed currencies as the world’s preferred payment method. Despite the fact that Bitcoin was decades away from being invented, the two sages could have been debating whether the cryptocurrency could ever ascend to the status of coin of the realm, or even a contender.
Friedrich Hayek, the Austrian-British colossus who championed classic liberalism, was on one of the podiums. Milton Friedman, a fellow proponent of free markets, stood across this fictitious stage. The disagreement between the typically simpatico duo was over whether competing currencies launched by private issuers would result in a more stable monetary system. When they met in the mid-to-late 1970s, the dollar regime was as deranged as it had ever been since World War II. Prices for gasoline, plane tickets, and home heating had skyrocketed as a result of the Arab oil embargo. To counteract the shock, the Federal Reserve flooded the markets with cheap money, eroding purchasing power across the board. The consumer price index, which had previously climbed at a slow and steady pace, exploded at a rate of 14 percent each year.
Hayek was a professor at the University of Chicago from 1950 to 1962, which coincided with Friedman’s long tenure there, and the two economists were well acquainted. However, the two did not have a face-to-face debate. In the mid-to-late 1970s, Hayek stated his point in a series of speeches and papers, as well as in his 1976 book The Denationalization of Money. In the 1970s and 1980s, they reportedly matched their opposing theories at industry conventions. Friedman’s first public criticism of Hayek’s theories appears to have occurred in the 1980s in a piece he co-wrote with fellow economist Anna Schwartz.
Politicians, intellectuals, and ordinary citizens all expressed concern that the system was flawed. By diminishing the value of U.S. dollars faster than American workers could earn them, the Fed was pursuing the polar opposite of its previous “sound money” objectives. In difficult times, Hayek argued, central banks would continue to overinflate the money supply to give economies a short, artificial boost, fanning more of the type of inflation that the United States was experiencing at the time. He proposed that private monies issued by banks or other businesses compete in an open market for customers with national currencies. By attracting the most users, the one or several contestants who did the greatest job of preserving stable purchasing power for consumers and businesses would win.
Privately managed currencies would eventually overtake the shaky greenback if the Fed continued to issue dollars that purchased less and less. The concept of “letting the best currency win” would put an end to irrational monetary policies, either by compelling central banks to reform or by allowing new, more stable currencies to gain control.
Two of the most well-known economists of the twentieth century were Milton Friedman and Friedrich Hayek.
Friedman has no qualms about letting the freedom bell ring by enabling different currencies to compete for dominance. He, on the other hand, thought Hayek was mistaken and that the challenges would fail. People and businesses, according to Friedman, are concerned about their purchasing power. However, they value using the same currency as their neighbors and commercial partners significantly more. Consumers and businesses, he claims, prefer to conduct their transactions in a single currency. Even if an alternative, which we’ll call XYZ-coin, were more stable than the dollar, Americans would prefer to use solely dollars rather than continuously switching back and forth between the two. As a result of their widespread acceptance, the incumbent currencies have a significant advantage over the invaders, preventing them from developing a foothold.
Hayek’s attitude has earned him the title of “Godfather of Bitcoin” among Bitcoin supporters. The European Central Bank claimed in a 2012 study on virtual currencies that “the roots of Bitcoin can be located in the Austrian school of economics,” of which Hayek was a key voice. When you Google “Hayek and Bitcoin,” you’ll find a slew of pieces from bloggers and academics referring to Hayek as “the prophet of cryptocurrencies” and quoting 1980s TV interviews in which the old economist “predicted Bitcoin.” Indeed, this side believes that the market will eventually gravitate toward Bitcoin, which is the most stable, dependable, and non-corruptible form of money that can’t be tampered with by central banks.
Many Bitcoin supporters believe the cryptocurrency has a bright future as a store of value, but not as a currency. MicroStrategy CEO Michael Saylor, who is known for putting billions of dollars in Bitcoin on the company’s balance sheet, thinks it’s a good investment but doesn’t think it’ll ever be used as a medium of exchange. Elon Musk, on the other hand, has claimed that “paper money is going away, and crypto is a vastly better means to transmit value, without a doubt.” “I believe that the world will eventually have a single currency, and that currency will be Bitcoin,” says Jack Dorsey, CEO of Twitter and Square. “Because of all the money printing and people looking at what’s going on and [thinking], ‘Wait a second, where are all these trills?’” says Cameron Winklevoss, CEO of Bitcoin exchange Gemini. What does this entail for the other monies I have on hand?”
Bitcoin, on the other hand, has found limited popularity for everyday transactions, while it has carved out a position for itself in the world of money transfers, particularly when privacy is a priority. “If people rush to Bitcoin as a currency, Hayek would be wrong, since he expected them to choose the money with the most steady purchasing power,” says William Luther, an economics professor at Florida Atlantic University. “Hayek’s preferred form of money was quite steady, whereas Bitcoin is the polar opposite. It’s a really volatile situation.”
Bitcoin, in Friedman’s opinion, would have little chance against the dollar or the euro. This is because the money that everyone now uses is the cheapest and most convenient to keep using. The exception is countries that have extremely inflationary monetary policies, which undermine purchasing power while also causing price volatility. Customers will purchase and sell on the black market using a reliable foreign currency in times of great volatility, according to Friedman, who noted that Venezuelans are currently using the dollar and euro. They don’t purchase food or pay rent in Bitcoin for the same reason they don’t use the Venezuelan bolivar: the signature cryptocurrencies lurching daily swings, averaging 9% from low to high, mean households never know what their budgets can buy from day to day.
On the future of challenger currencies, Hayek and Friedman had sharp disagreements. However, they would have similar opinions on Bitcoin. Both might applaud the idea as a risky, free-market experiment. But neither of them wants Bitcoin to be the dominant currency. Of course, Hayek made his thesis before the United States’ monetary policy stabilized in the 1980s and beyond. Moving to Bitcoin, according to Hayek, would be a step backwards, from a moderately stable currency to one that is dramatically unstable. Bitcoin, according to Friedman, would have the same handicap that all newcomers face: the virtual impossibility of gaining universal support.
However, contrary to what its advocates assert, the two legends concur that Bitcoin’s architecture has a fundamental fault. It assures that Bitcoin’s supply cannot vary in order to maintain purchasing power during up and down cycles. Let’s see if Bitcoin could compete with the dollar even if it were the most stable of currencies. Second, how Bitcoin meshes with Hayek and Friedman’s views on what makes a robust currency— the attributes that will keep customers and businesses whole for years to come.
The holy grail of monetary policy, according to Friedman and Hayek, is to achieve steady, predictable, and minimal price growth. However, early in his career, Friedman disagreed with Hayek about how to accomplish that aim. He claimed that demand for money, which is inversely connected to “velocity of money,” or transaction speed, has remained relatively consistent over time. As a result, he claimed, the Federal Reserve should expand the money supply at a certain, predetermined rate.
If the central bank wants to achieve 2% inflation and the economy grows at 2%, the optimal strategy is to increase the money supply by 4%. Then 4 percent more money would be spent each year to chase a 2 percent increase in the volume of products and services, raising prices by the 2 percent target. Luther argues that Friedman wants the Fed to set a constant rate of money expansion and then walk away. “The name of the game was the K-percent rule. The fixed rate of money supply increase was K.”
The K-rule resembles the Bitcoin paradigm, as Luther points out. The Bitcoin algorithm places a limit on the number of coins that may ever be produced and establishes a defined rate for new coins to be issued. “You could argue that Bitcoin resembles Friedman’s old K-rule,” Luther argues. The fact that Bitcoin’s supply is preprogrammed and inflexible, however, is a major flaw. Hayek advocated for the money supply to expand and decrease in order to maintain buying power. “Hayek claimed that if money supply outpaces money demand, an unsustainable boom in production will result, eventually leading to a recession. Companies would be duped into overproducing, forcing them to cut down at a high cost,” Luther warns.
Friedman changed his viewpoint in the 1980s, aligning himself more closely with Hayek. He discovered that the need for money varied far more than he had anticipated. As a result, he pushed for inflation targeting and modifying the monetary spigot according on economic conditions. “Friedman claimed that if the money supply collapses faster than the fall in money demand, or if the money supply increases faster than the growth in money demand, a recession will result,” Luther adds. “Like Hayek, Friedman came to believe that money should be supplied in response to demand.”
Bitcoin’s design does not allow it to expand or diminish its supply in response to changing economic conditions. The supply of newly issued Bitcoin cannot fluctuate with demand for it, which Friedman and Hayek considered to be the hallmark of sound monetary policy. Bitcoin’s supply is determined by its algorithm. It lacks the shock absorbers that Hayek and Friedman considered necessary. “Bitcoin is built in such a way that it cannot maintain purchasing power in reaction to fluctuations in demand,” Luther explains.
Because its supply is fixed, the price of Bitcoin is only affected by changes in the amount of Bitcoin purchased by individuals and institutions. “Bitcoin is designed in such a way that only a demand shock may change its price,” Luther explains.
Consider a world in which Bitcoin has supplanted the dollar. The economy suddenly switches into overdrive, with GDP growth increasing from 2% to 3%. According to the Friedman and Hayek models, the Fed might increase the money supply by one percentage point if the growth rate changed. This measure would enhance credit supply to meet rising demand for loans and bond sales to fund new plants, fabs, and research centers. The rate of inflation would remain unchanged. Bitcoin, on the other hand, is unable to expand its supply. Interest rates would rise in a Bitcoin-based system as demand for credit outstripped the capital available to lend from banks and investors. The boom would be soon deflated as a result of the squeeze.
Economic fluctuations would also exaggerate swings in the price of our new money for the same reason. When consumers and businesses compete for Bitcoin-denominated bonds and loans during an expansion, or when they sell those instruments during a downturn, the rate of Bitcoin issuance remains constant. In an expansion, Bitcoin’s price may skyrocket because no new bitcoins would be created, but the Fed would have released more dollars, limiting the rise. Large price swings in Bitcoin would put multinationals at risk by continuously altering what they’re paying in the new prevalent medium of exchange for semiconductors, appliances, and textiles made in China, Japan or Germany.
Bitcoin is now far too volatile to be used as a currency. “Small changes in its appeal relative to other currencies have a significant impact on how much people desire to use it in the future,” Luther says. “If we get bad news, people assume less people will use it, and the price drops dramatically.” He points to the spike after Elon Musk announced that Tesla had purchased $1.5 billion in Bitcoin, the subsequent drop after Musk announced that the EV maker would no longer accept it for auto purchases, and the surge after Visa and Mastercard stopped accepting payments for the Pornhub site, forcing users to resort to Bitcoin and other cryptocurrencies.
The volatility of Bitcoin is now nine times that of the S&P 500 and six times that of gold. Even if it obtains widespread adoption, Bitcoin’s price will still experience larger peaks and deeper valleys than rival currencies, due to its design, which does not allow for supply modifications to smooth out the swings.
Even if the proponents are correct and Bitcoin becomes more stable over time, it is unlikely to ever become a viable currency. There are two explanations for this. The first is that its rigid architecture would fail to protect purchasing power since, as previously said, the amount being supplied is completely inflexible. The second point is that countries will most likely create their own digital currencies. China has already announced plans for a digital yuan, which sent Bitcoin’s price soaring.
Luther continues, “The United States may also develop a digital money.” “The Federal Reserve currently issues dollars and manages digital dollar balances for banks. It might give rise to a new form of currency known as digital dollars, which would be comparable to cash and reserve balances. Customers may be able to cash in their digital currency.” People may exchange digital dollars like Bitcoin from wallet to wallet without going through banks, or pay at the checkout counter by scanning their iPhones, which would send payments from the consumer’s iPhone wallet to the retailer’s digital dollars account. These transactions would take place outside of the credit card system, avoiding high “interchange” costs. “A key risk for Bitcoin is that it will be outcompeted by digital currencies created by central banks,” Luther warns.
Bitcoin’s prospects would be further limited if sovereign states issued digital currencies. Bitcoin, on the other hand, has a lot of potential as a niche medium of exchange for transactions that require a lot of anonymity, especially big ones. Luther argues, “It’s the one thing Bitcoin succeeds at that other currencies don’t.” Of course, Bitcoin is used in a variety of illegal operations, including ransomware payments, and governments will try to curtail its underground use. However, Bitcoin will be difficult to control, which is one of its advantages. Luther contends that “governments can only do so much to discourage its use.” “Blocking Bitcoin transactions is considerably more difficult for governments than blocking the use of cash, which they can simply cease issuing and which is also used for hidden transactions.”
How do you think Friedman and Hayek would react to Bitcoin if they were alive today, according to Luther, who has studied the perspectives of major monetary economists? He comments, “They would appreciate its evolution and relative success as an experiment.” “In theory, they’d see it as a beneficial check on wasteful government expenditure. However, they would require a supply mechanism that accounts for fluctuations in demand in order to keep money, which Bitcoin lacks.” According to Luther, neither Friedman nor Hayek believe Bitcoin can or should replace the dollar as the United States’ principal currency. Its best role, they would presumably agree, is to keep transactions confidential, which is what it is now employed for.
In the financial realm, Bitcoin throws a huge shadow. However, as the two great brains may have predicted, its imposing image will fade as the world realizes that it has a strictly specialized future.
Kiara Sofia Smith
My current focus is blockchain technology and cryptocurrency. One could even call me a blockchain “enthusiast.” I have worked for almost a decade on several financial projects related to the stock market news, fundamental research and technical analysis for several blogs.
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