The Austrian school of economic thought is a frequent reference in the Bitcoin community and for advocates of cryptocurrencies. In this short note, we analyse some of the most used (and abused) Austrian arguments on blogs, articles, and forums of the crypto community.
Who are the Austrian Economists?
The Austrian school was born in Vienna in the late-19th / early-20th centuries, predominantly from the ideas of Carl Menger, Eugen Böhm von Bawerk, and Friedrich von Wieser. Although their economic thought is generally considered unorthodox, many ideas developed by the Austrians have become part of modern economic thinking. The most famous is the 'marginalist' approach, i.e. the idea that values, costs, revenues, productivity, etc. are determined by the importance of the last unit added to or subtracted from the total. This is now a standard assumption in modern macroeconomic models. It is worth noting that the Nobel Memorial Prize in Economic Sciences in 1974 was awarded to Friedrich Hayek (jointly with Gunnar Myrdal), who worked in the tradition of the Austrian school.
Which Austrian ideas are most shared by advocates of cryptocurrencies?
Three related ideas frequently arise:1
- Bitcoin is a new form of hard currency. This follows from the idea that the protocol is inspired by the former gold standard. Gold and bitcoins are obtained by mining and both have a fixed or inelastic supply curve. This idea aligns with the Austrian critique of fiat money and modern central banking.
- Cryptocurrencies bring an end to fractional reserve banking via its destabilising effects on the economy. Here the idea is that modern central banking is the primary source of business cycle fluctuations in the economy. Good riddance!
- Cryptocurrencies bring an end to the monopoly that central banks have on the issuance of money. The idea originates from Hayek’s critique of government monopoly over the issuance of money. He proposed that private entities should be allowed to issue non-interest-bearing certificates, competing in an open market for currencies.
What is money?
Money is traditionally known as an asset that acts as a (i) unit of account, (ii) store of value, and (iii) universal medium of exchange.
- Unit of account to track the relative prices of multiple distinct goods in an economy.
- Store of value to transfer value across time.
- Medium of exchange to bypass the 'double coincidence of wants' during any exchange.
The debate on how 'something' can become money is of great importance in the cryptocurrency space. Often this question appears linked to some interpretation of how money arises from commodities, based on the so called Menger-Mises Regression Theorem.2 This is the idea that in order for an economic good to become 'money', it must initially have other non-monetary uses.3
The idea that bitcoin (or other cryptocurrencies) may become widely accepted starting from the stage of commodity or collectible to currency seems to be based on some misunderstanding of both how currencies become money and the very nature of cryptocurrencies. First, it is very difficult to argue that any cryptocurrency is born as a collectible (or commodity). Bitcoin clearly does not fit the description. Second, while the historical truth and interpretation of the regression theorem is disputable, it does not say anything about how a new currency can become accepted and replace others.4
Although the actual process of how cryptocurrencies could be adopted as money is debated, it is worth noting that Bitcoin is often compared to gold as a store of value. This could be seen to justify its adoption as money.5 Indeed, a recurrent critique amongst Austrian economists is that the modern monetary system is based on fiat money and fractional reserves.
At the beginning of the 20th century, most countries backed their currencies with fixed amounts of gold, making them directly convertible. This system was institutionalised after WWII at the Bretton Woods Conference, when most countries adopted a fixed system of exchange rates against the US dollar that, in turn, was anchored to gold. However, the system started to crack. In 1971, the US government suspended the convertibility of the US dollar into gold. Since then, national currencies across the globe became pure fiat money and anchored only by trust in central banks. In modern economies, money is not backed by gold and not created by governments. In fact, the majority of money is created by commercial banks (“out of thin air”, as the saying goes). Whenever a bank makes a loan, it simultaneously creates a matching deposit on the liability side of its balance sheet, hence expanding the money supply.
This system is considered by Austrian economists too prone to hyperinflation and many other problems. For example, the website of the Mises Institute reads:6
Today's worldwide paper-, or "fiat-," money regime is an economically and socially destructive scheme — with far-reaching and seriously harmful economic and societal consequences, effects that extend beyond what most people would imagine.
Fiat money is inflationary; it benefits a few at the expense of many others; it causes boom-and-bust cycles; it leads to overindebtedness; it corrupts society's morals; and it will ultimately end in a depression on a grand scale.
To some, the solution to these evils is to remove the monopoly from governments and central banks and either go back to forms of money pegged to gold or to create a private market of competing monies.
This idea reverberates in the cryptocurrency space. For example, Saifedean Ammous, in his book “The Bitcoin Standard”, expects Bitcoin to become the new gold standard and the anchor of the international monetary system.
To the proponents of this idea, Bitcoin is similar to gold in two ways (beyond the fact that both are mined!). First, both are limited in quantity either by an asymptotically fixed or a very inelastic supply curve. Hence, if any, they are prone to deflation, not inflation. Second, they are both internationally available and removed from the control of governments. They do not need a central authority for their existence and have no political borders for their circulation.
These arguments seem to miss the historical evidence that independent central banks have been able to manage fiat money to achieve stable and low inflation. If anything, inflation since the last recession has been too low and below declared targets.
More generally, most economists would agree that the gold standard (or anything like it) is a bad idea. In his 2012 lecture “Origins and Mission of the Federal Reserve”, the Chair of Federal Reserve Board, Ben Bernanke proposed the following fundamental flaws of the gold standard:
- Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions. Hence money cannot be used by policymakers to absorb exogenous economics shocks and hence as a tool for macroeconomic stabilisation.
- All countries on the gold standard are forced to maintain fixed exchange rates. Hence exchange rates cannot be used as a shock absorber against external disturbances.
- Over the medium term, it can cause periods of inflation and deflation.
These critiques are equally applicable to a 'Bitcoin standard' regime. Moreover, having a currency with an absolute fixed supply and no option to devaluate against it implies that:
- All demand and supply shocks are reflected into prices, making them potentially very volatile in the short term.
- A growing economy priced against a fixed number of bitcoin would experience deflation over the medium and long run.
While the last property is generally regarded as undesirable by monetary economists, it is often mentioned as attractive. Indeed, being deflationary is interpreted as a good condition for an asset to be a store of value. This relates to the vision of Friedrich Hayek of a market in which privately issued currencies would compete primarily as stores of value.
Monetary policy as the source of business cycles
An important Austrian argument often brought in favour of cryptocurrencies concerns the sources of business cycles fluctuations. According to the Austrian theory, business cycles are the consequence of monetary interventions by central banks. The mechanisms can be described as follows: Monetary interventions lead to excessive expansion of bank credit and hence an increase in the supply of money, due to the fractional reserve banking system. In turn, this depresses interest rates. The distortion of a market signal regarding consumer intertemporal preferences generates overinvestment. Over time, these imbalances lead to recessions, during which firms have to liquidate failing investments and restructure.
This 'theory' of business cycles justifies the Austrian proposal to abandon modern central banking and fractional reserves to return to hard money or a market of privately issued currencies.
While this argument seems to be used in the cryptocurrency debate, it is important to notice that modern empirical research attributes the largest share of macroeconomic fluctuations to non-policy shocks. Monetary policy shocks only contribute towards 8% of the variance of output along the business cycle.7
A market of currencies
In his essay on the “Denationalism of Money: An Analysis of the Theory and Practice of Concurrent Currencies” (1976), Hayek maintained that governments should lose their monopoly over the issuance of money. This is to avoid the recurrent mismanagement of government-issued currencies. Private banks instead should be allowed to issue non-interest-bearing monies. These currencies would compete and be traded at variable exchange rates. All of the issuers able to provide a currency with a stable value would stay in the market, while the others would be eliminated over time. Such a process would enforce an efficient monetary system.
In Hayek’s vision, currencies would compete both as a unit of account and as a store of value. The latter property, however, would be key to the success of a currency. Indeed, consumers would stick to the currencies bringing them a better store of value over time.
Cryptocurrency proponents often support Hayek’s vision of a global market of privately issued currencies competing over their properties to create an efficient monetary system.
A few fundamental issues with this vision are apparent:8
- First, as mentioned, money is important as a tool for macroeconomic stabilisation. Cyclical monetary policy is used to both reduce and even out risks over the business cycle.
- Second, the unit of account role of currencies has strong network externalities. Frictions such as switching costs, exchange rate risks, limited cognitive capacity, etc. can push agents to coordinate on one unit of account and make the system stable over time.
Interestingly, in the “The Digitalization of Money”, Brunnermeier, James and Landau (2019) observed that switching costs are likely to be much lower in a digital environment, thus allowing for higher convertibility among monies.
Convertibility, in turn, can drive the phenomena of unbundling of the store of value and medium of exchange role of money. With unbundled money, currencies could differentiate and specialise, this potentially creating fiercer competition. As observed in Brunnermeier et al (2019):
[…] if currency A is a good store of value but a poor medium of exchange, and currency B is a good medium of exchange but a poor store of value, users may choose to hold A when they are not conducting transactions, converting some of their holdings into B only milliseconds before they need to execute a transaction. Ignoring exchange rate risk, the fact that B is a poor store of value would make no difference, as users keep their holdings for less than a second. Therefore, unlike in Hayek’s vision, B may not necessarily be driven out of the market in favor of the more stable A. Instead, the digital network can foster an environment in which both can thrive, serving distinct purposes.
This scenario of unbundling of the functions of money (and potentially of re-bundling of some of those to other functions) is potentially a scenario in which Bitcoin or other cryptocurrencies transform the currency space, and challenge the monopoly of governments over money, and the role of money as a public good.
Austrian economic thinking has experienced a revival on blogs, articles and forums of the crypto community. Although the school of thought has contributed to modern economic thinking, modern Austrian-inspired arguments on money and cryptocurrencies often overlook the great deal of progress gained via modern central banking.
However, the rise of digital currencies may still realise one the most visionary proposals of Austrian thinkers: a market in which privately and publicly issued monies compete. The emergence of new privately issued units of accounts connected to large digital platforms may challenge the role of central banks and cause an upheaval of the international monetary system. The interplay between public regulation and private innovation will determine the form and role of money in the future.
1 See also European Central Bank. “Virtual Currency Schemes”, October 2012
2 See for example, Laura Davidson and Walter E. Block, “Bitcoin, the Regression Theorem, and the Emergence of a New Medium of Exchange”. https://mises.org/library/bitcoin-regression-theorem-and-emergence-new-medium-exchange
3 Shostak, Frank. “The Bitcoin Money Myth”. https://mises.org/library/bitcoin-money-myth
4 Gertchev, Nikolay. "The Money-ness of Bitcoins". https://mises.org/library/money-ness-bitcoins
5 Peter St. Onge Cryptocurrencies and a Wider Regression Theorem. https://mises.org/library/cryptocurrencies-and-wider-regression-theorem
6 Manuel Polvieja, “Bitcoin and the Store of Value Narrative”. https://bisq.network/blog/bitcoin-and-the-store-of-value-narrative/
7 Szabo, Nick. “Bit Gold”, December 2005. https://nakamotoinstitute.org/bit-gold/
8 Ramey, V.A., 2016. "Macroeconomic Shocks and Their Propagation," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 71-162, Elsevier.
9 Brunnermeier, Markus K. , Harold James, and Jean-Pierre Landau, “The Digitalization of Money”, 2019 (NBER working paper).
10 Benigno, Pierpaolo Linda M. Schilling, and Harald Uhlig. “Cryptocurrencies, Currency Competition, and the Impossible Trinity”, 2019 (NBER working paper).