Money as a Technology: The Vulnerabilities and Governance Challenges of Cryptocurrency
Despite the enthusiasm surrounding them, cryptocurrencies are not immune to the vulnerabilities and criticisms that have plagued previous forms of money.
by Joe Bradford
Money, in its various forms, has long served as a fundamental technology facilitating economic activity and exchange. As a tool, money enables individuals and societies to complete tasks more efficiently, such as valuing goods and services, storing wealth, and conducting transactions. The emergence of cryptocurrencies, like Bitcoin, Ethereum, and others, represents a new iteration of this monetary technology, promising decentralization, transparency, and freedom from traditional financial intermediaries. However, despite the enthusiasm surrounding them, cryptocurrencies are not immune to the vulnerabilities and criticisms that have plagued previous forms of money. Despite holding crypto personally and advocating for its use, I wanted to engage in a thought experiment: Are there things we are missing when we talk about a crypto-future? Are there issues we conflate when we focus on the medium and not the model? Here, I argue that cryptocurrencies, including Bitcoin, fail to address the core issues highlighted by four major approaches to monetary theory and, without proper governance, they may pose even greater risks than traditional fiat currencies.
Cryptocurrencies and the Shortcomings of Monetary Theories
To understand the vulnerabilities of cryptocurrencies, it is essential to examine them through the lens of the four major approaches to monetary theory: metallism, chartalism, the quantity theory of money, and the credit theory of money.
Metallism, which ties the value of money to precious metals like gold or silver, has been criticized for its inherent scarcity and deflationary tendencies. Cryptocurrencies, particularly Bitcoin with its fixed supply cap of 21 million coins, bear striking resemblance to this metallist paradigm. The deflationary nature of Bitcoin, coupled with its speculative value, encourages hoarding rather than spending, potentially stifling economic activity and exacerbating wealth inequality.
This phenomenon finds historical parallels in the experience of the United States during the Great Depression of the 1930s, when the country was on the gold standard. As the economy contracted and deflation set in, the value of gold relative to goods and services increased, leading to a hoarding of gold and a reduction in the circulating money supply. This deflationary pressure exacerbated the economic downturn, discouraging spending and investment, and prolonging the Great Depression.
If Bitcoin, with its fixed supply and deflationary tendencies, had been the dominant form of money during the Great Depression, it is likely that the economic downturn would have been even more severe. The deflationary tendencies of Bitcoin, combined with its potential for speculative hoarding, thus pose significant risks to economic stability and growth, particularly during times of crisis.
What about chartalism? This theory asserts that money derives its value from government decree or law, highlighting the importance of legal tender status and the role of the state in monetary systems. Cryptocurrencies, by design, operate outside the purview of governments and central banks, lacking the legal backing and legitimacy that chartalists deem crucial.
This perspective finds support in Islamic economic thought, where the issuance and control of currency are traditionally seen as the responsibility of the governing authority. Muslim jurists have recognized the potential dangers of privately-issued currencies, which can be susceptible to fraud, counterfeiting, and manipulation in the absence of legal backing and standardization. The lack of central control over the money supply can make it more difficult for authorities to ensure stability, prevent fraud, and respond to economic crises.
Moreover, the lack of central control over the money supply can make it more difficult for authorities to respond to economic crises or manage inflation and deflation. Muslim jurists have emphasized the importance of maintaining a stable and predictable monetary system to encourage investment, facilitate trade, and promote overall economic well-being. The absence of legal backing and central control in cryptocurrencies thus raises concerns from an Islamic perspective about their ability to serve as a reliable and trustworthy medium of exchange.
A case in point is the recent decision by Tesla to stop accepting Bitcoin as payment for its vehicles, citing environmental concerns. This decision, made by a single company, had a significant impact on the value of Bitcoin, demonstrating the vulnerability of cryptocurrencies to the whims of influential market participants in the absence of legal backing. Such volatility and susceptibility to manipulation run counter to the Islamic ideal of a stable and trustworthy monetary system that serves the needs of the broader community.
The concerns raised by Muslim jurists about the dangers of privately-issued currencies and the need for central authority to ensure stability and facilitate economic activity highlight the potential limitations of cryptocurrencies as a viable alternative to state-backed fiat money. While cryptocurrencies may offer certain benefits in terms of decentralization and transparency, their lack of legal backing and central control raises questions about their long-term sustainability and compatibility with Islamic principles of economic justice and stability.
Let us now consider the quantity theory of money (QTM). This is an economic theory that seeks to explain the relationship between the money supply and the general price level of goods and services in an economy. The theory posits that changes in the money supply directly influence the price level, and that the velocity of money (i.e., the rate at which money changes hands) is relatively constant. In its simplest form, the QTM can be expressed by the equation MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the quantity of goods and services.
Cryptocurrencies, with their decentralized and often algorithmically-determined money supply, share some similarities with the QTM in their emphasis on the relationship between money supply and price levels. Many cryptocurrencies, such as Bitcoin, have a fixed or predictable supply schedule that is determined by the underlying protocol. Proponents of cryptocurrencies argue that this fixed and transparent supply schedule helps to ensure price stability and predictability, as the money supply is not subject to the discretionary decisions of central banks or governments. However, in practice, cryptocurrencies have been characterized by high levels of price volatility, with prices often fluctuating wildly in response to changes in market sentiment, regulatory developments, and other external factors.
The decentralized nature of cryptocurrencies, which lack a centralized authority for managing the money supply or ensuring price stability, presents challenges for the economic sovereignty and stability of nations. Decentralization could lead to situations where a nation’s monetary policy and supply are influenced by forces outside its control, potentially destabilizing the economy. This could undermine a nation’s economic sovereignty as central banks and governments traditionally regulate the money supply, set interest rates, and implement monetary policies to support economic growth, control inflation, and manage economic crises. Adopting a decentralized cryptocurrency as the primary currency would relinquish control over these crucial economic functions to the algorithms and market dynamics that control cryptocurrency.
This loss of control is risky for a nation’s ability to manage its economy and respond to economic downturns. For example, central banks usually lower interest rates and increase the money supply to boost lending, investment, and spending during a recession. However, with a decentralized cryptocurrency with a fixed supply, such measures would not be possible, which could worsen recessions and delay recovery. Even in systems that do not use interest rates, such as Islamic finance, employing repos and other treasury tools becomes problematic in a deflationary system where the central bank does not control the money supply, making it harder to respond to economic shocks or recessions.
A nation’s monetary policy could be compromised by the volatile nature of the global cryptocurrency market, influenced by speculative and irrational behavior. This volatility can lead to economic instability, capital flight, and other destabilizing effects that diminish economic sovereignty and increase vulnerability to geopolitical manipulation. Hostile nations could exploit this vulnerability, employing tactics such as market manipulation, orchestrating attacks to compromise transaction integrity, launching cyberattacks on critical infrastructure, or economically isolating the country. These actions could severely disrupt the nation’s economy and undermine public confidence in its financial system.
Conversely, nations with centralized currencies managed by national central banks are better positioned to counteract such threats. Central banks have the capability to stabilize currency values, ensure liquidity, and safeguard against manipulation. They are also better equipped to collaborate internationally to counteract cyber threats and illicit activities. The adoption of a decentralized cryptocurrency as a nation’s primary currency introduces risks beyond geopolitical vulnerability. It could exacerbate economic inequalities and financial exclusion, given the technical and financial barriers to cryptocurrency participation. The concentration of cryptocurrency ownership could further centralize economic power and influence among a small group of individuals, potentially creating a class of “crypto-elites” with disproportionate economic control.
While the QTM suggests a direct relationship between money supply and price levels, it oversimplifies the complexities of financial market dynamics. Cryptocurrencies, despite their fixed supply mechanisms, are not immune to price instabilities driven by market sentiment, regulatory changes, and broader economic conditions. The experiences of Bitcoin and other cryptocurrencies demonstrate that a rigid supply schedule does not guarantee price stability, underscoring the need for a comprehensive approach to managing economic policy in a cryptocurrency-influenced landscape.
Finally, let us turn to the credit theory of money (CTM). This theory posits that money is a social relationship of credit and debt, an IOU arising from the extension of credit. In modern economies, fiat currencies issued by central banks operate on a similar principle. Commercial banks create credit through fractional reserve banking, where they hold only a fraction of deposits in reserve and lend out the rest, effectively expanding the money supply. Cryptocurrencies share similarities with this theory, as they rely on trust and consensus among network participants.
Cryptocurrencies, while often touted as a departure from traditional financial systems, still rely on the trust and consensus of their network participants. In this sense, they share similarities with the CTM. When a user transacts with cryptocurrency, they are essentially trusting that the network will validate and record the transaction accurately and that other participants will recognize and accept the cryptocurrency as a valid form of payment. The pseudonymous nature of cryptocurrency transactions and the absence of legal recourse in case of fraud or theft exacerbate these risks. The Mt. Gox incident, where a prominent Bitcoin exchange collapsed due to hacking and mismanagement, illustrates the vulnerability of cryptocurrency ecosystems to breaches of trust.
Despite assumptions to the contrary, cryptocurrencies are not immune to the risks associated with credit creation and bank lending activities. Cryptocurrency exchanges and decentralized finance (DeFi) platforms can engage in lending and credit creation, leading to the expansion of purchasing power within the cryptocurrency ecosystem. While cryptocurrencies themselves are not typically used for lending, the exchanges and platforms that facilitate cryptocurrency transactions can engage in lending and credit creation. For example, some cryptocurrency exchanges offer margin trading, allowing users to borrow funds to trade cryptocurrencies. The emergence of DeFi platforms has introduced new forms of credit creation and lending within the cryptocurrency space. These platforms allow users to borrow and lend cryptocurrencies directly with each other, using smart contracts to automate the process. The creation of cryptocurrency-denominated debt on these platforms can lead to the expansion of purchasing power, similar to traditional bank lending.
The creation of debt, denominated in cryptocurrency, can lead to the expansion of purchasing power within the cryptocurrency ecosystem. The lack of regulation in this ecosystem can result in heightened risks, such as excessive leverage, under-collateralization, and liquidity mismatches. This highlights the fact that this issue at hand it one of monetary policy, not which monetary objects are used. The key difference, however, is that the credit creation in the cryptocurrency ecosystem is not subject to the same regulations and oversight as traditional banking. This lack of regulation can lead to heightened risks, such as excessive leverage, under-collateralization, and liquidity mismatches. In the event of defaults or market downturns, the cryptocurrency ecosystem may not have the same safeguards or backstops as traditional financial systems, regardless of whether there is an interest-based system at play or not, potentially leading to widespread losses and contagion.
Ultimately, the stability and reliability of cryptocurrencies as money depend not on their inherent characteristics but on the theories, policies, and regulations governing their use and the ecosystem in which they operate. The specific characteristics of cryptocurrencies, such as their deflationary nature, lack of legal backing, algorithmic money supply, and reliance on decentralized trust, can exacerbate the shortcomings identified by the four major monetary theories. By delving deeper into these vulnerabilities and their real-world implications, we can better understand the challenges that cryptocurrencies must overcome to achieve widespread acceptance and stability as a viable form of money.
The Need for Governance and Monetary Policy
The shortcomings of cryptocurrencies, as highlighted by the four major monetary theories, emphasize the crucial role of effective governance and sound monetary policy in ensuring the stability, integrity, and fairness of any monetary system. While cryptocurrencies’ decentralized and trustless nature is often touted as a strength, the absence of central oversight and control can make them more susceptible to manipulation, fraud, and instability compared to traditional fiat currencies.
Fiat currencies, despite their lack of intrinsic value, are supported by the legal and institutional frameworks of governments and central banks. These entities possess the tools and mandate to manage money supply, ensure price stability, and protect consumers from financial misconduct. Conversely, cryptocurrencies operate in a largely unregulated space, exposing users to market forces and the actions of powerful stakeholders, such as large miners or cryptocurrency exchanges.
Cryptocurrencies, being decentralized and based on cryptographic algorithms, do not inherently meet the conditions for sound Islamic monetary policy. The volatility and speculative nature of many cryptocurrencies can undermine the stability and predictability required for fair trade and economic growth. Moreover, the concentration of cryptocurrency ownership among a small number of early adopters and wealthy individuals can exacerbate wealth inequality, contradicting the Islamic principle of equitable wealth distribution. The use of cryptocurrencies for speculative trading and high-risk financial activities, such as leveraged margin trading, conflicts with the Islamic emphasis on real economic value and the avoidance of exploitative practices. The environmental impact of cryptocurrency mining, particularly in proof-of-work algorithms, also raises concerns about sustainability and social responsibility.
Sound monetary policy stems from the values and ethical framework of a society, rather than the specific form of money employed. In the Islamic context, these values are derived from Shariah principles, which prioritize the well-being and prosperity of the community. The primary focus of Islamic monetary governance is to establish a legal and ethical framework that ensures the stability, integrity, and fairness of the monetary system, regardless of the underlying technology. This approach emphasizes regulatory oversight, consumer protection, and the promotion of financial inclusion. By ensuring that the monetary system operates within a clear legal and ethical framework, Islamic monetary governance aims to foster sustainable economic growth, prevent monopolistic practices, and safeguard the wealth of the nation.
While cryptocurrencies may offer advantages in transparency and efficiency, their inherent characteristics do not automatically align with the principles of sound Islamic monetary policy. The stability, fairness, and sustainability of a monetary system depend on the underlying values and governance framework, rather than the specific form of money employed. Adopting cryptocurrencies within an Islamic monetary system would require careful consideration and robust regulatory frameworks to ensure compliance with Shariah principles and the promotion of social and economic justice.
The principles of Islamic monetary governance highlight the fact that the specific form of money—whether it be fiat, cryptocurrency, or a national digital currency—is less consequential than the values and rules that govern its use. The primary focus should be on establishing a legal and ethical framework that ensures the stability, integrity, and fairness of the monetary system, regardless of the underlying technology.
Possibilities and Limitations
The rise of cryptocurrencies has necessitated a reevaluation of their advantages, vulnerabilities, and impacts on economic systems. Advocates highlight their decentralization, transparency, and potential to enhance financial inclusion. However, examining these through established monetary theories uncovers notable deficiencies and obstacles.
Cryptocurrencies share concerns with metallism, such as deflation and speculative hoarding, which can depress economic activity and increase wealth disparity. Their lack of governmental backing and centralized control, noted in chartalism and Islamic economic theories, questions their stability, reliability, and sustainability as exchange mediums. The quantity theory of money’s application to cryptocurrencies does not fully address their market dynamics, marked by volatility and external influences, challenging economic sovereignty and stability by potentially diminishing national control over monetary policies. The credit theory of money points to the dangers of unregulated credit within the cryptocurrency sector, including excessive leverage and liquidity risks, which could precipitate widespread financial instability during market crises.
The excitement surrounding Bitcoin and other cryptocurrencies often leads to an overestimation of their potential, conflating what they could achieve under ideal conditions with their current capabilities and challenges. This enthusiasm overlooks critical vulnerabilities and implications for economic systems, ignoring the nuanced reality of how these digital assets operate within existing financial frameworks and their impact on economic stability and policy.
Proponents of cryptocurrencies champion them for their decentralization, transparency, and potential to enhance financial inclusion. However, the mere use of a currency does not sound money make. When compared with popular monetary theories and critiques of them, significant shortcomings are found in crypto. This analysis underscores the importance of governance and sound policy for monetary system integrity and fairness. Islamic monetary governance principles, advocating for stability, equitable wealth distribution, and sustainable growth offer a framework for assessing cryptocurrencies’ risks and benefits. Despite their advantages in efficiency and transparency, cryptocurrencies’ alignment with sound monetary principles is not automatic. The stability and fairness of any monetary system relies on its governance values, not merely on the form of money. Establishing a legal and ethical framework that ensures monetary system stability and integrity, irrespective of technology, is key to leveraging monetary innovation benefits while controlling its drawbacks.