Are Cryptocurrencies Crowding Out Traditional Money?
In 2008, we witnessed the birth of the world’s first cryptocurrency, bitcoin. Ten years later, we’re seeing a surge in discussion around the idea that these cryptocurrencies could crowd out traditional money. For instance, Malta’s Prime Minister Joseph Muscat labeled cryptocurrencies the “inevitable future of money”. Futurist Thomas Frey has estimated that “cryptocurrencies are going to displace roughly 25% of national currencies by 2030”. In addition, VC investor Tim Draper has even planted the possibility that “in five years, if you try to use fiat currency they will laugh at you.”. This would equate to a marked transformation of the world’s economy. But is the crowding out effect a reality and, if so, to what extent? Could it actually threaten the supremacy of fiat money?
In reality, after last year’s rapid cryptocurrency market capitalisation surge, crypto markets are now currently seeing a slower year. It could be said then that, for now, fiat money remains king, with these bold predictions about the eradication of traditional money proving overestimated. Still, there is evidence that cryptocurrencies are closing in on traditional currencies. Let’s take a deep dive beyond the buzz to look at the features of this growing trend, and what it might mean in reality for financial markets.
The Money Creation Myth
Before delving into the phenomenon that’s seen cryptocurrencies starting to crowd out fiat money, it’s vital to comprehend how money is actually generated. Fiat money, the traditional currency we employ every day, is often thought to be created by individuals borrowing money from others (OPMs). However, contrary to popular perception, the majority of the money in circulation in the modern economy is created by commercial banks making loans.
The money creation cycle begins when a customer takes out a loan, such as a mortgage or a credit card loan. Upon this transaction, the bank credits new money to the customer’s account, and records the debt on their balance sheet. This process essentially generates new fiat money that wasn’t in existence prior to this moment. It’s for this very reason that economists have labeled certain deposits as ‘fountain pen money’, generated instantaneously by a mark of a pen upon approval of a loan.
Conversely, as a customer pays off a debt, that money disappears from the economy. This means that when customers repay loans at a more rapid rate than banks are creating new ones, money supply drops. This concept, and increases in bank lending, have of course notably influenced modern economic crises.
As a digital currency, cryptocurrencies are conversely not issued by banks, but rather by algorithms, recorded by a digital public ledger and encrypted via cryptography technologies. Whilst fiat currency presents a centralised model, cryptocurrency remains decentralised.
How cryptocurrencies are crowding out fiat money
The crowding out effect in relation to traditional money is certainly gathering momentum. However, it isn’t taking the form many claim it to be, and continues to be surrounded by myth and misconception. For instance, it’s commonly believed that taking out a loan, logging onto an exchange platform or buying bitcoins equates to an increase in, for instance, bitcoin supply and a correlative decrease in fiat money. In fact, the opposite is true. As a user purchases cryptocurrencies, money supply increases.
To dismantle these misconceptions, traditional money and cryptocurrencies must be viewed as parallel, independent entities.
Fiat money circulates within the financial industry, crypto exists in its own ecosystem reliant on blockchain technology that’s external from the global financial system. This means the supply of each isn’t reliant or disrupted by the other. Therefore, exchanging US Dollars for bitcoin will neither decrease the supply of traditional money, nor will it boost bitcoin money supply (which is typically the result of mining).
In reality, the way cryptocurrencies have started to crowd out traditional money is via an indirect route. Early investors in crypto gained wealth rapidly, and reached a stage at which they needed to ‘cash out’. Since many used their profits to pay mortgages on their houses and outstanding consumer loans, this initiated a decrease in traditional money supplies. This macroeconomic effect is what equates to the ‘crowding out’ effect.
There’s a counter-argument which posits that, in order to purchase cryptocurrency at such a rapid rate many would have had to borrow money from banks, meaning that the value of cryptocurrencies was inflated. The increase in value here then wouldn’t be reflected in the creation of additional money. As with any other debt-fueled speculation bubble, this spike in inflation was short-lived, and as the crypto market slowed, has reduced substantially.
What does this mean?
The crowding out effect of cryptocurrencies is certainly becoming an ever-more pressing phenomenon. However, this is not a trend banks and financial institutions really have to worry about at this stage, given that the cryptomarket is still in its infancy. Indeed, as can be seen in the graphic above, the size of the cryptocurrency market (€174B, market capitalisation of top 100 cryptocurrencies) is tiny in comparison to, for instance, the entire EU economy (€15,4T, nominal GDP).
So, cryptocurrencies, in terms of currency auctions, complement traditional money but aren’t set to replace it any time soon. A recent report published by South Korea’s central bank reached the same conclusion, that crowding out would only occur under extreme conditions and, largely, digital and fiat currencies can peacefully coexist. That said, cryptocurrencies will continue to thrive and coexist in parallel to traditional money. With increasing numbers of organisations permitting crypto as a method of payment, the adoption rates of these currencies are likely to increase. How this will affect the relationship between digital disruptive currencies and traditional currencies remains to be seen.