Paul Krugman recently used his New York Times opinion column to explain why he’s a cryptocurrency skeptic. I mostly agree with his overall conclusion, and much of what he says is sensible – but one part of his analysis seems so odd that I wonder whether he really meant it. That’s the part where he says “fiat currencies have underlying value because men with guns say they do.” (A fiat currency is one that’s not backed by any underlying asset like gold or silver. The U.S. dollar and most other modern-day currencies are fiat currencies. Many people have the comforting illusion that the gold in Fort Knox somehow backs up U.S. dollars, but that’s not right and hasn’t been true since the 1970’s.)

Now, Krugman is a professional economist, has won the Nobel Prize, has written multiple books, and has a regular column in the Times. He has far more credentials on this issue than I do. So why am I sure that he’s wrong about this claim?

There is a kind of “naïve economics” that believes that national fiat currencies are better – more sound – than cryptocurrencies. However, it’s easier to make the case that all of these currencies are essentially consensual illusions. The value of any fiat currency or cryptocurrency is the price you can get for it right now. A tie to a national government or a tie to a particular algorithm and community may be useful, insofar as they support the illusion of value. But if the consensus shifts and everyone starts to say that a fiat currency or cryptocurrency has failed, there is nothing about either kind of tie that helps.

Right now, Venezuela is suffering hyperinflation, even though that government still has plenty of men with guns. Before that, Zimbabwe was another vivid demonstration of hyperinflation, again with no shortage of armed men. And you don’t have to be limited to examples of countries with disastrous economies. Anywhere that there is a difference between an “official” exchange rate and a “market” or “black market” exchange rate, it’s safe to say that the armed men supporting the government are in favor of the “official” rate, but that most actual exchanges of money take place at the unofficial rate.

Indeed, a term of art in economics is “dollarization.” That’s the substitution of dollars (or some other country’s stable currency) because the local government’s currency is perceived as problematic. If we were to take Krugman’s claim at face value, then it seems as though dollarization could not exist. After all, no sovereign government would allow currency substitution. Likewise, no substitute-currency transactions could take place except in a failed state.

In reality, dollarization is quite widespread in today’s world – even if we eliminate the cases where a small state doesn’t bother with printing its own currency. In any economy, most sales transactions are quite small but happening all over the place. It’s far beyond the capacity of a state to police every such transaction.

It’s also hard to distinguish the start of dollarization from barter. If Alice trades her five chickens for Bob’s cow directly, that’s just trading – it would be weird for a state to insist that every trade take place via the local currency. Then if Alice just happens to own some gold or some dollars that she wants to trade for a cow, it’s not obvious why that’s different from using chickens. The state could outlaw owning gold or dollars, but otherwise it’s hard to see where to draw the line between bartering dollars and using dollars as a substitute currency.

Let’s concede that a state can refuse to accept payment of taxes in gold or dollars (or chickens, for that matter). It can insist on receiving payment in its own currency, and that is the core of Krugman’s remark about “men with guns” providing some guarantee of value. But as with the existence of an “official exchange rate,” that insistence on the national currency for government payments may not reflect much in terms of economic reality.

 

2 Comments

  1. Ajay on August 22, 2018 at 5:51 pm

    Maybe Krugman is reminding us that the Government acts towards correcting unfavourable changes in the value of a fiat currency. A dip in the ‘value’ of a bitcoin from $20K to $6K in the fiat currency world would have resulted in changes in monetary policies to preserve investor and public confidence and prevent further drops.
    This is non existent in the crypto world.
    I understand its all just speculation, and surely homo economicus doesn’t exist. So we unfortunate humans do need some ‘comforting’ which is likely why crypto currency has a tough challenge ahead to gain traction.

    • Mark Stuart Day on August 23, 2018 at 8:29 am

      I agree with your observation that bitcoin has an additional problem: by design, bitcoin has no lender of last resort who can print money as needed if/when there’s a financial panic. I suspect that hard-core bitcoin advocates would describe this as a feature, rather than a bug, but I think they would find themselves in the minority with that view. Most sensible discussion of financial crises and central banks seems to include a role for central bankers to actively address the occasional problem of widespread loss of confidence.
      But I would disagree with your rather generous assessment that maybe that’s what Krugman meant to say. If anything, it seems like the opposite of what he was saying: he was arguing for “tethers” between a fiat currency and more “real world” forms of value. The stronger those tethers are, the less you can play the monetary easing game if/when it’s needed.

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