Fiat money, cryptocurrencies and monetary theory

This chapter attempts to account for the rising value of cryptocurrencies using basic concepts of monetary theory. A positive value of fiat money is itself problematic inasmuch as that value apparently depends entirely on its expected resale value. A current value entirely dependent on expected future resale value seems inconsistent with backward induction. While fiat money can avoid the backward-induction problem if it is made acceptable in payment of taxes, acceptability for tax payments is unavailable to cryptocurrencies. Is the rising value of bitcoin and other cryptocurrencies a bubble? The paper argues that network effects may be an alternative mechanism for avoiding the logic of backward induction. Because users of any good subject to substantial network effects incur costs by switching to an incompatible alternative to the good currently used, users of a bitcoin for certain transactions may be locked into continued use of bitcoin despite an expectation that its future value will eventually go to zero. Thus, even if bitcoin and other cryptocurrencies are bubble phenomena, network effects may lock existing users of bitcoin into continued use of bitcoin for those transactions for which bitcoins provide superior transactional services to those provided by conventional currencies. Nevertheless, the prospects for bitcoin's expansion beyond its current niche uses are dim, because its architecture implies that a significant expansion in the demand for its transactional services would lead to rapid appreciation that is incompatible with service as a medium of exchange.