In the 1920s a Florida citrus grower named William Howey hit on a way to raise money from investors. He would sell them strips of land in his groves and tend the trees on their behalf, giving them a share of the profit after the harvest. The transaction was presented as an ordinary sale of real estate, but for practical purposes the buyers had become shareholders in his farm. After Howey died in 1938, the then-new U.S. Securities and Exchange Commission sought an injunction against his company to stop the sales. In 1946 the Supreme Court ruled that Howey’s contracts should have been registered with the SEC as securities—essentially, shares of stock.
The court said that what matters is the substance of a transaction, not its form. If it waddles like a duck and quacks like a duck, it’s a duck. Keep that wisdom in mind the next time some bluffer tries to dazzle you with a complicated story about cryptocurrencies. When it comes to understanding new technologies, focus on what they do, not how they do it.
Governments and policymakers, like investors, have struggled to wrap their minds around cryptocurrencies. The gyrations of Bitcoin and the like can cause speculators to make and lose fortunes. “I don’t really see what the actual true underlying value of some of these cryptocurrencies actually is in practice,” Federal Reserve Bank of New York President William Dudley said on Feb. 22. Yves Mersch, a member of the European Central Bank’s Executive Board, likened them in a Feb. 8 speech to “the will-o’-the-wisp, a malignant creature that dwelt in marshes” and lured travelers to “their untimely death and a watery grave.”
This is when history can be a guide. Cryptographic money may be new, but money itself is as old as civilization. It’s taken the form of beads, barley, tobacco, cowrie shells, and even giant stone discs, like the great rai of Yap in the South Pacific. Experience with other kinds of money hints that the volatility in the value of cryptocurrencies may be incurable, something that could be a fatal flaw for their use as a medium of exchange.
Jesús Fernández-Villaverde, an economist at the University of Pennsylvania, counts himself a cryptocurrency skeptic. He argues that today’s profusion of the exotically named tokens—more than 1,500 have been issued—resembles the 19th century heyday of “free banking,” when commercial banks issued their own private-label monies in many countries, including Australia, Sweden, Switzerland, the U.K., and the U.S. In Scotland, the era of free banking lasted for more than a century until it was suppressed by the British Parliament in 1845. During that time Scotland went from poor to nearly as rich as England.
There’s one crucial difference between then and now, though, Fernández-Villaverde says, and it has nothing to do with high-speed computing. The difference is that the supply of the currencies could be managed. Scottish banks had a strong incentive to build public confidence in the stability of their currencies, and they calibrated their supply to demand. In contrast, the libertarian appeal of cryptocurrencies is that they can’t be controlled by anybody, even their issuers. There is nothing—and no one—to anchor their value. True, there’s a cap on the number of Bitcoin that can ever be produced, which is supposed to protect it from hyperinflation, but the chaotic ups and downs in price show that it’s vulnerable to speculative inflation and deflation.
Another illuminating precedent for cryptocurrencies is the famous (to economists) story of the Capitol Hill Babysitting Cooperative, which was founded in the late 1950s. Members pay other parents to take care of their kids using scrip—private money—that they earn by taking care of other people’s kids. That’s similar to the way “miners” create and earn Bitcoin by using computers. The co-op nearly fell apart in the 1970s because families were hoarding scrip to make sure they could afford a babysitter when they needed one. It was revived when the co-op printed more scrip to take away the incentive to hoard. Cryptocurrencies are equally vulnerable to market failure, but there’s no scope for a beneficial intervention to match supply and demand, as there is with an ordinary currency managed by a competent central bank, says Fernández-Villaverde.
So far this has been about cryptocurrencies as money, but a lot of the tokens aren’t intended to be used as alternatives to dollars, euros, or yen. They have narrower functions for special-purpose digital companies. People who buy them are betting that the issuing companies will succeed. In other words, as in the case of William Howey’s orange groves, buyers are effectively acquiring a piece of a business. Since it’s substance rather than form that matters, it would seem that these initial coin offerings should be registered as securities and regulated accordingly. SEC…