If Friedman and Hayek were still alive, what would they think of Bitcoin?

20 years ago, Jack Ma, Guan Mingsheng, Cai Chongxin, Wu Jiong, Jin Jianhang and Peng Lei took dozens of pieces of paper in the office and wrote the words about values ​​on the glass plate one by one. After several hours of careful selection, they selected 9 inspirational words. They did not expect that these words would suddenly become a satire on this Internet giant 20 years later.

This is a legendary debate between two giants of monetary economics in the 20th century. The focus of the debate is whether there will be a "challenger currency" that can replace government-issued fiat currencies and become a new medium of payment worldwide. Although Bitcoin is a product of several decades later for them, if the two masters were still alive, how would they view Bitcoin and whether they would think it has the ability to challenge fiat currencies?

The first to take the stage was Friedrich Hayek, an Austrian-British economist and master of classical liberalism, and his opponent was Milton Friedman, an advocate of the free market. Hayek and Friedman had similar views on many issues, but the focus of their debate was whether it was possible to build a more stable monetary system if a privately issued competitive currency emerged. In the mid-to-late 1970s, due to the Arab oil embargo, the prices of gasoline, air tickets and even home heating in the United States soared, and the US dollar system entered its most dangerous period since World War II. In response to this impact, the Federal Reserve flooded the market with money, weakening the purchasing power of almost everyone. The US consumer price index has always risen at a relatively stable rate, but the growth rate during this period reached 14%.

Hayek taught at the University of Chicago from 1950 to 1962, where he and Friedman worked together for many years. The two economists knew each other well, but they never had a face-to-face debate. Hayek put his views into a series of speeches and papers in the mid-to-late 1970s, and published a book, The Denationalization of Money, in 1976. In the 1970s and 1980s, the two had not yet opposed their views. However, starting in the 1980s, Friedman publicly criticized Hayek's views for the first time in a book co-authored with economist Anna Schwartz.

At the time, American politicians, scholars, and ordinary people were worried that the dollar system would collapse. The Federal Reserve adopted a policy that was completely opposite to the previous "sound money" policy, and the dollar depreciated faster than American workers could earn dollars. Hayek believed that in times of economic hardship, central banks would quickly push the economy to an artificial high point by overissuing currency, which would lead to the kind of inflation that the United States was experiencing at the time. Hayek believed that the solution to this situation was to allow banks or other companies to issue private currencies to compete with sovereign currencies on the open market. Whichever private currency or currencies can best maintain the stable purchasing power of consumers will successfully attract the most users.

If the Fed continues to overprint money, causing the purchasing power of the dollar to become weaker and weaker, private currencies will replace the dollar. This "let the best currency win" philosophy will put an end to the government's reckless monetary policy, and the central bank will either be forced to reform or introduce a new, more stable monetary policy.

Friedman (left) and Hayek, two of the most famous economists of the 20th century. Image credit: Bettmann/Getty Images; Hulton-Deutsch Collection/CORBIS/Getty Images

Friedman is not against competitive currencies challenging fiat currencies. But he thinks Hayek is wrong and that "challenger currencies" are doomed to fail. In Friedman's view, people and businesses do care about purchasing power, but they care more about whether they use the same currency as their neighbors and trading partners. He said that consumers and businesses prefer to use one currency for everything. Even if there is a currency that is stronger than the dollar - let's say it's called XYZ coin, Americans would rather use only the dollar than frequently exchange between XYZ coin and the dollar. Therefore, it is precisely because fiat currency has been widely accepted that it has a huge advantage and can prevent any new currency from replacing it.

It is precisely because of Hayek's above-mentioned position that he is regarded as the "Godfather of Bitcoin" by Bitcoin enthusiasts. A study on virtual currency by the European Central Bank in 2012 pointed out: "The theoretical basis of Bitcoin can be traced back to the Austrian School of Economics." Hayek is the representative of the Austrian School. Search the keywords "Hayek and Bitcoin" on Google, and you will find countless articles that regard Hayek as the "Prophet of Virtual Currency." They also cited a TV interview in the 1980s to prove that Hayek had "predicted Bitcoin." These people firmly believe that the market will eventually choose a most stable and reliable currency that will not be corrupted by the central bank, and that is Bitcoin.

Many Bitcoin supporters believe that Bitcoin is promising as a means of storing value, but not necessarily as a currency. Michael Saylor, CEO of MicroStrategy, holds billions of dollars in Bitcoin. He believes that Bitcoin is a good investment, but Bitcoin will never become a means of payment. Elon Musk once said: "Paper money will die, and virtual currency is a better way to transfer value, that's for sure." Jack Dorsey, CEO of Twitter and Square, is also very optimistic about Bitcoin. He believes: "The world will eventually have only one currency, and I personally think that is Bitcoin." Cameron Winklevoss, CEO of Bitcoin exchange Gemini, believes that as an advanced currency, Bitcoin has a promising future. "Because when people understand the principle of paper money, they will ask: 'Wait a minute, where do so many trillions of dollars come from? They are just a pile of printed paper. What does it mean to these dollars in my hand?'"

In fact, Bitcoin is rarely accepted for everyday purchases, but it plays a niche role in money transfers, especially when a high degree of privacy is required. "If everyone is flocking to Bitcoin, then Hayek was wrong because he predicted that people would choose the currency with the most stable purchasing power," said William Luther, an economics professor at Florida Atlantic University. "The kind of currency Hayek liked was very stable, and Bitcoin is the opposite, it is extremely unstable."

From Friedman's point of view, it is unlikely that Bitcoin will replace the dollar or the euro, because everyone will only use the currency with the lowest cost and the most convenient. If there is an exception, there is only one possibility, that is, the country has implemented a high-inflationary monetary policy, which has destroyed the purchasing power of ordinary people and caused wild price fluctuations. Friedman pointed out that in the case of extreme price fluctuations, ordinary people will use foreign currencies to trade goods on the black market, just as Venezuelans are currently using dollars and euros. The reason why people don't use Bitcoin for shopping is the same as why people don't use Venezuelan currency - Bitcoin's value fluctuates greatly every day, and fluctuations of 9% up and down are common. Therefore, ordinary people never know what their money can buy today or tomorrow.

Hayek and Friedman had serious disagreements about the prospects of "challenger currencies," but their views on Bitcoin should be similar. Both men would probably praise Bitcoin as a bold free market experiment, but neither would think that Bitcoin would become a major form of money. Of course, Hayek's views were made before the United States returned to prudent monetary policy in the 1980s. In Hayek's view, if the market turned to Bitcoin in an all-round way, it would be a "wrong path", equivalent to giving up a relatively stable currency and choosing an extremely unstable currency. In Friedman's view, the dilemma facing Bitcoin is the same for all new currencies - it is almost impossible for them to gain widespread consumer acceptance.

In addition, these two legends would agree that, contrary to what Bitcoin supporters claim, there is a fundamental flaw in Bitcoin's architecture that prevents the supply of Bitcoin from being adjusted periodically to maintain its purchasing power. First, let's see if Bitcoin can compete with the US dollar, even if it is the most stable currency. Second, does it meet Hayek and Friedman's expectations for an ideal currency, that is, in the long run, does it have the strength to protect the interests of consumers and businesses.

Friedman: Bitcoin loses because of the "network effect"

Friedman believed that Hayek's "parallel competing currencies" would not work because of "network effects" (the popularity of something depends on the number of people using it). In the case of currency, the size of the "network" is equal to the total number of consumers and businesses that use dollars or euros for transactions. According to Friedman's theory, the more people use dollars, the easier and cheaper it will be for them to buy and sell goods and circulate currency. "If all my customers and trading partners use dollars, and all their customers and trading partners use dollars, I will also use dollars to save time and money instead of euros or other currencies," Luther explained.

If a business or consumer uses another currency, once they need to trade with a neighbor or customer who uses the U.S. dollar, they will have to bear the cost of converting their money into U.S. dollars, which is obviously an additional transaction cost. Therefore, using a universally accepted currency is obviously more cost-effective than using a currency that is not universally accepted. Luther said: "If you are a vending machine agent and you change to a new currency as a payment medium, then you have to upgrade these machines." In addition, in order to accept this new currency, the company also needs to adopt related pricing and accounting systems, which all bring additional costs.

Friedman believes that a single currency has great advantages because it saves a lot of time and money compared to a system with multiple currencies. In addition, the transaction and conversion costs of different currencies are also very high. Therefore, even if the current major currencies are somewhat unstable, people and businesses will still prefer the current currencies. He also pointed out that over time, the German mark and Swiss franc have been much stronger in maintaining their value than the US dollar. American citizens also use these two currencies when traveling, but they do not use them in the United States because the cost of converting them back and forth to US dollars is very expensive.

Hayek believed that people were more sensitive to fluctuations in the value of a currency than to transaction costs. Luther pointed out: "Hayek believed that in the absence of legal restrictions, the cost of replacing currencies is negligible, and what matters is which currency is superior." If a country allows competing private currencies, consumers will naturally be attracted to the best currency. They will abandon the legal currency that has lost its purchasing power and invest in the newer, more reliable currency.

Hayek pointed out that the "challenger currency" that ultimately wins must ensure that a certain amount of new currency can buy the same or almost the same goods and services every year, rather than the purchasing power of legal currency decreasing as it does. Hayek wrote: "The main attraction that a competitive currency can provide is the guarantee of price stability."

So why didn’t people in countries with chaotic monetary policies turn to private currencies? Hayek argued that it was simply because local laws prohibited competing currencies. Friedman argued that legal factors were unimportant, and that except in a few extreme cases, consumers and businesses would find it too costly to use a currency that most of their neighbors and stores didn’t use.

A few years later, a case study from Somalia supported Friedman’s argument. When the Somali government collapsed in 1991, the Somali shilling was the most widely used currency in the country, but ordinary people were free to use any currency. In this situation, several foreign currencies competed with the Somali shilling, causing it to depreciate rapidly. Although more than one competing currency was more stable than the Somali shilling, most people continued to do business in Somali shillings. In this open contest, Friedman’s “network effect” theory won out over Hayek’s view that the people’s desire for stability prevailed. What was particularly surprising was that ordinary Somalians were able to use the US dollar, but this did not undermine the shilling’s position. Even Friedman himself would probably have been surprised by the power of the network effect in Somalia.

Bitcoin’s design flaws

Friedman and Hayek both believed that the ideal monetary policy was to achieve stable, predictable, and moderate price growth. However, early in Friedman's career, he disagreed with Hayek on how to achieve this goal. He believed that over time, the demand for holding money would be inversely proportional to the velocity of money. Therefore, he believed that the Federal Reserve should increase the money supply at a fixed, preset rate.

For example: If the central bank's inflation target is 2%, and the economy is usually growing at 2%, then the best way is to increase the money supply by 4%. The 4% of extra money will promote a 2% increase in the transaction volume of goods and services, thereby achieving the 2% price increase target. Luther explained: "Friedman wants the Fed to set the increase in money supply at a fixed ratio, which is also called the K percentage rule, where K is the fixed money supply growth rate."

As Luther points out, the K rule looks a lot like the Bitcoin model. Bitcoin's algorithm also limits the number of Bitcoins that can be issued and sets a fixed rate for the issuance of new coins. "You might say that Bitcoin is very similar to Friedman's K rule," Luther said. But the fact that Bitcoin's supply is designed by a computer program and lacks flexibility is an obvious weakness. Hayek believed that the money supply should have a certain elasticity so that purchasing power can be stable. "Hayek believed that if the increase in money exceeds the demand for money, it will lead to an unsustainable production boom and eventually a recession. The 'cheated' companies will first overproduce and then reduce the scale of production at great cost," Luther said.

By the 1980s, Friedman revised his views and began to move closer to Hayek. He found that the changes in money demand were much greater than he had previously expected. Therefore, he accepted the concept of inflation targeting and advocated adjusting monetary policy according to the economic environment. Luther introduced: "Friedman believed that if the collapse of the money supply exceeded the reduction in money demand, or the increase in money demand was not met by a corresponding increase in the money supply, a recession would follow. Friedman began to believe, like Hayek, that the money supply should be synchronized with demand."

Bitcoin is not designed to have the flexibility to expand or contract the money supply in response to economic conditions, nor does the number of new coins change as demand for holding them rises and falls—a necessary quality for good monetary policy, as Friedman and Hayek both believed. Bitcoin’s supply is predetermined by an algorithm, and it does not have the “shock absorber” function that Hayek and Friedman considered so important. “Bitcoin is not designed to maintain purchasing power as demand changes,” Luther said.

Since the number of bitcoins is fixed, the rise and fall of the value of bitcoins depends mainly on changes in the amount of purchases by individual and institutional investors. As Luther pointed out: "Only a dramatic change in demand can affect its price, which is the special design of bitcoin."

Let's imagine a world where Bitcoin replaces the dollar. Suppose the economy suddenly grows rapidly, and the US GDP soars from 2% to 3%. According to Friedman or Hayek's model, the Fed might increase the money supply by one percentage point, which might also lead to an increase in the supply of credit to meet the demand for debt bonds needed to build new factories, laboratories, and R&D centers. In this way, the overall inflation rate remains unchanged. However, Bitcoin cannot increase its supply. Assuming Bitcoin becomes legal tender, interest rates will soar as the demand for credit exceeds the funds that banks and investors can lend. The resulting tightening will cause the economic boom to quickly collapse.

In addition, for the same reason, changes in the economic environment will amplify changes in the price of the new currency. In good times, consumers and companies will rush to buy bonds and loans denominated in bitcoin, and sell these instruments in bad times, but there will be no change in the rate of bitcoin issuance to buffer such fluctuations. In times of economic expansion, the price of bitcoin may rise sharply because there will be no bitcoin. In the real world, the Federal Reserve will issue more dollars to curb the rise in the price of the currency. Wild fluctuations in the price of bitcoin will increase the risks faced by multinational companies because changes in the value of the currency mean that the prices of semiconductors, home appliances or textiles they buy from China, Japan, Germany and other places are also changing.

Volatility issues

As a currency, Bitcoin is still too volatile. "Even if its attractiveness changes slightly relative to other currencies, it will have a huge impact on people's willingness to use it in the future," Luther said. "If we hear bad news, people will think that fewer people want to use it, and its value will suddenly dive." For example, a while ago, Elon Musk announced that Tesla would purchase $1.5 billion worth of Bitcoin, and the value of Bitcoin immediately soared; then Tesla announced that it would no longer accept Bitcoin for car purchases, and its value fell sharply. For another example, after Visa and Mastercard announced that they would no longer support payment for a certain erotic website, the value of Bitcoin soared again, because people can now only use virtual currencies such as Bitcoin to recharge the website.

Bitcoin is now nine times more volatile than the S&P 500 and six times more volatile than gold. Even as Bitcoin becomes more widely accepted, its volatility remains far greater than other competing currencies because its design does not support changes in supply to reduce its volatility.

Even if Bitcoin becomes more stable over time, it is unlikely to become a successful currency. There are two reasons for this: first, Bitcoin’s rigid structure cannot guarantee its purchasing power because, as we discussed above, its issuance is not flexible enough; second, countries may issue their own digital currencies. For example, China has announced plans to digitize the RMB. This news alone has hit the price of Bitcoin hard.

Luther pointed out: "The United States can also create a digital currency. The Federal Reserve is the issuer of the US dollar and holds digitized US dollar reserves on behalf of banks. It can create a new currency called "digital dollars" that can be exchanged for cash dollars and reserves at the same value. Consumers can also exchange digital dollars for cash." People can trade digital dollars through e-wallets, just like Bitcoin transactions, without going through banks. It is also possible to scan the phone at the checkout counter to make payments, so that the balance is transferred from the consumer's mobile wallet to the merchant's digital dollar account. These payment activities are carried out outside the credit card system and save high "transaction fees." Luther pointed out: "For Bitcoin, one of the main dangers it faces is that it may be surpassed by digital currencies issued by central banks of various countries."

The Future of Bitcoin: Where is it Heading?

Digital currencies issued by sovereign states will further limit the future of Bitcoin. But Bitcoin still has great potential as a medium of exchange, especially in large transactions that require privacy. Luther said: "Bitcoin does this particularly well, and other currencies cannot compare with it in this regard." Of course, Bitcoin is also used in many illegal transactions, including paying ransom for ransomware attacks, so governments want to crack down on underground Bitcoin transactions. However, Bitcoin is difficult to control, and this is also one of its advantages. Luther said: "Cash is also used in underground transactions, but it is much more difficult for the government to prevent Bitcoin transactions than cash."

If Friedman and Hayek were still alive, what would they think of Bitcoin? Luther, who has carefully studied the views of these two economists, said: "As an experiment, they would highly value the development of Bitcoin and its relative success. In theory, they might think that Bitcoin as a currency can effectively curb the government's unbridled spending, but they also hope that Bitcoin can have a money supply mechanism to regulate changes in the demand for money, which Bitcoin does not have." Luther believes that Friedman and Hayek would never think that Bitcoin could replace the US dollar as the main currency in the United States. At most, they would think that the best role of Bitcoin is to keep transactions private as it is now.

Bitcoin is already a financial behemoth, but judging by the theories of these two great economists, its grandeur will likely fade as the world realizes its capabilities are very limited.