'Printing money causes inflation.' This is one of the clichés of economics. In one sense, though, it doesn’t seem to be true because the emergence of crypto-currencies has not led to any significant rise in inflation. Why not?
One reason is that, despite all the talk, such currencies are still small. There are more than 1,500 of them now with a combined market value of $271bn (£189bn); Bitcoin accounts for $116bn of this. This is only equivalent to 2.2 per cent of the US money stock. Which is small beer.
What’s more, this money does not, for the most part, freely exchange for ordinary goods and services. It does not therefore do much to raise demand and hence prices.
One reason for this is that it costs a fortune to use Bitcoin as a means of payment; £20 according to one estimate. This rules it out as a way of buying ordinary stuff.
A second reason is that crypto-currencies are risky. Benjamin Edelman at Harvard Business School and colleagues list some of these risks. Not only is there price risk, but there’s also liquidity risk: you can’t offload many Bitcoins without moving the price against you. And there’s also counterparty risk: many crypto-currency exchanges have closed – most notoriously Mt Gox – often losing some or all of their participants’ money in the process. Risks such as these, says the Bank of England’s John Lewis, mean that crypto-currencies will struggle to compete with conventional money as a convenient means of payment.
For these reasons, they are mostly now used for either speculative purposes or to finance illegal activity such as the buying of drugs: economists at the University of Sydney have estimated that the latter accounts for half of Bitcoin transactions.
For now, therefore, crypto-currencies are a small and largely separate part of the economy. For this reason, the Bank of England’s financial policy committee recently said that they “do not currently pose a material risk to UK financial stability”.
But what if they grow and mature and become serious currencies? Might they then be a source of inflation?
They could be, through two mechanisms. One is an ordinary wealth effect. If crypto-currency prices continue to rise (which might be a big if) their holders will get richer and they’ll want to spend their gains, just as equity investors might during a bull market. The other is that higher crypto-currency prices increase incentives for people to mine the currencies, but this raises demand for electricity: mining the currencies requires you to solve mathematical puzzles which need powerful computers. That increased demand could, in extremis, raise electricity prices and hence perhaps prices generally.
Central banks, however, have a solution to this. In such an event, they can raise interest rates – in effect reducing the supply of conventional currencies. This would cut the price of crypto-currencies thereby reducing their inflationary threat – in just the same way that a rate rise might reduce the inflationary effect of rising share prices.
In this way, crypto-currencies would simply become another transmission mechanism through which monetary policy affects inflation.
Sceptics might think all this is science fiction, as crypto-currencies won’t grow so big. Maybe. Even so, there is a point to all this. It’s that statements such as 'printing money causes inflation' are too glib. We must always ask: what’s the mechanism? And in the case of crypto-currencies there is – for now at any rate – no good mechanism in operation here.
