In the last six months, the price of Ethereum has increased by forty-five times from $8 a piece to a whopping $365. Should we be investing in a market that has these kinds of gains?

Ethereum is the latest instance of what is known as cryptocurrency. Cryptocurrency is a digital currency that is encrypted to regulate the amount of currency in circulation. A more well known one is Bitcoin. However, one of the reservations for investing in such a currency is that it’s extremely volatile; and it’s a reasonable fear, indeed. Ethereum’s price has fluctuated 40 dollars in the past week, with a 40 dollar dip in price followed by a 10 dollar recovery. That’s terrifying for people considering buying in.

One of the major causes for this type of fluctuation is that there is speculation in the market. Yes, speculation is that buzz word you usually hear watching the talking heads of the stock market, but it does have a meaning. It means investment in stocks or currencies with the hope to gain from fluctuating prices.

Although many see speculation as potentially dangerous, it’s an unavoidable part of the market. People are going to buy things when they see them as potentially valuable in the future. From Bitcoins to baseball cards, everything can be bought with the intent of selling for a profit when the value goes up in the future.

A potential problem arises when speculation outweighs transactions. That is to say, people are buying bitcoin for it’s speculated future value rather than using it to buy stuff from a retailer. Speculation on its own can create a lot of volatility in the market, as seen with Ethereum (now worth $327, a $40 drop since I started this blog post).

James Tobin saw this happening with foreign currencies and wanted to find a way to slow the waxing and waning of their value down by curbing speculation. James Tobin was the winner of the Nobel Prize in Economics in 1981 “for his analysis of financial markets and their relationships to expenditure decisions.”

Nobel Winning Economist James Tobin. Picture taken from Wikipedia.

Tobin was regarded by many to be the most distinguished Keynesian, serving as one of John F. Kennedy’s Council of Economic Advisors. His realm of expertise was financial markets, and among his contributions, two really stood out: Tobin’s q and the Tobin tax.

Tobin’s q is a mathematical method to analyze whether one should invest in a certain asset. Basically what the math determines is whether the asset’s value is greater than its replacement cost. For example, if the value of a house is greater than what it is being sold at in the housing market, then you should invest.

The more political contribution by Tobin is the Tobin tax. This was Tobin’s idea to reduce speculation in the currency market. Obviously, Tobin had no idea we would be dealing with cryptocurrencies, but he did want to curb foreign speculation in currencies. He saw the value of different currencies fluctuating wildly because people would “buy and sell” the money in order to make a profit. If investors with deep pockets, or if a bunch of investors with medium sized pockets decide to buy a bunch of Japanese yen, the value of the yen would increase. Conversely, if the investors that own a bunch of Japanese yen decide to sell it back, the value of the yen goes down. Doing this quickly and irregularly causes these unexpected fluctuations that make it tough for other investors to see the true value of the currency and making it harder to invest.

What he proposed was a tax that would be used on international financial transactions. This would hopefully reduce the amount of speculation occurring in the market since the costs of doing so would rise. However, as with all economics, there are many unintended consequences of these actions.

It’s important to note there’s very little empirical evidence that Tobin’s tax actually works. Even if it does, it reduces the liquidity of currencies and creates issues in other parts of the economy. The volatility of the market is unavoidable, and while scary, it’s a risk people have to take.

Tobin was a brilliant Keynesian economist, who was trying to address some legitimate issues with the financial markets. However, he couldn’t foresee the ineffectiveness, or even worse, the negative impact of his policy suggestions like the Tobin tax on the foreign currency market.

When considering cryptocurrency, a tax wouldn’t work at all since one of the major benefits of currencies like Bitcoin and Ethereum is that they can’t be touched or regulated by the government. Cryptocurrencies will continue to be a high risk, high reward market until speculation in the market is outweighed by the number of transactions occurring. As of right now, there are no meaningful policies we can implement to change that.

Cryptocurrency is a uniquely risky investment compared to your typical stock. However, you should treat these cryptocurrencies like an investment: Being cautious with when and how much you invest, and you would still be better off than if you simply left your cash in the bank for that same period of time.

The vast complexity of the world of cryptocurrency. Photo taken from Money Crashers.

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