Shilling for Bitcoins

Bitcoins have been on a wild ride these past several months. After the November 2013 crash which saw the value of bitcoins plummet from over $1000 a coin to less than $300 a coin in just over a year, bitcoins seem to stabilize in a fairly tight range between $250 and $350 until early November 2015 when the price started to climb gradually reaching $730 last July before a brief decline to less than $600 in August, when another sustained price rise commenced. The price rise accelerated in December, and bitcoin price broke the $1000 barrier early in January, reaching $1100 last week before plummeting to less than $800 (a loss of almost of a third in value). Bitcoins have again recovered, climbing back over $900, and now at about $890 as of this writing (11:22pm EST).

In earlier posts (e.g., here and here) I have suggested that bitcoins are a bubble phenomenon, because bitcoins have no fundamental value, their only use being a medium of exchange. Some people believe that all forms of paper or token money, unless associated with some sort of promise or expectation of convertibility into a real asset, are bubbles. The reason why privately issued inconvertible paper money is unlikely to have any value is that people would expect it eventually to have zero value in the future, inasmuch as no one would want to be stuck holding paper money when there is no one left to trade with. The rational expectation that the future value of paper money must go to zero implies, by the mathematical argument known as backward induction, that its value today must be zero. If its value today exceeds zero, then the violation of backward induction, must be termed as a bubble.

That at least is the theory. However, that theory of the worthlessness of paper money applies only to privately issued money, not to government issued money, because government issued money can be given a current value if the government accepts the paper money it issues as payment for tax liability. At peak periods when the public has a net liability to pay taxes to the government, the aggregate outstanding stock of money must have a real value at least as great as the net outstanding aggregate private-sector tax liability to the government.

So I was very interested today to read a post on NADAQ.com “Why Bitcoin Has Value” by David Perry, chief architect for BitcoinStore and author of the Bitcoin blog Coding in My Sleep. Perry deals intelligently with many of the issues that I have raised in my earlier posts, so it will be interesting to try to follow him as he tries to explain why Bitcoins really do have value.

To begin, we really need to understand why anything has value. Fans of post-apocalyptic fiction will often point out that in the end, the only things of real value are those that sustain and defend life. Perhaps they’re right on one level, but with the rise of civilized societies things got a bit more complex, because the things that sustain and defend those societies also gain a certain degree of value. It is in this context that all monies, Bitcoin included, gain their value. Since our societies rely heavily on trade and commerce, anything that facilitates the exchange of goods and services has some degree of value.

In case you missed it, there was a bit of a logical leap there. Things can be valuable either because we are willing to give up something in return for the services we derive from owning them or possessing them, or because we believe that we can exchange them to other people for things that we derive services from owning or possessing them. If something is valuable only because it facilitates trade, you run into the logical problem of backward induction. At some point, far into the future, there will be nobody left to trade with, so the medium of exchange won’t have any more value. Something like gold does have value today because it glitters and people are willing to give up something to be able to derive those glitter services. But a piece of paper? No glitter services from a piece of paper. Of course if the government prints the piece of paper, the piece of paper can serve as a get-out-of-jail card, which some people will be willing to pay a lot for. A bitcoin does not glitter and it won’t get you out of jail.

Imagine, for example, a pre-money marketplace where the barter system is king. Perhaps you’re a fisherman coming to market with the day’s catch and you’re looking to go home with some eggs. Unfortunately for you, the chicken farmer has no use for fish at the moment, so you need to arrange a complex series of exchanges to end up with something the egg seller actually wants. You’ll probably lose a percentage of your fish’s value with each trade, and you also must know the exchange rate of everything with respect to everything else. What a mess.

This is where money saves the day. By agreeing on one intermediate commodity, say, silver coins, two is the maximum number of exchanges anyone has to make. And there’s only one exchange rate for every other commodity that matters: its cost in silver coins.

In truth there is more complexity involved—some things, like your fish, would make very poor money indeed. Fish don’t stay good for very long, they’re not particularly divisible, and depending on the exchange rate, you might have to carry a truly absurd amount of them to make your day’s purchases.

On the other hand, silver coins have their inherent problems too, when traded on extremely large or extremely small scales. This is what is truly valuable about Bitcoin: It’s better money.

Again that same pesky old problem. Silver, like gold, provides services other than serving as money. It has a value independent of being a medium of exchange, so, at the margin, there are people out there who value it as much for its glitter or other real services as other people value it for its services as a medium of exchange. But the only series that a bitcoin provides is that someone out there expects somebody else to accept it in trade. Why makes that a sustainable value rather than a bubble? Just asking, but I’m still waiting for an answer.

It’s been a long time since those first “hard” monies were developed, and today we transact primarily with digital representations of paper currency. We imagine bank vaults filled with stacks of cash, but that’s almost never the case these days—most money exists merely as numbers in a database. There’s nothing wrong with this type of system, either; it works fantastically well in an age where physical presence during a transaction is not a given. The problem is that the system is aging and far too often plagued by incompetence or greed.

Every IT guy knows that from time to time you have to take a drastic step: throw the old system in the trash and build a new one from scratch. Old systems, such as our current monetary system, have been patched so many times they are no longer functioning as efficiently as they should.

We previously patched our problems with gold and silver by introducing paper banknotes. We patched further problems by removing the precious metal backing those banknotes, then patched them again and again to allow wire transfers, credit cards, debit cards, direct deposit and online billpay. All the cornerstones of modern life are just patches on this ancient system.

But what would you do if you had the chance to start over? What if you could make purely digital money based on modern technologies to solve modern needs? What if we didn’t need those dusty old systems or the people making absurd profits maintaining them? This is Bitcoin.

Am I missing something? Just what is the defect with the good old dollar that the Bitcoin is improving upon? This sounds like: “it’s better, cuz it’s newer.” That’s not an explanation; it’s just like saying: “it’s better, cuz I say it’s better.”

Bitcoin isn’t another patch, another layer of abstraction added on top of an aging and over-complex system. Bitcoin isn’t another bank or payment processor coming up with new ways to move old dollars. Bitcoin is instead a simple, elegant and modern replacement for the entire concept of money. It has value for exactly the same reason as the paper money in your wallet: It simplifies the exchange of goods and services, not in the antique setting of a barter system bazaar, but in the current setting of modern internet-enabled life.

“But that’s only why it’s useful,” I hear some of you saying. “Why does it actually have value?”

Yes! That’s exactly what I’m saying, and I’m still waiting for an answer.

The two-word answer is one most economists are familiar with: network effect. The network effect is a lovely piece of jargon that refers to the quite commonsense statement that networked products and services tend to have more value when more people use them. The most common example is the telephone. During its early days when few people had access to telephones their utility, and therefore their value, were minimal. Today practically everyone has a phone, so its utility and value is [sic] so high as to be unquestionable. In this way the value of Bitcoin is directly tied to the number of its users and the frequency of their use.

OK, I get that. Just one problem. The dollar has already internalized all those network effects. To get people to switch from dollars to bitcoins, bitcoins would have to offer transactions services that are spectacularly better than those provided by the dollar. What exactly are those spectacularly better transactions services that bitcoins are providing?

Of course Bitcoin’s value stemming from the network effect is not without its own unique difficulties. When the network is still relatively small, each new group’s entry or egress can create massive price fluctuations, resulting in huge profits for early adopters. Unfortunately, this makes Bitcoin look, on the surface, too good to be true—a bit like a Ponzi or pyramid scheme.

Ponzis and pyramids are distinct and different forms of fraud, but they share one thing in common: The first ones in make a lot of money while the last ones in foot the bill. Both feature initial “investors” being paid out directly from new investors’ money. The return is always too good to be true and the gains (for those who actually get gains) are exponential.

The huge increase in value (along with occasional huge drops in value) may be good for early investors, but they are fatal for an aspiring medium of exchange. What you want from a medium of exchange is not a rapidly increasing value, but a nearly (if not necessarily perfectly) stable value. There is no upper limit on the value of a bitcoin and no lower limit. So the bitcoin lacks any mechanism for ensure the stable value that is essential for a well-functioning medium of exchange.

Because Bitcoin’s value has risen so dramatically since its 2009 debut, it seems to fit this sort of a profile at first glance, but then so does every new technology. It’s just not normally the case that we get to invest in this sort of technology and profit as it’s adopted. Imagine being able to invest in the concept of email back in 1965 when some clever hacker at MIT found a way to use primitive multi-user computer systems to pass messages. It might have seemed like a silly waste then, but owning even a tiny percentage of the rights to email today would make one wealthy beyond imagining.

Technologies follow a known adoption curve, which tends to include a period of exponential rise. Bitcoin is no exception. Ponzis and pyramids both create value for their oldest investors by stealing from the new. There’s no economics involved—just theft.

Bitcoin creates value for the old investors and the new by splitting a finite currency supply more ways. That’s not trickery or theft, just good old-fashioned supply and demand at work—a basic and ancient economic principle applied to the world’s newest currency system.

The maximum number of bitcoins is bounded from above, meaning that if it ever did begin to internalize those network effects and the demand for bitcoins did rise, the increased demand would cause its value to skyrocket, which would undermine its suitability as a medium of exchange. The market capitalization of bitcoins hit an all-time high of $15 billion last week. The US monetary base is $3.5 trillion, which is about 230 times the market capitalization of bitcoins. I mean, get real. Bitcoins, by design, are incapable of ever becoming a widely adopted medium of exchange. So even if there were to be a collapse of the dollar — and that outcome may be beyond the capacity of even a Trump Presidency to achieve – it could not be the bitcoin that replaced it as the world’s dominant currency.

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36 Responses to “Shilling for Bitcoins”


  1. 1 JKH January 17, 2017 at 10:35 pm

    Bitcoin as a bona fide currency is a joke. The only reason it has any relevance in the long run is the block chain technology that underlies it. The banks are seriously interested in understanding that technology, which is the only reason why the technology itself likely has some relevance to the long run development of the monetary system. But that’s a coincidence that’s got nothing to do with the idea of Bitcoin as a currency or the people that shill it as such.

    In the long run, to the degree that people are attracted to it because of its prospects as a currency of any significant importance, Bitcoin is a Ponzi scheme. You can’t sever the idea of what money is from sovereign taxation policy and monetary policy.

    And the application of this networking stuff as an argument is nothing more than fraudulent logic. It’s self-referencing, without any true force as an independent idea. It’s just economics jargon conveniently used by the barkers.

    Bitcoin as currency is a scam in the long run.

  2. 2 Lorenzo from Oz January 17, 2017 at 11:00 pm

    I find “bubble” talk usually just a confusing short hand for “asset price instability”. Given that the supply of bitcoins is, to put it mildly, poorly responsive to demand, one would expect it to have the unstable price it does.

    As to the argument that bitcoins “should” be without value, that seems to be the triumph of theory over fact. That they continue to have positive value suggests that they are providing value: the role of theory should be to explain that fact, not accuse it of being a wrong fact.

    Homo sapiens are strongly inclined to take cues from other people. (We have a term for the people who are not — we call them autistic.) Observing that there is a community of people who use bitcoin as a medium of exchange gives it value as a medium of exchange, with the blockchain restriction acting as a substitute constraint to alternative uses that commodity moneys have.

    In other words, the technology which makes supply poorly responsive to demand (hence creating highly unstable prices) is the same technology which provides a reassuring constraint, giving it positive value as a medium of exchange. That commodity money’s have one sort of reassuring constraint does not mean that another such cannot also operate. After all, commodity moneys typically have a premium precisely because they are a medium of exchange. Bitcoin has just found another way to generate that premium.

  3. 3 Coinosphere January 18, 2017 at 12:48 am

    Looking forward to your future bitcoin articles.

    One by one, you’ll be stripped of your false beliefs and eventually come to realize that it is, indeed, everything the perfect money should be.

    …It’s just got some growing pains to get through before then.

  4. 4 laeeth January 18, 2017 at 2:38 am

    Hi David.

    “OK, I get that. Just one problem. The dollar has already internalized all those network effects. To get people to switch from dollars to bitcoins, bitcoins would have to offer transactions services that are spectacularly better than those provided by the dollar.”

    Not really, because bitcoins are much superior both for payments and as a store of value to the Venezuelan currency, for example. Every new great thing emerges from the fringe in the beginning – a lesson from Ibn Khaldun, Toynbee, and more recently from Clayton Christensen’s Innovators Dilemma.

    Serbia in 1992:
    http://www.setimes.com/html2/english/040217-DAVOR-001.htm
    “the citizens of Yugoslavia were in a constant race against time — buying whatever they could, wherever there was anything to be bought. Prices increased at a rate of 2 per cent per hour or 64 per cent per day. In 1993, hyperinflation reached a record 400,000 billion per cent. In October of that year, 600 grams of pork cost 26 dinars, with the same amount costing 21 billion dinars three months later.”

    Gary North on Weimar hyperinflation:
    “Here is my favorite story that illustrates this. Before he died, I knew Dr. Norbert Einstein. He was Albert’s cousin. He was a banker. He told me that only late in the German inflation did his Aunt Rosa catch on to what was happening to the value of money. She then wanted to get into goods and out of money. But the truly marketable goods were gone. They were being hoarded. All she found was a large inventory of bedpans. She bought them in late 1923. Then came the currency reform of December, 1923. It produced the recession of 1924. There was Aunt Rosa, figuratively sitting on top of a pile of bedpans.

    I’m not suggesting hyperinflation is imminent in the USA (a period of surprisingly high inflation is, but that’s another matter). Just that to become more adopted – even as a store of value (something that is, I agree, not it’s strength) – bitcoin only needs to be better than the worst currencies.

    And yet as it does become more widely adopted there first, that raises its marketability for more conventional uses.

    “What exactly are those spectacularly better transactions services that bitcoins are providing?”

    Have you tried wiring money abroad recently? I worked with some contractors in Russia – I wasn’t paying so much, but I paid 20 pounds in fees and more on the exchange rate. And I could only send international payments during restricted period of banking hours, and they kept being held up by spurious fraud checks. And whilst we have sanctions with Russia, so far they didn’t interfere too much – but that situation might be very different if things were more difficult. (In such cases the set of things that are legal includes the set of things that regulation tends to make a pain in the neck to get done). As a medium of exchange, Bitcoin is already superior in many ways. And that’s for larger payments of a few thousand pounds, and for smaller payments this is all the more true.

    “Of course Bitcoin’s value stemming from the network effect is not without its own unique difficulties. When the network is still relatively small, each new group’s entry or egress can create massive price fluctuations, resulting in huge profits for early adopters.”

    It’s my belief that you are mixing things up here. Money has three functions – store of value, medium of exchange, and unit of account. Historically they have tended to go together, though not always. In inflationary periods it’s quite common for prices to be quoted in a hard currency (like Deutschemarks in Serbia) but for payments to be made in the official (weak) currency. And similarly, during such periods money becomes a hot potato and people keep their transaction, precautionary, and speculative balances as small as possible.

    Fama wrote a very creative paper in I think the early 90s on the new monetary economics. The initial form was a little hare-brained, but Tyler Cowen and his-then graduate student, Randall Kroszner wrote a book tidying up his ideas, entitled The New Monetary Economics. The principle there is to separate out the three functions of money. There were many practical objections to this approach at that time, but practical objections can often be overcome as conditions change, technology being part of such conditions.

    People who say that Bitcoin is a terrible store of value or unit of account are missing the point entirely. I really mean it. Bitcoin is intrinsically not suited to those purposes, for just the reasons you point to. However it, and its spiritual kin, are very suited to being a medium of exchange.

    What would such a world look like? Quote prices in whatever local convention is most popular – perhaps US dollars, perhaps ounces of gold, perhaps SDRs. No reason we have to have the same convention globally, or even within a single country. Perhaps for example oil-producing states in the US should have a different convention to that of the coastal cities – this would reduce costs from adjustments to shocks. These days for the end-user it doesn’t really matter how the price is set, because it’s easy to provide the price in local currency terms.

    Use cryptocurrency (perhaps Bitcoin, perhaps some superior successor yet to be widely known) as a medium of exchange.

    And use mutual fund shares (perhaps money market funds, perhaps gold depository receipts, perhaps global equities – most likely some combination of all of these) as a store of value.

    How would this work? I live in London and subscribe to the New York Times, agreeing to pay $30 a month. Every month the sterling equivalent of $30 of my mutual fund shares are liquidated, converted to the equivalent dollar value of bitcoin, sent to the NYT, converted back to dollars and transformed into a purchase of mutual fund shares held in the NYT company treasury.

    The above sounds complicated, but it really isn’t as it will all be automated and transparent in a simple way to the user. What’s missing is that checkable money market mutual funds don’t offer the ability to make conversions to and payments in bitcoin, and the reason for that is simple – regulation has been hostile. But the momentum of regulation is changing, and the future is very different.

    I suggested to you before that bitcoin was not a bubble, and the price performance since then has been interesting. I wouldn’t necessarily say it’s the greatest investment here – it might be okay, but that’s not my point. Bitcoin has value because in practice it’s more convenient to hold a small transactions balance, and the adoption of the currency is growing pretty quickly from a very small base.

    “The huge increase in value (along with occasional huge drops in value) may be good for early investors, but they are fatal for an aspiring medium of exchange.”
    This is completely wrong. Volatility has little relevance for money qua medium of exchange.

    “What you want from a medium of exchange is not a rapidly increasing value, but a nearly (if not necessarily perfectly) stable value.”

    You’re mixing up two different functions of money – medium of exchange and store of value. If they were not separable then you would have a point, but history shows that they are separable.

    Laeeth.

  5. 5 AJ January 18, 2017 at 6:51 am

    David,

    Thanks for the post. Question on the concept of backwards induction. Assuming that a rational agent has a finite life and Bitcoins will have a positive value at the end of his or her life, does backward induction really work in this model? At some point in the indefinite future, Bitcoins will be worthless but to a rational agent today who cares? It will be worth something when he or she passes away.

    AJ

  6. 6 J Edgar Mihelic January 18, 2017 at 7:19 am

    Am I missing someting here – “There is no upper limit on the value of a bitcoin and no lower limit.”

    Isn’t there a zero lower bound? Or is that just a lack of imagination?

  7. 7 Tom Stickler (@tom_stickler) January 18, 2017 at 7:43 am

    Laeeth may think he has a good argument for Bitcoin with his example of liquidating $30 equivalent in Pounds from his mutual fund shares, sending it to New York, where it is converted to Dollars to pay his NYT subscription.

    Where is the indispensable role for Bitcoin in this transaction?

    Unless the Bitcoin price in Pounds and Dollars is exactly comparable to the exchange rate between Pounds and Dollars, there will be a premium paid by someone. And if there is no premium, someone is burning bytes at some finite cost for no remuneration.

    The only thing that has a future in monetary transactions is some sort of blockchain technology, not the virtual manifestations, such as “Bitcoin”.

  8. 8 JP Koning January 18, 2017 at 9:32 am

    Laeth: “It’s my belief that you are mixing things up here. Money has…”

    In accusing David Glasner of mixing things up, you’re actually responding to a quote made by David Perry.

    Lorenzo: “That they continue to have positive value suggests that they are providing value: the role of theory should be to explain that fact, not accuse it of being a wrong fact.”

    Good point, but units in Bernie Madoff’s scheme had positive value for many years, although in theory they never should have had any value.

    David, I agree with pretty much all of this post. I do wonder if there isn’t some “glitter” potential in bitcoin insofar is it is a status symbol. I’m also not a fan of your tax liability argument for fiat money. If governments suddenly required payments of taxes in, say, diamonds, central bank money would still have value. People would hold fewer banknotes to pay taxes, but the same amount to buy other stuff. The central bank would conduct open market sales until all unwanted currency is removed and its inflation target preserved.

  9. 9 Eric Dennis January 18, 2017 at 10:33 am

    The long run value proposition of bitcoin is probably not as a medium of exchange, but rather as a reserve asset. (Because bitcoin supply is, by design, insensitive to demand fluctuations. It is possible to design another cryptocurrency to address this problem, but let’s stick to bitcoin here.) Future banks could issue banknote-like claims backed by and convertible-on-demand into bitcoins.

    Bitcoin as a reserve asset is a technological improvement in certain ways over gold and in other ways over federal reserve notes. Just like gold coins as a reserve asset would be an improvement over iron bars. Bitcoins have a dramatically higher value density than gold: one USB stick could store one million ounces-worth of gold at current exchange rates. And bitcoins, because of their decentralized security features, are far easier to transport: just open an app, enter a destination, and hit send. We cannot rely on the Fed to be a great app developer. Centralization is a drawback. Also and importantly, based on historical experience, the Fed does not offer a predictable future path for the total supply of its reserve asset.

  10. 10 Sven January 18, 2017 at 11:15 am

    I really do not understand why economists find it so hard to understand why fiat money has value and not prone to major breakdowns. The tax liability argument in the post is a good one, it is however not the important one.

    The real reason why fiat money (as currently practiced) has value lies in the fact, that the only way a new unit of that money gets injected in the economy is by swapping it against any form of safe debt contract with a fixed denomination in the same currency. That implies that the debtors of all these debt contracts do have a *real* need for that currency, in order to be able to redeem those debt contracts. Even if every single person in the economy suddenly decides to not use that currency as a medium of exchange or account anymore, the money will still be valuable, because debt contracts are already assumed. The fact, that the debtor of these contracts is in practice most of the time a state just shows, that this is a generalization of the common tax-theory of fiat money value.

    The above argument does of course not automatically imply that fiat money has stable value, but if you couple that with a decent central bank mandate, you get precisely that!

  11. 11 Diego Espinosa January 18, 2017 at 12:44 pm

    David,
    Some of your arguments seem incomplete.

    First, backward induction. One could assume that, in the distant future, the government will not accept the present currency unit for tax liabilities. One can’t exactly use New Peso’s to pay taxes in Argentina, for instance. Not likely in the U.S.? Over a long enough time period, the probability becomes material. Then, by your backward induction argument, the government-issued currency has no value today.

    Second, the requirement of stability for a competing medium of exchange runs counter to the evidence. The problem is all competing media are unstable when measured in the present medium of account. By your logic, that instability would permanently shield present media of account from competition. However, we know that, historically, the emergence of competing media is not altogether unusual.

    Third, you argue that the competing medium must have far superior qualities as a medium of exchange. However, the “exchange” quality is not fixed. Rather, it emerges over time via a network effect, as you correctly point out. Competing exchange media start out with similar, or even inferior exchange qualities. Often their functionality appeals to a small sub-segment of the network (say, money launderers). However, at some point, the adoption by that subsegment may reach a tipping point, such that the quality of exchange begins to increase for other segments. As they adopt it, the quality grows further, and attempts to squelch it (say, by driving it underground) only heighten its value : this is a self-reinforcing feedback loop, the stuff of network behavior. Exchange utility is fundamentally an emergent quality.

    Bitcoin arguably is in the midst of such a self-reinforcing dynamic. It first picked up utility from tech geeks and money launderers. Then, it gained speculative utility. Next, it gained utility as a means of avoiding Chinese capital flight restrictions and Indian demonetization. The global war on cash is also fueling its emergence: one can imagine a Trump “Modi”, which cancels existing $100 bills in favor of e-currency. At that point, dollars would lose their “bearer” quality almost entirely. All the while, more and more people would be transacting in bitcoin, increasing its network-derived utility. In such a scenario, you have only your “backward induction” argument to fall back on, which, by logic, is incorrect.

  12. 12 James King January 18, 2017 at 1:30 pm

    What I see from a few of the posters here as well as Bitcoin fans in general is the notion that its excellent liquidity somehow makes it suitable as a medium of exchange. Liquidity, however, is no panacea. Bottom line, as Glasner points out, it is not scarcity that makes certain money suitable as mediums of exchange, it’s stability. The minute Satoshi decided to cap Bitcoin production at 21 million units, that was when its chance of becoming a mainstream medium of exchange fell to near zero.

    As for Bitcoin’s supposed “network effects,” that’s a pretty preposterous argument. More people use M-PESA than transact in Bitcoin by what I’m fairly sure is a wide margin. For that matter, the “network effects” of pretty much every major and most minor currencies on the planet substantially dwarfs Bitcoin.

    Bitcoin is a dead end as a currency. It may stick around as a speculative vehicle for awhile until people understand that it has absolutely no intrinsic value. Starbucks gift cards are literally better money than Bitcoin.

  13. 13 laeeth January 18, 2017 at 3:20 pm

    “Tom Stickler (@tom_stickler) on January 18, 2017 at 7:43 am
    Laeeth may think he has a good argument for Bitcoin with his example of liquidating $30 equivalent in Pounds from his mutual fund shares, sending it to New York, where it is converted to Dollars to pay his NYT subscription.

    Where is the indispensable role for Bitcoin in this transaction?”

    I am not evangelising for Bitcoin – I have no dog in that fight (but it’s certainly entertaining to watch the passions aroused – “shilling”, “fraudulent”). I do think people will find it helpful to pay attention to the tidied up ideas of Eugene Fama, but that is entirely up to them.

    Very few things in economics are indispensable. That’s an Aunt Sally of an argument if ever there was one. Bitcoin isn’t necessary and the world would function perfectly adequately without it. The same is true of most other technological advances. Obviously, very obviously Bitcoin has many substitutes.

    What’s my next best alternative to using Bitcoin as a means of payment for my NY Times subscription? I could use PayPal, which will debit my account in sterling and charge a spread for the currency conversion, or I could bill it to a credit card, which will cost me a few pounds for each payment with the currency conversion on top, or I could pay twenty pounds per payment with a currency conversion fee on top for a SWIFT payment that probably takes a few days but if it goes astray (which happens now and then) could take weeks.

    And so Bitcoin is cheaper for both small payments and large ones, and its quicker for large payments and there is no possibility of a charge back in either case, and I don’t need to trust my bank and my bank doesn’t need to trust its correspondent bank, and so on.

    But my primary point is not that Bitcoin is far superior as a medium of exchange ; it is that it does a more than adequate job as such, and that people who believe that its lower suitability as a store of value or unit of account have much relevance for its suitability as a medium of exchange really need to make an argument for why, because Fama et al already explained in the early 90s why the three functions of money can be unbundled and one may dispute their arguments but may not just act as if they didn’t exist.

    It really doesn’t matter to me if people choose to ignore these arguments, since I am not an academic and not involved with Bitcoin. I just think that it’s a pity, as I should like to see a greater seriousness of debate in discussions about monetary systems and acting as if the new monetary economics didn’t exist isn’t the way I think someone taking the topic of monetary regimes seriously would behave.

  14. 14 laeeth January 18, 2017 at 3:42 pm

    “James King on January 18, 2017 at 1:30 pm
    What I see from a few of the posters here as well as Bitcoin fans in general is the notion that its excellent liquidity somehow makes it suitable as a medium of exchange. Liquidity, however, is no panacea. Bottom line, as Glasner points out, it is not scarcity that makes certain money suitable as mediums of exchange, it’s stability.

    What has stability in value got to do with suitability as a medium of exchange? They are two different concepts that whilst often historically associated are conceptually distinct.

    The value of the dollar collapsed in the first half of 1973 – for example collapsing against the deutschemark from 3.2 to 2.3. And its not like internal stability was better either. Did this have much bearing on the dollars acceptance as a medium of exchange? Not really, and even today it is the dominant currency of world trade.

  15. 15 James King January 18, 2017 at 3:55 pm

    Laeeth – “What has stability in value got to do with suitability as a medium of exchange? They are two different concepts that whilst often historically associated are conceptually distinct.

    The value of the dollar collapsed in the first half of 1973…”

    The dollar is backed by the strongest economy and military that has ever existed in human history. Yeah, that is stability. What backs Bitcoin other than blind faith?

    However, for the purpose of your response, what is the purpose of using Bitcoin as a medium of exchange if it is going to be an appreciating asset? Key word being “appreciating.” As demand for it increases, velocity will decrease. It’s barely used as a medium of exchange even now.

    Bitcoin fans don’t seem to get that people spend dollars because they store only a tiny bit of value. Ironically, the more Bitcoin appreciates in value, the less suitable it is as a medium of exchange. The fact that it is super-liquid ultimately means nothing.

  16. 16 laeeth January 18, 2017 at 4:06 pm

    “JP Koning on January 18, 2017 at 9:32 am
    Laeth: “It’s my belief that you are mixing things up here. Money has…”

    In accusing David Glasner of mixing things up, you’re actually responding to a quote made by David Perry.”

    Not really. Just constrained in my ability to edit by the combination of the little wordpress edit box and the limitations of writing on a smartphone. My reply was to what David wrote, and the quote was slightly out of place.

    Do you feel I misrepresented David’s arguments? I don’t believe I did, but please explain why if you do.

    David doesn’t make a distinction between the conceptually separate and distinct if historically associated functions of money. And I think one needs to make an argument for why being not so hot as a store of value has much bearing on suitability as a medium of exchange.

    Am economist is someone who sees something working in practice and asks if it would work on theory. That’s a rather apt old joke here, because Bitcoin works very well as a medium of exchange for people who use it in practice. And here we are not just lecturing birds how to fly (Taleb phrasing) nut lecturing then on how this flying thing is never going to work. Because people do use Bitcoin for transactions, find its often better than alternatives, and adoption is growing. So perhaps economists are missing something.

    Three years ago when people declared Bitcoin a bubble of asked what developments would cause them to realise they had been mistaken. Well Bitcoin all but doubled since then. What would need to happen to falsify your belief?

    laeeth on April 26, 2014 at 6:24 am
    Hi.

    Milton Friedman’s 1953 essay on positive economics (http://digamo.free.fr/hausman82.pdf#page=76) continues to exert an influence on the field, although there is today greater emphasis on micro-foundations.

    “The ultimate goal of a positive science is the development of a “theory” or
    “hypothesis” that yields valid and meaningful (i.e., not truistic) predictions
    about phenomena not yet observed. Such a theory is, in general, a complex
    intermixture of two elements. In part, it is a “language” designed to promote
    “systematic and organized methods of reasoning.”5 In part, it is a body of
    substantive hypotheses designed to abstract essential features of complex
    reality”

    Dr Glasner and some other commenters here hold the belief that bitcoin is a bubble. The point about a bubble is that it eventually bursts, and the old highs are not seen for many years to come.

    So suggesting that bitcoin is a bubble implies a theory of bubbles and a set of beliefs about bitcoin that relate to this theory.

    If we do not over the next 5-10 years see developments in accordance with the bubble hypothesis, will those bubble-ists be willing to revisit their ideas in the light of such surprising information?

    I suggest it will not be satisfactory – should this be the case – to point to new developments that could not have been known at the time of writing. For markets are forward-looking, incorporating information that could never be known to one man, and perhaps possibilities that could only be distantly imagined.

    The cleanest way of deciding this would be to have a wager, but I don’t suppose this is clearly legal under US law. So I suggest we just revisit this thread in c. 3 years, and then again in 5.

    In the field of investing (and we speaking here of views about the prospects of a spot market where necessarily speculative views about the future shape pricing), I have always learnt more from studying my errors, than from my successes.

    Laeeth.

    David Glasner on April 27, 2014 at 3:19 pm
    Laeeth, I am really just trying to think through the logic here, not to predict what will happen to the price of bitcoins. I am not saying that my explanation for the value of bitcoins is the correct one, just inviting people to offer a better one. I agree that it’s not satisfactory to say that the value of bitcoin must go to zero without specifying when it will go to zero. I am just pointing out what seems to me to be a problem in accounting for its value. If that puts me in the same category (with or without your dispensation) as Joe Stiglitz, I think I can live with that stigma.

    I am not so sure that the end state of bitcoin is zero, I am just presenting the argument that it is zero, and inviting people to provide arguments to the contrary. You almost seem to be suggesting that owning a bitcoin is somehow analogous to having an ownership share in the bitcoin enterprise. If that’s the correct way to think about it, then perhaps that does provide a clue to why bitcoins can have a positive value. But if that’s not the case, then I think that there is still a problem.

    You ask why I think demand will taper off. I think that except for a very narrow class of transactions, people have better and less costly options for media of exchange with which to effect transactions. I am guessing that a lot of the demand for bitcoins has been driven by an expectation of rising prices and that if the price drops significantly, a lot of people will try to cash out. If you think that argument is insufficiently researched and inadequately supported, you may well be right and you are free to draw the appropriate conclusions, but I don’t think that I extracted an unreasonable price from you in exchange for that argument.

    Thanks for the references. I agree that if bitcoins prove to be viable and gain acceptance over an extended period of time, that will favor the Menger theory over the state theory, but it will also blast a gaping hole in Mises’s regression theorem. At any rate, I think that the key point on which we differ is that I am asserting, like Mises, that a medium of exchange must have value before it can serve as a medium of exchange, while you are saying that serving as a medium of exchange can impart value to an asset that would otherwise have no value.

  17. 17 laeeth January 18, 2017 at 4:36 pm


    James King
    23 minutesThe Currency Paradox
    Laeeth – “What has stability in value got to do with suitability as a medium of exchange? They are two different concepts that whilst often historically associated are conceptually distinct.
    The value of the dollar collapsed in the first half of 1973…”
    The dollar is backed by the strongest economy and military that has ever existed in human history. Yeah, that is stability. What backs Bitcoin other than blind faith?”

    Please define your terms – what does stability mean, since you clearly are using it in a sense other than what is conventionally referred to by being a good store of value.

    “However, for the purpose of your response, what is the purpose of using Bitcoin as a medium of exchange if it is going to be an appreciating asset?”

    I dont care if it’s appreciating, depreciating, or trading sideways if it is a medium of exchange
    Bitcoin come in, Bitcoin go out. I am flat Bitcoin delta. Why should I care what the price does?

    “As demand for it increases, velocity will decrease”
    You’re carrying over a metaphor that doesn’t have much use in this context because there isn’t really a link between Bitcoin demand and nominal US GDP.

    MV=PT.

    So if one insists the supply of Bitcoin x the velocity of bitcoin = price level in Bitcoin x real gdp. And it’s tautologically true, but I am not sure that one can get much more insight from that.

    Yes, if the demand to hold Bitcoin at a certain price holding nominal GDP constant increases then velocity will fall. By definition! And so? What’s interesting about that?


    Bitcoin fans don’t seem to get that people spend dollars because they store only a tiny bit of value. Ironically, the more Bitcoin appreciates in value, the less suitable it is as a medium of exchange. The fact that it is super-liquid ultimately means nothing.”

    A strange assertion to make. It’s quite easy to trade in fractions of a US cent with Bitcoin. What had the sticker price got to do with anything when I can spent a millionth of a Bitcoin and smaller quire easily.

  18. 18 James King January 18, 2017 at 7:42 pm

    laeeth – “Please define your terms – what does stability mean, since you clearly are using it in a sense other than what is conventionally referred to by being a good store of value.”

    I mean it in any sense regarding Bitcoin. It’s volatility shows that it is currently a poor store of value. And, again, what is it backed by? My response was to get you to understand why your example re: the dollar was just a mental exercise. In the end, the dollar is backed by the U.S. economy and military. Bitcoin is backed by….?

    laeeth – “I dont care if it’s appreciating, depreciating, or trading sideways if it is a medium of exchange
    Bitcoin come in, Bitcoin go out. I am flat Bitcoin delta. Why should I care what the price does?”

    You can use virtully anything as a medium of exchange. But what is Bitcoin’s fungibility vs practically any other currency or commodity? It’s semantics to say that it is a medium of exchange. So are Starbuck’s gift cards. Is Bitcoin a *mainstream* medium of exchange? No, absolutely not.

    laeeth – ““As demand for it increases, velocity will decrease”
    You’re carrying over a metaphor that doesn’t have much use in this context because there isn’t really a link between Bitcoin demand and nominal US GDP.”

    No, I mean simply that people will have no incentive to spend Bitcoin if it is rapidly appreciating. Oh, that’s right, the whole ” divisibility” argument. The problem is that excessive demand for a fixed currency has the same dynamic as excessive supply for a non-fixed limit currency. More on this below.

    “A strange assertion to make. It’s quite easy to trade in fractions of a US cent with Bitcoin. What had the sticker price got to do with anything when I can spent a millionth of a Bitcoin and smaller quire easily.”

    Indeed. If Bitcoin is appreciating, you will by nature spend less than you acquire. The effect is that subsequent holders will have the opportunity to acquire less Bitcoin relative to its total purchasing power. Awesome for early adopters, terrible for everyone else. In a high demand environment, the percentage used for actual everyday transactions will continue to shrink. Assuming that Bitcoin is indeed a hedge against hyperinflation, what kind of purchasing power will be held by most BTC users in a hyperinflationary environment under those circumstances?

    Bitcoin suckles at the teat of fiat. In a hyperinflationary environment, it would offer absolutely no protection because the very measurement that gives Bitcoin its value would be worthless.

    Bitcoin ONLY works right now, in this early phase. If a bitcoin were to ever be worth $10,000 and a dollar still had respectable purchasing power, what would be the advantage of buying a bitcoin for $10.000? The most likely scenario in which a single bitcoin was worth $10K would be hyperinflation of the US dollar and then why would anyone care about owning Bitcoin then? What advantage would it provide under those circumstances? Short answer, none.

  19. 19 JKH January 19, 2017 at 3:57 am

    Further to my initial comment …

    Bitcoin is like a foreign currency with no home country. It has no home anchor with respect to government taxation value and government legal tender laws.

    As a “foreign currency” operating in nothing but “non-home” markets, it is absolutely useless unless ultimately convertible into a legitimate currency in some home market(s) – e.g. convertible into US dollars, Euro, etc.

    It’s not useless now because it does have that convertibility. And it may always have it.

    But its valuation will always depend in part but essentially on that type of conversion availability – unless it becomes a legitimate home currency whose value is anchored by government taxation and legal tender laws – somewhere.

    And that will never happen unless some government declares it as such. Moreover, that government would have to eliminate its prior currency – e.g. eliminate the US dollar (as the galactically absurd case) as a currency that is even acceptable for tax payments in order to force such legal tender adoption of the new Bitcoin currency. The Fed would have to start doing OMOs and QE with Bitcoin. And to avoid “foreign exchange” risk, the government would insist that its expenditures be invoiced in the new currency. And if that happened, Bitcoin would become the primary medium of account currency.

    Good luck on all that. It will obviously never happen (although the probability might be slightly higher somewhere in Africa).

    OK. Bitcoin is a “currency”. But its currency characteristics are no greater in concept than Apple stock if that were traded on the same type of exchange platform with that glorious block chain.

    Meanwhile, no substantial commercial operation will set prices in Bitcoin – without being prepared to change them several times a day according to its “foreign currency” value. Sure, some people will accept Bitcoin in trade. But not without the backstop of available conversion into a legitimate government anchored currency.

    And all that network stuff is smoke and mirrors in terms of ultimate causality. It’s a characteristic that evolves and gets exhibited as a result of other enabling characteristics that must operate in the background – such as convertibility into anchoring taxation and legal tender value. It doesn’t come from blockchain voodoo.

  20. 20 Frank Restly January 19, 2017 at 4:26 pm

    JKH,

    “Block chain Voodoo” as you call it, is simply a non-centralized record of transactions. It would be similar to every dollar in your wallet having a complete list of all transactions ever completed using that dollar.

    This is one significant difference from the currency that we use every day and has some interesting legal implications. We often say that money is fungible – it is impossible (at least for physical currency) to say with any certainty which dollar of income / finance purchased what good.

    And so, when entertaining methods of “reigning in” Wall Street, the emphasis seems to be that banks must finance lending operations with the sale of equity shares. That’s fine, except, banks use money for other purposes – payment of employees, capital improvements / expanding physical operations, etc. Presumably, banks (under a share sale to lend arrangement) would still be able to borrow to fund these other endeavors.

    The question becomes – How does a U. S. regulator determine from a bank’s cash flow and balance sheets the source of money that was lent out and the source of money to fund other endeavors?

    Digital currency with an attached transaction history facilitates that kind of record keeping.

    From a privacy standpoint there are obvious objections to that level of intrusion – the government (in supporting a bit coin type currency) now has the ability to monitor every single purchase I make – how dare they.

    But, I will say that not very long ago, all U. S. government debt was sold as Bearer Bonds.

    https://en.wikipedia.org/wiki/Bearer_bond

    Meaning, that those bonds were sold to anonymous buyers and transferrable without the U. S. federal government knowing who owned it’s debt. These days, all U. S. government debt is sold with a CUSIP number:

    https://en.wikipedia.org/wiki/CUSIP

  21. 21 David Glasner January 19, 2017 at 5:10 pm

    JKH, I broadly agree with you, but I think that network externalities are indeed very relevant. It’s just that they work against bitcoins not in their favor.

    Lorenzo, As you may, or perhaps may not, realize, I use “bubble” semi-ironically to underscore my perplexity with the phenomenon. The value of bitcoins, which I do not deny, seems difficult to explain using fairly conventional monetary theoretic reasoning, though I am not sure that the tax argument is really that conventional, despite an impressive list of economists who have invoked it in the past. So I am just trying to draw attention to the disconnect between theory and fact, not to deny the obvious. And I am trying to suggest some ways in which the theory could somehow account for the empirical anomaly. That is what usually happens when theorists are confronted with an anomalous fact. Sometimes the theory, with some minor tweaking, can assimilate the fact, and sometimes it can’t. We shall see. As to the point of your final paragraph, I was suggesting that the reassuring constant that you refer to, is actually a fatal flaw that renders bitcoin incapable of ever becoming a widely used medium of exchange. Again that is a theoretical prediction, but clearly one that is eminently refutable.

    Coinsphere, Well I hope you enjoy watching and waiting for my next bitcoin post, whenever that will be.

    Laeeth, Good to hear from you again. If the US dollar is the world’s dominant currency, what is the point of comparing bitcoins to the Venezuelan currency? People in hyperinflating countries hold dollars not bitcoins. The amount of dollars held abroad dwarfs the total capitalization of bitcoins. It’s because of network externalities that people all over the world quote prices in dollars and use it as an international standard. To think that the dollar will be displaced by bitcoins is akin to thinking that English will be replaced as an international mode of communication by Esperanto.

    You said:

    “Volatility has little relevance for money qua medium of exchange.”
    Really? Do you think that the 30% appreciation enjoyed by gold between 1929 and 1933 had little relevance for the gold standard?

    “You’re mixing up two different functions of money – medium of exchange and store of value. If they were not separable then you would have a point, but history shows that they are separable.”

    I don’t know what historical events you are referring to. Please be specific.
    You say that Bitcoins can be used as a medium of exchange without being medium of account or a store of value, but that doesn’t address the question I posed which is how can bitcoins serve as a medium of exchange if they have no value. A checkable money market fund, which I have no problem with, has nothing to do with bitcoins.

    I still don’t understand how bitcoins get value. To say bitcoins are valuable because they are a medium of exchange is a form of question-begging. Interesting that you cite Fama’s paper in this regard. Are you aware that Fama agrees with me that bitcoins are a bubble?

    “’People won’t use it because basically it’s very difficult to know how much you need to settle. It is quite variable, they won’t want to hold it as just a way of settling payments, they will try to get rid of it quickly, as they do; and that’s not good for the survival of that kind of a unit of account,” he said in his interview.’”

    AJ, Backward induction doesn’t depend agents living until the expected event takes place. Forward looking individuals may take into account events that they expect to occur after their death if they believe that other people will also anticipate those events.

    J Edgar Mihelic, I did not state that very clearly. What I meant to say is that there is no commitment by anyone to keep the value of bitcoins from rising above some upper bound or falling below some bound. Obviously, bitcoins cannot become less than worthless, but no one is providing any commitment to preserve a minimum value for bitcoins.

    Tom, There is a cost of performing a trade from pounds to dollar or vice versa at any moment. That’s like a conversion cost charged by your bank or your credit card or whatever. I think Laeeth’s point is that you can cash in a bitcoin and vice versa at a given moment without incurring that trading cost or brokerage fee. But I am not so sure that is correct. At any moment are people able to buy bitcoins with dollars at exactly the same price that other people are buying dollars with bitcoins? I don’t know, but I am guessing that there is a bid ask spread for bitcoins just as there is for other traded assets on liquid markets.

    JP, I use the tax liability argument because it is the only answer to a question I have that would otherwise go unanswered. Your argument about open market operations only works provided that a demand for money exists, but that is begging the question.

    Eric, Even if banks created bitcoin denominated deposits, the value of bitcoins would depend totally on the monetary demand for bitcoins, as its supply could not change, so all the variability in demand would correspond in variability in value. That seems very dangerous to me.

    Sven, Interesting point, but debt contracts are nominal so debtors would be happy to pay back their debts in debased or worthless dollars. The government, however, extracts taxes in real terms, so the nominal tax liability increases as dollars fall in value.

    Diego, I don’t think the tax liability argument is affected by backward induction. The value of currency today is derived from the expectation that the government will currency in payment of tax liabilities at the next peak tax period which occurs every quarter. Avoiding a jail sentence now is worth something even if I have no assurance that I will be able to do so at some undetermined point in the future.

    The stability that I am talking about is avoiding steep appreciation which implies rapid deflation and leads to economic breakdown and very high depreciation. But this kind of instability is possible once a medium of exchange has internalized network effects so that switching costs become very high, meaning that even substantial inflation would not lead to its replacement by another medium of exchange under most circumstances. But the social costs of instability could still be very high, especially in the case of deflation.

    I agree in principle that one can conceive of an alternate medium of exchange gradually displacing an entrenched medium of exchange. But it seems totally inconceivable to me that the dollar would be displaced by bitcoins, but we shall see what happens.

    James, I agree.

    Laeeth, I chose the title of this post because it reminded me of “dialing for dollars,” an old television sow that I remember from my youth, not as a way of expressing my moral outrage over bitcoins. I also don’t think the cost of paying for a $30 transaction with a credit card account in pounds should cost you “a few pounds.” The foreign transaction fee I pay when using my credit card is 3%.

    Stability of value is not as necessary for an entrenched money, like the dollar, that has already internalized the network effects, thereby creating a huge entry to barrier to potential competing media of exchange. People are willing to continue using the existing medium of exchange, despite incurring high holding costs or enduring other inconveniences, because of the costs of switching to another medium of exchange unless everyone else is switching along with you. But switching to an unstable medium of exchange when very few other people have done so makes no sense.

    James, I think liquidity is important, but in large economies in which a single medium of exchange is already in use, there are very large barriers to switching to another medium of exchange, mostly derived from the network effects that add to the demand of the existing medium of exchange.

    Laeeth, My understanding of Fama’s argument, which was anticipated by Fischer Black actually, is that you could draw on a portfolio of assets with a fluctuating value in making transactions and you could deposit payments into that account without the intervening step of a medium of exchange. That seems to me to be a bit different from the way in which you are interpreting Fama’s contribution and I don’t see how it specifically relates to bitcoins. Again as I noted above, your argument presumes that bitcoins can retain a positive value. I agree that bitcoins have held up pretty well so far, but there is still a problem in explaining where its value comes from. To attribute the value of a medium of exchange solely to its being a medium of exchange is, to put it mildly, problematic.

    Thanks for quoting me. I am flattered that you have gone back to look up what I wrote three years ago. I am predisposed theoretically to doubt that bitcoins will become a significant monetary innovation, and I am still waiting for a good explanation of why the current price of bitcoins is not a bubble phenomenon, but I have no problem acknowledging that the recent price rise suggests that there is something going on that I don’t fully understand. Unfortunately, it’s not the only phenomenon that I am now struggling to understand.

  22. 22 kaleberg January 19, 2017 at 7:12 pm

    One thing that makes money valuable is that it is hard to counterfeit whether by its nature of being rare or by the process being banned by some government. Users have to be able to trust that an element of the currency is authentic. Currency provides this by dint of government enforcement. Gold provides this by being relatively rare and hard to synthesize. Electronic transfers between financial institutions provide this by limiting actors to a small and relatively static group.

    Bitcoin provides this by a combination of cryptography and building a chain of trusted operations as opposed to a chain of trusted actors. One of the weakness of bitcoin is its potential vulnerability to cryptographic, or more likely, other forms of technical attack. It relies on various internet protocols and a basic level of system security. I’m willing to believe it can be improved, but it is hard to see why a financial institution would be interested in it, save for convenience. Financial institutions already have a form of block chain, and it is not clear why they would want to open it to outsiders.

    Bitcoin, as currently designed, also has serious scaling problems. There is only one block chain with one root. This imposes bottlenecks that would have to be resolved if it was to be used for everyday purchases. If nothing else, the block size, which is tied to the level of computational power required, would have to be expanded if the block chain needed updating every time someone bought a soft drink from a vending machine.

    The value of money is largely based on people’s belief that it has value. I don’t think this trust is weakened just because there is a possibility that it might not be worthless at some future point. A lot of economics is built on the increased desirability of things in the present as opposed to in the future. Why else would someone offer me even a 1% per year premium on my money? They want the use of it now as opposed to then. If interest rates remain positive, all money moves towards zero value in the infinite future. A quintillion dollars in the year AD quintillion is worthless today, but that makes a single dollar no less valuable now.

    The tax argument is surprisingly powerful. Look at the Belgian Congo under King Leopold. He imposed a modest head tax on each individual in what was formerly a non-cash economy. If you didn’t pay, his government would do horrible things to you and your family, so people were forced to work in mines, on farms and elsewhere under terrible conditions. It is one of the great atrocity stories of European colonization. Even though it was perfectly possible to live in the Congo without ever owning a penny, requiring even a few pennies in tax totally changed the society and we can see its scars today.

  23. 23 oobetel January 20, 2017 at 2:53 pm

    “that theory of the worthlessness of paper money applies only to privately issued money, not to government issued money, because government issued money can be given a current value if the government accepts the paper money it issues as payment for tax liability”

    Wrong. The “theory of the worthlessness of paper money” applies to both privately and government issued money. You see, there are fundamentally no differences between the government accepting a particular currency for taxes, or merchants accepting a particular currency for payments.

    Either way the fact that someone, anyone, accepts a currency (for any reason) is what gives it value.

    That said, yes the value of the USD has a more solid foundation because the size of the economy functioning on USD (government or merchants accepting it) is larger than the size of the economy functioning on Bitcoin. But similarly Bitcoin already has a more solid foundation than the government money of smaller countries. And as the Bitcoin economy grows in size, its value-giving foundation continues to grow…

  24. 24 Rob Rawlings January 21, 2017 at 7:19 am

    Why doesn’t ‘ backward induction’ apply to commodity money too ? If gold has value for non-monetary purposes then any additional demand to hold it for monetary uses will increase its value above this non-monetary value. But if people know that one day gold will have no monetary value then shouldn’t backward induction give it a tendency to lose this additional monetary value and fall back to its non-monetary value?

  25. 25 James King January 21, 2017 at 8:13 am

    That’s a great point. I really don’t understand the fixation with gold as money. People consider it a hedge against hyperinflation but, if hyperinflation were to actually occur in the U.S. or any major economy, why would anyone care about it? My guess is that toilet paper would have far more value under those circumstances as would anything of any actual utility. I think .22 caliber bullets have a greater chance of becoming money in a hyperinflationary environment.

    Gold seems to be one of those things we do because we’ve always done it. I think gold and silver became popular as money because they were pretty easily identifiable and soft enough to be able to be practically divided into smaller denominations for exchange. None of that matters now. While both actually have intrinsic utility, from the perspective of their practical qualities, they are both extremely abundant.

    Unless it is a commodity with high intrinsic or practical value (I wrote a blog post once on why ethanol would actually be a great money), I don’t know why commodities such as gold and silver have the mystique they do. In a hyperinflation, I could think of a million things that would make better money.

  26. 26 Sven January 22, 2017 at 12:17 am

    @David Glasner:
    You wrote:
    >>Sven, Interesting point, but debt contracts are nominal so debtors would be happy to pay back their debts in debased or worthless dollars.

    The point is that given a credible central bank which will alter the amount of base money according to money demand, a setup in which debt contracts in that special currency are already assumed cannot be debased by chance. The reason is, that the debtors of the contracts will *always* be willing to pay something (like commodities, other currencies or their labor) for obtaining the currency in question, if it is only in small enough supply.

    So, what I am trying to say is: Having a currency with already assumed debt contracts + a sound working institution (like a central bank) which is in full control of the amount of base money will always ensure in itself that the currency will be of value.
    That means as long as there is at least one last unit of that currency left in circulation. Of course it can happen, that this sound central banks need to withdraw all currency units from circulation within a few years in order to ensure its value. In that case, the currency in question abolishes itself (without getting valueless!), because people don’t want to use it anymore.

    No need for a tax theory of monetary values, the above theory is sufficiant. The tax theory is however important to ensure, that the described “self-abolishment” cannot happen.

  27. 27 Lorenzo from Oz January 22, 2017 at 11:58 pm

    That there are so many ways to use the term ‘bubble’ is another reason why it is not a useful term. And I have no trouble with the notion that bitcoin is only ever going to be bit player in monetary terms.

    My biggest problem is that I don’t buy the backward induction argument. It does not matter how certain something is to happen, if the chance of it happening in any particular time period is sufficiently low, and there is no discernible change in the probability of happening between time periods, then it provides no basis for changing our behaviour. To put it another way, certainty of happening without specific probability of happening in a particular time period provides no basis for affecting action.

  28. 28 Lorenzo from Oz January 22, 2017 at 11:59 pm

    JP Koning: the Madoff case was because of fraud, so only provides an analogy if there is some equivalent information failure.

  29. 29 Ellie Kesselman January 23, 2017 at 12:26 am

    I can see some merit to Laeeth’s comments in favor of Bitcoin as a medium of exchange, for international transactions. (Even that isn’t without its downsides. Although you’ll avoid money transfer fees, there are transaction fees to convert fiat money to and from Bitcoin, e.g. when using Coinbase as digital wallet. Maintaining a digital wallet of your own is a no-fee alternative, but there are associated risks.)

    Bitcoin advocates claim that it can serve as a replacement to fiat currency, for everything, not just business or cross-currency exchange. For everyday domestic transactions, in any country with a central bank and a reasonably functional economy, fiat currency is superior to Bitcoin. Here’s why:

    1. Cash and electronic transactions of fiat money are faster than with cryptocurrency. VISA averages 2,000 transactions per second (tps) with peak capacity of 56,000 tps. PayPal averages 115 tps. The Bitcoin network can process at sustained rate of only 7 tps, due to the current Bitcoin protocol of a 1 MB block size restriction. (That introduces another serious drawback, the problem of contentious and warring factions of the Bitcoin developer community).
    2. As David Glasner said, the network effect works against Bitcoin. Fiat currency has the advantage of existing point-of-sale terminal infrastructure, ACH, ATMs etc. Bitcoin automatic teller machines were not a success, not even in Greece during Syriza’s confrontation with the ECB (troika?), as a Euro alternative.
    3. Fiat currency is trusted by the primary purchasers for households: women. It won’t be easy for Bitcoin to disrupt that.

    Frank Restly alludes to another drawback of Bitcoin. It is neither fungible nor anonymous unlike fiat cash (or gold). Bitcoin has a verifiable transaction history, which can be confirmed on the blockchain. Law enforcement and other government authorities such as the IRS could more easily prosecute illegal flight capital flows and money laundering in a blockchain-based digital currency world. I doubt that most businesses, even while operating legally, would want all their transactions to be identifiable on a public digital ledger.

  30. 30 Frank Restly January 23, 2017 at 10:50 am

    Ellie,

    “Frank Restly alludes to another drawback of Bitcoin.”

    It’s either a drawback or a feature depending on who you talk to and what you are trying to accomplish.

    If you are trying to institute a system where banks can only fund loans through the sale of equity shares, then the block chain in a digital currency becomes an important feature in ensuring that banks operate as such while still being able to borrow to fund other endeavors.

    Also, the door swings both ways. While law enforcement would be able to more easily track illicit private sector activities, a public record would provide a more transparent view of government expenditures and campaign finance.

  31. 31 Eric Dennis January 23, 2017 at 11:08 am

    David,

    Ah, but this is precisely the situation to which George Selgin’s free banking analysis applies, assuming the demand for bitcoin is dominated by the demand for it as a reserve asset. As I’m sure you know, Selgin’s theorem is that for a constant stock of reserves, adverse clearing will equilibrate banks’ note issue to stabilize demand for reserves at precisely the fixed supply of reserves that actually exists. Do you see a reason for that mechanism not to operate for bitcoin?

  32. 32 David Glasner January 23, 2017 at 6:05 pm

    Kaleberg, Thanks for your informative comment, much of which I agree with or at least seems quite persuasive to me. Here’s something that I would quibble with. You said:

    “The value of money is largely based on people’s belief that it has value. I don’t think this trust is weakened just because there is a possibility that it might not be worthless at some future point. [I am guessing that you include that “not” by mistake.] A lot of economics is built on the increased desirability of things in the present as opposed to in the future. Why else would someone offer me even a 1% per year premium on my money? They want the use of it now as opposed to then. If interest rates remain positive, all money moves towards zero value in the infinite future. A quintillion dollars in the year AD quintillion is worthless today, but that makes a single dollar no less valuable now.”

    There seems to be a lot of confusion between present value and value in the future in the last two sentences, which I won’t try to sort out. What I will say is that if the value of a money is contingent entirely on future resale, there is real bootstrap problem (which is just another name for my backward induction argument). And that gap in the logic of how a pure medium of exchange comes to have value in the first place is what the taxation argument is supposed to fill.

    oobetel, You dispute my argument that a privately produced fiat money, in theory, cannot have a positive value, but that governmentally produced fiat money can have a positive value because the government can make it acceptable for discharging tax liabilities, because private suppliers of fiat money could make their moneys acceptable in payments for their products. The difference is that governments are imposing taxes on everyone anyway. Except in a company town where a single private company employs everyone, there are no private companies that are selling enough products to make it feasible for a merchant to issue money by making that money acceptable in payment for its products. But there have been some cases in which companies that employed everyone in the town in which they had a plant did issue scrip which did function more or less as a kind of ersatz currency within the town.

    Rob, You raise an interesting point. If everyone realized that gold was going to become worthless at some date, then backward induction would in principle become worthless once it ceased to provide any real valuable services, say if all gold were turned into lead. But as long as gold provides glitter services in the present there is no reason for gold to lose its value if people continue to place a positive value on those glitter services.

    James, I don’t see why you think that hyperinflation would not be disastrous. The characteristics of the real service flow associated with a commodity money are not as important as a low cost of transportation, of storge, and relative ease of scalablity. I don’t know much about ethanol, but I can’t see carrying a barrel of ethanol to the grocery to do my weekly shopping.

    Sven, The question is whether the central bank would have to withdraw all the money it created on the first day to ensure that its value didn’t go to zero.

    Lorenzo, I understand and sympathize with your distaste for the use of “bubble.” I think that the reason I adopted it in this context was mainly to ironically turn the tables on critics of fiat money. The point about the backward induction argument is that when it works logically, then the future is telescoped back into the present. The logic is airtight and inescapable. When it doesn’t work, the challenge is to find the flaw in the logic and try to understand why the logic breaks down and under what circumstances would the logic be compelling. In the absence of such a logical and dialectic analysis, one can still identify the indeterminacy or potential instability that is lurking below the surface.

    Ellie and Frank, Given its vulnerability to detection by law enforcement, why do you think that bitcoins are as widely used in illegal transactions as they are widely assumed to be? Or do you think that that is some kind of urban legend?

    Eric, I’m sorry, but I don’t follow your point. How is stability in a banking system maintained with a fixed supply of reserves when the demand for reserves fluctuates?

  33. 33 James King January 23, 2017 at 6:54 pm

    David Glasner – “James, I don’t see why you think that hyperinflation would not be disastrous. The characteristics of the real service flow associated with a commodity money are not as important as a low cost of transportation, of storge, and relative ease of scalablity. I don’t know much about ethanol, but I can’t see carrying a barrel of ethanol to the grocery to do my weekly shopping.”

    I very much think hyperinflation, particularly of the U.S. dollar, would be disastrous. What I don’t fully get is how a commodity money, such as gold, silver, or even Bitcoin would help under those circumstances. My guess is that, in the event of the worst, the need to acquire items of high intrinsic or perceived utility will supercede any preconceptions regarding what is acceptable money. For instance, in a hyperinflationary U.S., I can see people ignoring gold or silver as money and using small caliber bullets, cigarettes, or other relatively transportable and desirable items as mediums of exchange. For hyperinflation in less developed parts of the world, no one seems to be using commodity money but instead U.S. dollars.

    My idea re: ethanol is a credit backed with ethanol. I make the case here:

    https://currencyparadox.wordpress.com/2014/09/05/better-money-in-a-bottle/?preview=true

  34. 34 Frank Restly January 23, 2017 at 8:19 pm

    David,

    “Given its vulnerability to detection by law enforcement, why do you think that bitcoins are as widely used in illegal transactions as they are widely assumed to be? Or do you think that that is some kind of urban legend?”

    I have no idea how widely bit coins are used and what they are used for – legitimate or illegal purposes. Having never used one before (bit coin) I am only speculating on the potential benefits / hazards in using them.

    I presume that you have never used them either?

  35. 35 David Glasner February 1, 2017 at 11:39 am

    James, Thanks for the clarification. If there were a collapse of the US dollar, I am guessing that people would switch to another currency already in use — a currency for which the demand has already been bolstered by network effects — rather than to some new currency or commodity.

    Frank, I guess we’re both equally clueless in other words.


  1. 1 Banking theory: a monetary theory that’s more heterodox than heterodoxy – Synthetic Assets Trackback on March 20, 2017 at 5:34 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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