Archive for January, 2018

Is “a Stable Cryptocurrency” an Oxymoron?

By way of a tweet by the indefatigable and insightful Frances Coppola, I just came upon this smackdown by Preston Byrne of the recent cryptocurrency startup called the Basecoin. I actually agree with much of Byrne’s critique, and I am on record (see several earlier blogposts such as this, this, and this) in suggesting that Bitcoins are a bubble. However, despite my deep skepticism about Bitcoins and other cryptocurrencies, I have also pointed out that, at least in theory, it’s possible to imagine a scenario in which a cryptocurrency would be viable. And because Byrne makes such a powerful (but I think overstated) case against Basecoin, I want to examine his argument a bit more carefully. But before I discuss Byrne’s blogpost, some theoretical background might be useful.

One of my first posts after launching this blog was called “The Paradox of Fiat Money” in which I posed this question: how do fiat moneys retain a positive value, when the future value of any fiat money will surely fall to zero? This question is based on the backward-induction argument that is widely used in game theory and dynamic programming. If you can figure out the end state of a process, you can reason backwards and infer the values that are optimally consistent with that end state.

If the value of money must go to zero in some future time period, and the demand for money now is derived entirely from the expectation that it will retain a positive value tomorrow, so that other people will accept from you the money that you have accepted in exchange today, then the value of the fiat money should go to zero immediately, because everyone, knowing that its future value must fall to zero, will refuse to accept between now and that future time when its value must be zero. There are ways of sidestepping the logic of backward induction, but I suggested, following a diverse group of orthodox neoclassical economists, including P. H. Wicksteed, Abba Lerner, and Earl Thompson, that the value of fiat money is derived, at least in part, from the current acceptability of fiat money in discharging tax liabilities, thereby creating an ongoing current demand for fiat money.

After I raised the problem of explaining the positive value of fiat money, I began thinking about the bitcoin phenomenon which seems to present a similar paradox, and a different approach to the problem of explaining the positive value of fiat money, and of bitcoins. The alternative approach focuses on the network externality that is associated with the demand for money; the willingness of people to hold and accept a medium of exchange increases as the number of other people that are willing to accept and hold that medium of exchange. Your demand for money increases the usefulness that money has for me. But the existence of that network externality creates a certain lock-in effect, because if you and I are potential transactors with each other, your demand for a  particular money makes it more difficult for me to switch away the medium of exchange that we are both using to another one that you are not using.  So while backward induction encourages us to switch away from the fiat money that we are both using, the network externality encourages us to keep using the fiat money that we are both using. The net effect is unclear, but it suggests that an equilibrium with a positive value for a fiat money may be unstable, creating a tipping point beyond which the demand for a fiat money, and its value, may start to fall very rapidly as people all start rushing for the exit at the same time.

So the takeaway for cryptocurrencies is that even though a cryptocurrency, offering nothing to the holder of the currency but its future resale value, is inherently worthless and therefore inherently vulnerable to a relentless and irreversible loss of value once that loss of value is generally anticipated, if the cryptocurrency can somehow attract sufficient initial acceptance as a medium of exchange, the inevitable loss of value can at least be delayed, allowing the cryptocurrency to gain acceptance, through a growing core of transactors offering and accepting it as payment. For this to happen, the cryptocurrency must provide some real advantage to its core transactors not otherwise available to them when transacting with other currencies.

The difficulty of attracting transactors who will use the cryptocurrency is greatly compounded if the value of the cryptocurrency rapidly appreciates in value. It may seem paradoxical that a rapid increase in the value of an asset – or more precisely the expectation of a rapid increase in the value of an asset – detracts from its suitability as a medium of exchange, but an expectation of rapid appreciation tends to drive any asset already being used as a currency out of circulation. That tendency is a long-and-widely recognized phenomenon, which even has both a name and a pithy epigram attached to it: “Gresham’s Law” and “bad money drives out the good.”

The phenomenon has been observed for centuries, typically occurring when two moneys with equal face value circulate concurrently, but with one money having more valuable material content than the other. For example, if a coinage consists of both full-bodied and clipped coins with equal face value, people hoard the more valuable full-bodied coins, offering only the clipped coins in exchange. Similarly, if some denominations of the same currency are gold coins and others are silver coins, so that the relative values of the coins are legally fixed, a substantial shift in the relative market values of silver and gold causes the relatively undervalued (good) coins to be hoarded, disappearing from circulation, leaving only the relatively overvalued (bad) coins in circulation. I note in passing that a fixed exchange rate between the two currencies is not, as has often been suggested, necessary for Gresham’s Law to operate when the rate of appreciation of one of the currencies is sufficiently fast.

So if I have a choice of exchanging dollars with a stable or even falling value to obtain the goods and services that I desire, why would I instead use an appreciating asset to buy those goods and services? Insofar as people are buying bitcoins now in expectation of future appreciation, they are not going be turning around to buy stuff with bitcoins when they could just as easily pay with dollars. The bitcoin bubble is therefore necessarily self-destructive. Demand is being fueled by the expectation of further appreciation, but the only service that a bitcoin offers is acceptability in exchange when making transactions — one transaction at any rate: being sold for dollars — while the expectation of appreciation is precisely what discourages people from using bitcoins to buy anything. Why then are bitcoins appreciating? That is the antimony that renders the widespread acceptance of bitcoins as a medium of exchange inconceivable.

Promoters of bitcoins extol the blockchain technology that makes trading with bitcoins anonymous and secure. My understanding of the blockchain technology is completely superficial, but there are recurring reports of hacking into bitcoin accounts and fraudulent transactions, creating doubts about the purported security and anonymity of bitcoins. Moreover, the decentralized character of bitcoin transactions slows down and increases the cost of executing a transaction with Bitcoin.

But let us stipulate for discussion purposes that Bitcoins do provide enhanced security and anonymity in performing transactions that more than compensate for the added costs of transacting with Bitcoins or other blockchain-based currencies, at least for some transactions. We all know which kinds of transactions require anonymity, and they are only a small subset of all the transactions carried out. So the number of transactions for which Bitcoins or blockchain-based cryptocurrencies might be preferred by transactors can’t be a very large fraction of the total number of transactions mediated by conventional currencies. But one could at least make a plausible argument that a niche market for a medium of exchange designed for secure anonymous transactions might be large enough to make a completely secure and anonymous medium of exchange viable. But we know that the Bitcoin will never be that alternative medium of exchange.

Understanding the fatal internal contradiction inherent in the Bitcoin, creators of cryptocurrency called Basecoin claim to have designed a cyptocurrency that will, or at any rate is supposed to, maintain a stable value even while profits accrue to investors from the anticipated increase in the demand for Basecoins. Other cryptocurrencies like Tether and Dai also purport to provide a stable value in terms of dollars, though the mechanism by which this is accomplished has not been made transparent, as promoters of Basecoins promise to do. But here’s the problem: for a new currency, whose value its promoters promise to stabilize, to generate profits to its backers from an increasing demand for that currency, the new currency units issued as demand increases must be created at a cost well below the value at which the currency is to be stabilized.

Because new Bitcoins are so costly to create, the quantity of Bitcoins can’t be increased sufficiently to prevent Bitcoins from appreciating as the demand for Bitcoins increases. The very increase in demand for Bitcoins is what renders it unsuitable to serve as a medium of exchange. So if the value of Basecoins substantially exceeds the cost of producing Basecoins, what prevents the value of Basecoins from falling to the cost of creating new Basecoins, or at least what keeps the market from anticipating that the value of Basecoins will fall to to the cost of producing new Basecoins?

To address this problem, designers of the Basecoin have created a computer protocol that is supposed to increase or decrease the quantity of Basecoins according as the value of Basecoins either exceeds, or falls short of, its target exchange value of $1 per Basecoin.  As an aside, let me just observe that even if we stipulate that the protocol would operate to stabilize the value of Basecoins at $1, there is still a problem in assuring traders that the protocol will be followed in practice. So it would seem necessary to make the protocol code publicly accessible so that potential investors backing Basecoin and holders of Basecoin could ascertain that the protocol would indeed operate as represented by Basecoin designers. So what might be needed is a WikiBasecoin.

But what I am interested in exploring here is whether the Basecoin protocol or some other similar protocol could actually work as asserted by the Basecoin White Paper. In an interesting blog post, Preston Byrne has argued that such a protocol cannot possibly work

Basecoin claims to solve the problem of wildly fluctuating cryptocurrency prices through the issuance of a cryptocurrency for which “tokens can be robustly pegged to arbitrary assets or baskets of goods while remaining completely decentralized.” This is achieved, the paper states in its abstract, by the fact that “1 Basecoin can be pegged to always trade for 1 USD. In the future, Basecoin could potentially even eclipse the dollar and be updated to a peg to the CPI or basket of goods. . . .”

Basecoin claims that it can “algorithmically adjust…the supply of Basecoin tokens in response to changes in, for example, the Basecoin-USD exchange rate… implementing a monetary policy similar to that executed by central banks around the world”.

Two points.

First, this is not how central banks manage the money supply. . . .

But of course, Basecoin isn’t actually creating a monetary supply, which central banks will into existence and then use to buy assets, primarily debt securities. Basecoin works by creating an investable asset which the “central bank” (i.e. the algorithm, because it’s nothing like a central bank) issues to holders of the tokens which those token holders then sell to new entrants into the scheme.

Buying assets to create money vs. selling assets to obtain money. There’s a big difference.

Byrne, of course, is correct that there is a big difference between the buying of assets to create money and the selling of assets to obtain money by promoters of a cryptocurrency. But the assets being sold to create money are created by the promoters of the money-issuing concern to accumulate the working capital that the promoters are planning to use in creating their currency, so the comparison between buying assets to create money and selling assets to obtain money is not exactly on point.

What Byrne is missing is that the central bank can take the demand for its currency as more or less given, a kind of economic fact of nature, though the exact explanation of that fact remains disturbingly elusive. The goal of a cryptocurrency promoter, however, is to create a demand for its currency that doesn’t already exist. That is above all a marketing and PR challenge. (Actually, a challenge that has been rather successfully met, though for Bitcoins at any rate the operational challenge of creating a viable currency to meet the newly created demand seems logically impossible.)

Second,

We need to talk about how a peg does and doesn’t work. . . .

Currently there are very efficient ways to peg the price of something to something else, let’s say (to keep it simple) $1. The first of these would be to execute a trust deed (cost: $0) saying that some entity, e.g. a bank, holds a set sum of money, say $1 billion, on trust absolutely for the holders of a token, which let’s call Dollarcoin for present purposes. If the token is redeemable at par from that bank (qua Trustee and not as depository), then the token ought to trade at close to $1, with perhaps a slight discount depending on the insolvency risk to which a Dollarcoin holder is exposed (although there are well-worn methods to keep the underlying dollars insolvency-remote, i.e. insulated from the risk of a collapse of that bank).

Put another way, there is a way to turn 1 dollarcoin into a $1 here [sic]. Easy-peasy, no questions asked, with ancient technology like paper and pens or SQL tables. The downside of course is that you need to 100% cash collateralize the system, which is (from a cost of capital perspective) rather expensive. This is the reason why fractional reserve banking exists.

The mistake here is that 100% cash collateralization is not required for convertibility and parity. Under the gold-standard, the convertibility of various national currencies into gold at fixed parities was maintained with far less than 100% gold cover against those currencies, and commercial banks and money-market funds routinely maintain the convertibility of deposits into currency at one-to-one parities with far less than 100% currency reserves against deposits. Sometimes convertibility in such systems breaks down temporarily, but such breakdowns are neither necessary nor inevitable, though they may sometimes, given the alternatives, be the best available option. I understand that banks undertake a legal obligation to convert deposits into currency at a one-to-one rate, but such a legal obligation is not the only possible legal rule under which banks could operate. The Bank of England during the legal restriction of convertibility of its Banknotes into gold from 1797 to 1819, was operating without any legal obligation to convert its Banknotes into gold, though it was widely expected at some future date convertibility would be resumed.

While I am completely sympathetic to Byrne’s skepticism about the viability of cryptocurrencies, even cryptocurrencies with some kind of formal or informal peg with respect to an actual currency like the dollar, he seems to think that because there are circumstances under which the currencies will fail, he has shown that it is impossible for the currencies ever to succeed. I believe that it would be a stretch for a currency like the Basecoin to be successful, but one can at least imagine a set of circumstances under which, in contrast to the Bitcoin, the Basecoin could be successful, though even under the rosiest possible scenario I can’t imagine how the Basecoin or any other cryptocurrency could displace the dollar as the world’s dominant currency. To be sure, success of the Basecoin or some other “stabililzed” cryptocurrency is a long-shot, but success is not logically self-contradictory. Sometimes a prophecy, however improbable, can be self-fulfilling.

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Milton Friedman and the Phillips Curve

In December 1967, Milton Friedman delivered his Presidential Address to the American Economic Association in Washington DC. In those days the AEA met in the week between Christmas and New Years, in contrast to the more recent practice of holding the convention in the week after New Years. That’s why the anniversary of Friedman’s 1967 address was celebrated at the 2018 AEA convention. A special session was dedicated to commemoration of that famous address, published in the March 1968 American Economic Review, and fittingly one of the papers at the session as presented by the outgoing AEA president Olivier Blanchard, who also wrote one of the papers discussed at the session. Other papers were written by Thomas Sargent and Robert Hall, and by Greg Mankiw and Ricardo Reis. The papers were discussed by Lawrence Summers, Eric Nakamura, and Stanley Fischer. An all-star cast.

Maybe in a future post, I will comment on the papers presented in the Friedman session, but in this post I want to discuss a point that has been generally overlooked, not only in the three “golden” anniversary papers on Friedman and the Phillips Curve, but, as best as I can recall, in all the commentaries I’ve seen about Friedman and the Phillips Curve. The key point to understand about Friedman’s address is that his argument was basically an extension of the idea of monetary neutrality, which says that the real equilibrium of an economy corresponds to a set of relative prices that allows all agents simultaneously to execute their optimal desired purchases and sales conditioned on those relative prices. So it is only relative prices, not absolute prices, that matter. Taking an economy in equilibrium, if you were suddenly to double all prices, relative prices remaining unchanged, the equilibrium would be preserved and the economy would proceed exactly – and optimally – as before as if nothing had changed. (There are some complications about what is happening to the quantity of money in this thought experiment that I am skipping over.) On the other hand, if you change just a single price, not only would the market in which that price is determined be disequilibrated, at least one, and potentially more than one, other market would be disequilibrated. The point here is that the real economy rules, and equilibrium in the real economy depends on relative, not absolute, prices.

What Friedman did was to argue that if money is neutral with respect to changes in the price level, it should also be neutral with respect to changes in the rate of inflation. The idea that you can wring some extra output and employment out of the economy just by choosing to increase the rate of inflation goes against the grain of two basic principles: (1) monetary neutrality (i.e., the real equilibrium of the economy is determined solely by real factors) and (2) Friedman’s famous non-existence (of a free lunch) theorem. In other words, you can’t make the economy as a whole better off just by printing money.

Or can you?

Actually you can, and Friedman himself understood that you can, but he argued that the possibility of making the economy as a whole better of (in the sense of increasing total output and employment) depends crucially on whether inflation is expected or unexpected. Only if inflation is not expected does it serve to increase output and employment. If inflation is correctly expected, the neutrality principle reasserts itself so that output and employment are no different from what they would have been had prices not changed.

What that means is that policy makers (monetary authorities) can cause output and employment to increase by inflating the currency, as implied by the downward-sloping Phillips Curve, but that simply reflects that actual inflation exceeds expected inflation. And, sure, the monetary authorities can always surprise the public by raising the rate of inflation above the rate expected by the public , but that doesn’t mean that the public can be perpetually fooled by a monetary authority determined to keep inflation higher than expected. If that is the strategy of the monetary authorities, it will lead, sooner or later, to a very unpleasant outcome.

So, in any time period – the length of the time period corresponding to the time during which expectations are given – the short-run Phillips Curve for that time period is downward-sloping. But given the futility of perpetually delivering higher than expected inflation, the long-run Phillips Curve from the point of view of the monetary authorities trying to devise a sustainable policy must be essentially vertical.

Two quick parenthetical remarks. Friedman’s argument was far from original. Many critics of Keynesian policies had made similar arguments; the names Hayek, Haberler, Mises and Viner come immediately to mind, but the list could easily be lengthened. But the earliest version of the argument of which I am aware is Hayek’s 1934 reply in Econometrica to a discussion of Prices and Production by Alvin Hansen and Herbert Tout in their 1933 article reviewing recent business-cycle literature in Econometrica in which they criticized Hayek’s assertion that a monetary expansion that financed investment spending in excess of voluntary savings would be unsustainable. They pointed out that there was nothing to prevent the monetary authority from continuing to create money, thereby continually financing investment in excess of voluntary savings. Hayek’s reply was that a permanent constant rate of monetary expansion would not suffice to permanently finance investment in excess of savings, because once that monetary expansion was expected, prices would adjust so that in real terms the constant flow of monetary expansion would correspond to the same amount of investment that had been undertaken prior to the first and unexpected round of monetary expansion. To maintain a rate of investment permanently in excess of voluntary savings would require progressively increasing rates of monetary expansion over and above the expected rate of monetary expansion, which would sooner or later prove unsustainable. The gist of the argument, more than three decades before Friedman’s 1967 Presidential address, was exactly the same as Friedman’s.

A further aside. But what Hayek failed to see in making this argument was that, in so doing, he was refuting his own argument in Prices and Production that only a constant rate of total expenditure and total income is consistent with maintenance of a real equilibrium in which voluntary saving and planned investment are equal. Obviously, any rate of monetary expansion, if correctly foreseen, would be consistent with a real equilibrium with saving equal to investment.

My second remark is to note the ambiguous meaning of the short-run Phillips Curve relationship. The underlying causal relationship reflected in the negative correlation between inflation and unemployment can be understood either as increases in inflation causing unemployment to go down, or as increases in unemployment causing inflation to go down. Undoubtedly the causality runs in both directions, but subtle differences in the understanding of the causal mechanism can lead to very different policy implications. Usually the Keynesian understanding of the causality is that it runs from unemployment to inflation, while a more monetarist understanding treats inflation as a policy instrument that determines (with expected inflation treated as a parameter) at least directionally the short-run change in the rate of unemployment.

Now here is the main point that I want to make in this post. The standard interpretation of the Friedman argument is that since attempts to increase output and employment by monetary expansion are futile, the best policy for a monetary authority to pursue is a stable and predictable one that keeps the economy at or near the optimal long-run growth path that is determined by real – not monetary – factors. Thus, the best policy is to find a clear and predictable rule for how the monetary authority will behave, so that monetary mismanagement doesn’t inadvertently become a destabilizing force causing the economy to deviate from its optimal growth path. In the 50 years since Friedman’s address, this message has been taken to heart by monetary economists and monetary authorities, leading to a broad consensus in favor of inflation targeting with the target now almost always set at 2% annual inflation. (I leave aside for now the tricky question of what a clear and predictable monetary rule would look like.)

But this interpretation, clearly the one that Friedman himself drew from his argument, doesn’t actually follow from the argument that monetary expansion can’t affect the long-run equilibrium growth path of an economy. The monetary neutrality argument, being a pure comparative-statics exercise, assumes that an economy, starting from a position of equilibrium, is subjected to a parametric change (either in the quantity of money or in the price level) and then asks what will the new equilibrium of the economy look like? The answer is: it will look exactly like the prior equilibrium, except that the price level will be twice as high with twice as much money as previously, but with relative prices unchanged. The same sort of reasoning, with appropriate adjustments, can show that changing the expected rate of inflation will have no effect on the real equilibrium of the economy, with only the rate of inflation and the rate of monetary expansion affected.

This comparative-statics exercise teaches us something, but not as much as Friedman and his followers thought. True, you can’t get more out of the economy – at least not for very long – than its real equilibrium will generate. But what if the economy is not operating at its real equilibrium? Even Friedman didn’t believe that the economy always operates at its real equilibrium. Just read his Monetary History of the United States. Real-business cycle theorists do believe that the economy always operates at its real equilibrium, but they, unlike Friedman, think monetary policy is useless, so we can forget about them — at least for purposes of this discussion. So if we have reason to think that the economy is falling short of its real equilibrium, as almost all of us believe that it sometimes does, why should we assume that monetary policy might not nudge the economy in the direction of its real equilibrium?

The answer to that question is not so obvious, but one answer might be that if you use monetary policy to move the economy toward its real equilibrium, you might make mistakes sometimes and overshoot the real equilibrium and then bad stuff would happen and inflation would run out of control, and confidence in the currency would be shattered, and you would find yourself in a re-run of the horrible 1970s. I get that argument, and it is not totally without merit, but I wouldn’t characterize it as overly compelling. On a list of compelling arguments, I would put it just above, or possibly just below, the domino theory on the basis of which the US fought the Vietnam War.

But even if the argument is not overly compelling, it should not be dismissed entirely, so here is a way of taking it into account. Just for fun, I will call it a Taylor Rule for the Inflation Target (IT). Let us assume that the long-run inflation target is 2% and let us say that (YY*) is the output gap between current real GDP and potential GDP (i.e., the GDP corresponding to the real equilibrium of the economy). We could then define the following Taylor Rule for the inflation target:

IT = α(2%) + β((YY*)/ Y*).

This equation says that the inflation target in any period would be a linear combination of the default Inflation Target of 2% times an adjustment coefficient α designed to keep successively chosen Inflation targets from deviating from the long-term price-level-path corresponding to 2% annual inflation and some fraction β of the output gap expressed as a percentage of potential GDP. Thus, for example, if the output gap was -0.5% and β was 0.5, the short-term Inflation Target would be raised to 4.5% if α were 1.

However, if on average output gaps are expected to be negative, then α would have to be chosen to be less than 1 in order for the actual time path of the price level to revert back to a target price-level corresponding to a 2% annual rate.

Such a procedure would fit well with the current dual inflation and employment mandate of the Federal Reserve. The long-term price level path would correspond to the price-stability mandate, while the adjustable short-term choice of the IT would correspond to and promote the goal of maximum employment by raising the inflation target when unemployment was high as a countercyclical policy for promoting recovery. But short-term changes in the IT would not be allowed to cause a long-term deviation of the price level from its target path. The dual mandate would ensure that relatively higher inflation in periods of high unemployment would be compensated for by periods of relatively low inflation in periods of low unemployment.

Alternatively, you could just target nominal GDP at a rate consistent with a long-run average 2% inflation target for the price level, with the target for nominal GDP adjusted over time as needed to ensure that the 2% average inflation target for the price level was also maintained.


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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