Uneasy Money

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.