Archive for the 'bitcoins' Category

Bitcoin Doesn’t Rule

Published December 16, 2020 bitcoins , fiat money , network effects 4 Comments
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Look out, bitcoin’s back. After the first bitcoin bubble burst almost exactly three years ago on December 15, 2017, when bitcoin hit its previous all-time high of over $19,600, bitcoin lost more than 80% its value, falling to less than $3200 on December 14, 2018. It gradually recovered, more than doubling its value (to over $7000) by December 13, 2019 and reached a new all-time high today at $20,872.

Bitcoin’s remarkable recovery is again sparking senseless talk by its more extreme promoters that it  will soon transform the world monetary system leading the collapse of fiat currencies and a flight to bitcoin to escape the hyperinflationary collapse of worthless unbacked fiat currencies. This is nonsense, as I have explained at length in a number of previous posts (e.g., here, here, and here) at even greater length in a forthcoming paper, a draft of which is available here.

In this post, I offer a summary of my argument about why bitcoin, despite its success as a speculative asset, is intrinsically unsuited to be a widely used medium of exchange, let alone a dominant currency. Indeed, success as a speculative asset is precisely what disqualifies it as anything more than a niche medium of exchange.

By a “medium of exchange,” I mean a good or instrument readily accepted in exchange by agents even if they don’t value the non-monetary services provided by that good or instrument in the expectation that other agents will be accepted in exchange at a reasonably predictable value close to its current value. After a good begins to function as a medium of exchange, its value may rise above the value it would have had if it were demanded only for the real services it provides, but arbitrage ensures that the value of a medium of exchange will be equalized in all uses, monetary or and real, so the expected value of a medium of exchange will not vary as a result of the intended use for which it is acquired.

By a “pure medium of exchange” I mean a good or instrument providing no non-monetary services and therefore demanded solely on account of its expected future resale value. The analysis of the value of a pure medium of exchange seems to hinge on three different factors affecting its expected future resale value: (1) backward induction, (2) tax liability, and (3) network effects.

Backward induction refers to the influence of a predictable future state on the present. If agents all foresee a future event that influence of that future event, however distant, must rebound backward towards the present. Thus, the certainty that a pure medium of exchange must lose its value once no one is willing to accept in exchange, its predictable loss of value must deprive it of value immediately, because no one will want to be the last person to accept it.

Backward induction is used routinely in formal exchange and game-theoretic models, but its relevance is often disputed when the certainty and the timing of the last period is unclear. In that environment, people seem more willing to assume that there will always be someone else around who will accept the medium of exchange at a positive value. Even so, backward induction at least suggests that the value of any pure medium of exchange is sensitive to expectational shocks, making a pure medium of exchange a potentially unstable pillar of an economic system.

Tax liability refers to the acceptability of a medium of exchange to discharge tax liabilities to the government. Acceptability to discharge a stream of future tax liabilities imposed by the government can maintain a positive value for a pure medium of exchange even if the backward induction argument is otherwise compelling. However, acceptability to discharge tax payments is routinely extended to government issued, or government sanctioned, fiat currencies but never to privately issued cryptocurrencies.

Network effects result from the property of some goods that their usefulness is contingent on and enhanced by the extent to which the good is used by other people. Think of the difference between a refrigerator and a telephone. Clearly, the desirability of and the demand for a medium of exchange increases with the number of other people using that medium of exchange. Additionally, as more people use any given medium of exchange, the cost to any individual user of switching to another medium of exchange than that used by the network of users of which that user is a part increases.

Network effects are important for many reasons, but for purposes of this discussion, network effects are particularly important because they provide another explanation than the tax-liability argument for why backward induction need not drive the value of a pure medium of exchange to zero. If a new medium of exchange provides some exchange service superior to, or not provided at all by, the service provided by the existing, more widely used, medium of exchange, and it attracts even a small network of users that take advantage of that service, a demand for the continued use of the alternative medium of exchange may be created. If the switching cost associated with adopting another medium of exchange and foregoing the unique service provided by the new medium of exchange is sufficiently high, current users of the new medium of exchange may persist in use of the new medium of exchange despite its predictable future loss of value.

Thus, even though it provides no current real services, and even though its current value is drawn entirely from its expected future value, bitcoin may have succeeded in providing a niche medium of exchange service for transactions in which one or both parties have a strong desire or need for anonymity. The underlying blockchain technology is thought to provide such assurance to those transacting with bitcoins. At least for now, this niche service seems to serve a small network of users better than any available alternative, and the current costs of switching to an alternative medium of exchange providing similar assurance of anonymity may be prohibitive. That network effect, combined with high switching cost, may be sufficient to prevent backward induction from driving the value of bitcoins down to zero, as might otherwise seem likely.

While this argument suggests that bitcoin will not soon disappear, the hopes of its promoters and supporters for continued appreciation to result in the collapse of fiat currencies and their replacement by bitcoin and possibly other cryptocurrencies seem destined for disappointment. Expectations of rapid appreciation do not attract new uses into the network of users of a medium of exchange. On the contrary, as implicitly recognized by the familiar proposition (now known as Gresham’s Law) that bad money drives out the good, the expectation of rapid appreciation deters, rather than attracts, traders from using the appreciating (good) money in exchange, encouraging instead the use of the alternative (bad) money whose value is expected to be comparatively stable. Centuries, if not millenia, of monetary experience have demonstrated the wisdom of this proposition over and over again.

The very success of bitcoin as a speculative asset turns out to be the kiss of death for its chances of ever displacing the dollar as the dominant currency in the world.

My Paper “Fiat Money, Cryptocurrencies and the Pure Theory of Money” is now available on SSRN

Published November 2, 2020 bitcoins , cryptocurrency , fiat money , network effects 1 Comment
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I have just posted a draft of a paper that will appear in a forthcoming volume, Edward Elgar Handbook of Blockchain and Cryptocurrencies. The paper draws on a number of my earlier posts on fiat currencies, bitcoins and cryptocurrencies, such as this, this, this and this.

Here is the abstract of my paper.

This paper attempts to account for the rising value of cryptocurrencies using basic concepts of monetary theory. A positive value of fiat money is itself problematic inasmuch as that value apparently depends entirely on its expected resale value. A current value entirely dependent on expected future resale value seems inconsistent with backward induction. While fiat money can avoid the backward-induction problem if it is made acceptable in payment of taxes, acceptability for tax payments is unavailable to cryptocurrencies. Is the rising value of bitcoin and other cryptocurrencies a bubble? The paper argues that network effects may be an alternative mechanism for avoiding the logic of backward induction. Because users of any good subject to substantial network effects incur costs by switching to an incompatible alternative to the good currently used, users of a bitcoin for certain transactions may be locked into continued use of bitcoin despite an expectation that its future value will eventually go to zero. Thus, even if bitcoin and other cryptocurrencies are bubble phenomena, network effects may lock existing users of bitcoin into continued use of bitcoin for those transactions for which bitcoins provide superior transactional services to those provided by conventional currencies. Nevertheless, the prospects for bitcoin’s expansion beyond its current niche uses are dim, because its architecture implies that a significant expansion in the demand for its transactional services would lead to rapid appreciation that is incompatible with service as a medium of exchange.

Noah Smith on Bitcoins: A Failure with a Golden Future

Published February 1, 2018 bitcoins , cryptocurrency , Noah Smith 21 Comments

Noah Smith and I agree that, as I argued in my previous post, Bitcoins have no chance of becoming a successful money, much less replacing or displacing the dollar as the most important and widely used money in the world. In a post on Bloomberg yesterday, Noah explains why Bitcoins are nearly useless as money, reiterating a number of the points I made and adding some others of his own. However, I think that Bitcoins must sooner or later become worthless, while Noah thinks that Bitcoins, like gold, can be a worthwhile investment for those who think that it is fiat money that is going to become worthless. Here’s how Noah puts it.

So cryptocurrencies won’t be actual currencies, except for drug dealers and other people who can’t use normal forms of payment. But will they be good financial investments? Some won’t — some will be scams, and many will simply fall into disuse and be forgotten. But some may remain good investments, and even go up in price over many decades.

A similar phenomenon has already happened: gold. Legendary investor Warren Buffett once ridiculed gold for being an unproductive asset, but the price of the yellow metal has climbed over time:

Why has gold increased in price? One reason is that it’s not quite useless — people use gold for jewelry and some industrial applications, so the metal slowly goes out of circulation, increasing its scarcity.

And another reason is that central banks now own more than 17% of all the gold in the world. In the 1980s and 1990s, when the value of gold was steadily dropping to as little as $250 an ounce, central banks were selling off their unproductive gold stocks, until they realized that, in selling off their gold stocks, they were driving down the value of all the gold sitting in their vaults. Once they figured out what they were doing, they agreed among themselves that they would start buying gold instead of selling it. And in the early years of this century, gold prices started to rebound.

But another reason is that people simply believe in gold. In the end, the price of an asset is what people believe it’s worth.

Yes, but it sure does help when there are large central banks out there buying unwanted gold, and piling it up in vaults where no one else can do anything with it.

Many people believe that fiat currencies will eventually collapse, and that gold will reemerge as the global currency.

And it’s the large central banks that issue the principal fiat currencies whose immense holdings of gold reserves that keep the price of gold from collapsing.

That narrative has survived over many decades, and the rise of Bitcoin as an alternative hasn’t killed it yet. Maybe there’s a deeply embedded collective memory of the Middle Ages, when governments around the world were so unstable that gold and other precious metals were widely used to make payments.

In the Middle Ages, the idea of, and the technology for creating, fiat money had not yet been invented, though coin debasement was widely practiced. It took centuries before a workable system for controlling fiat money was developed.

Gold bugs, as advocates of gold as an investment are commonly known, may simply be hedging against the perceived possibility that the world will enter a new medieval period.

How ill-mannered of them not to thank central banks for preventing the value of gold from collapsing.

Similarly, Bitcoin or other cryptocurrencies may never go to zero, even if no one ends up using them for anything. They represent a belief in the theory that fiat money is doomed, and a hedge against the possibility that fiat-based payments systems will one day collapse. When looking for a cryptocurrency to invest in, it might be useful to think not about which is the best payments system, but which represents the most enduring expression of skepticism about fiat money itself.

The problem with cryptocurrencies is that there is no reason to think that central banks will start amassing huge stockpiles of cryptocurrencies, thereby ensuring that the demand for cryptocurrencies will always be sufficient to keep their value at or above whatever level the central banks are comfortable with.

It just seems odd to me that some people want to invest in Bitcoins, which provide no present or future real services, and almost no present or future monetary services, in the belief that it is fiat money, which clearly does provide present and future monetary services, and provides the non-trivial additional benefit of enabling one to discharge tax liabilities to the government, is going to become worthless sometime in the future.

If your bet that Bitcoins are going to become valuable depends on the forecast that dollars will become worthless, you probably need to rethink your investment strategy.

Is “a Stable Cryptocurrency” an Oxymoron?

Published January 25, 2018 bitcoins , cryptocurrency 16 Comments
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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.

Further Thoughts on Bitcoins, Fiat Moneys, and Network Effects

Published January 22, 2017 bitcoins , fiat money , network effects , William Luther 28 Comments

In a couple of tweets to me and J. P. Koning, William Luther pointed out, I think correctly, that the validity of the backward-induction argument in my previous post explaining why bitcoins, or any fiat currency not made acceptable for discharging tax obligations, cannot retain a positive value requires that there be a terminal date after which bitcoins or fiat currency will no longer be accepted in exchange be known with certainty.

 

But if the terminal date is unknown, the backward-induction argument doesn’t work, because everyone (or at least a sufficient number of people) may assume that there will always be someone else willing to accept their soon-to-be worthless holdings of fiat money in exchange for something valuable. Thus, without a certain terminal date, it is not logically necessary for the value of fiat money to fall to zero immediately, even though everyone realizes that,  at some undetermined future time, its value will fall to zero.

In short, the point is that if enough people think that they will be able to unload their holdings of a fundamentally worthless asset on someone more foolish than they are, a pyramid scheme need not collapse quickly, but may operate successfully for a long time. Uncertainty about the terminal date gives people an incentive to gamble on when the moment of truth will arrive. As long as enough people are willing to take the gamble, the pyramid won’t collapse, even if those people know that it sooner or later it will collapse.

Robert Louis Stevenson described the theory quite nicely in a short story, “The Bottle Imp,” which has inspired a philosophic literature concerning the backward induction argument that is known as the “bottle imp paradox,” (further references in the linked wikipedia entry) and the related related “unexpected hanging paradox,” and the “greater fool theory.”

Although Luther’s point is well-taken, it’s not clear to me that, at least on an informal level, my argument about fiat money is without relevance. Even though a zero value for fiat money is logically necessary, a positive value is not assured. The value of fiat money is indeterminate, and the risk of a collapse of value or a hyperinflation is, would indeed be a constant risk for a pure fiat money if there were no other factors, e.g., acceptability for discharging tax liabilities, operating else to support a positive value. Even if a positive value were maintained for a time, a collapse of value could occur quite suddenly; there could well be a tipping point at which a critical mass of people expecting the value to fall to zero could overwhelm the optimism of those expecting the value to remain remain positive causing a convergence of self-fulfilling expectations of a zero value.

But this is where network effects come into the picture to play a stabilizing role. If network effects are very strong, which they certainly are for a medium of exchange in any advanced market economy, there is a powerful lock-in for most people, because almost all transactions taking place in the economy are carried out by way of a direct or indirect transfer of the medium of exchange. Recontracting in terms of an alternative medium of exchange is not only costly for each individual, but would require an unraveling of the existing infrastructure for carrying out these transactions with little chance of replacing it with a new medium-of-exchange-network infrastructure.

Once transactors have been locked in to the existing medium-of-exchange-network infrastructure, the costs of abandoning the existing medium of exchange may be prohibitive, thereby preventing a switch from the existing medium of exchange, even though people realize that there is a high probability that the medium of exchange will eventually lose its value, the costs to each individual of opting out of the medium-of-exchange network being prohibitive as would be the transactions costs of arriving at a voluntary collective shift to some new medium of exchange.

However, it is possible that small countries whose economies are highly integrated with the economies of neighboring countries, are in a better position to switch from to an alternative currency if the likelihood that the currently used medium of exchange will become worthless increases. So the chances of seeing a sudden collapse of an existing medium of exchange are greater in small open economies than in large, relatively self-contained, economies.

Based on the above reasoning suggests the following preliminary conjecture: the probability that a fiat currency that is not acceptable for discharging tax liabilities could retain a positive value would depend on two factors: a) the strength of network effects, and b) the proportion of users of the existing medium of exchange that have occasion to use an alternative medium of exchange in carrying out their routine transactions.

Shilling for Bitcoins

Published January 17, 2017 bitcoins , fiat money 38 Comments
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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.

Talk about Sound Money: Heckuva Job, Bitcoin

Published November 10, 2015 bitcoins 7 Comments
Tags: ,

One of the buzzwords of assorted right-wing libertarians and conservatives is sound money. What’s interesting about their advocacy of “sound money” is that they typically identify “sound money” with restoring gold standard, or, more edgily, adoption of some new privately created currency like the bitcoin.

The past couple of months have seen a rapid run-up in the value of bitcoins which, after shooting up to over $1000 in 2014, had fallen back to the $200-300 range where it had been wallowing until for some reason it recently started a steady rise until shooting up to over $400 last week.

So I was interested in reading Dan McCrum’s piece in the Financial Times the other day in which he compared bitcoins to a pyramid scheme, providing a lot of historical background on similar schemes going back to General Gregor MacGregor in 1821. McCrum also points out an inherent flaw in the bitcoin which is that the very feature that is supposed to ensure its stability — the absolute limit on the total number of bitcoins — will ultimately cause its failure.

The inherent flaw of pyramid schemes is that they must always suck in new converts to avoid collapse, and the exponential growth in users is impossible to sustain. Bitcoin shares some of these features. It requires constant evangelism because its value derives from its use.

The limited supply of bitcoins then becomes a fatal constraint. The more people use it, the greater the price must rise, dissuading its use as a currency.

Of course, after each run-up in the value of the bitcoin, a reaction sets in, people then shifting away from bitcoins as a medium of exchange, causing its value to drop, so the bitcoin is naturally beset by sharp swings in its value – just what you want from sound money. Yeah, right. So, after a price increase of over 60% in less than a month, bitcoins have lost 20% of their value in a week. Have a look:

coindesk-bpi-chart-1

Doesn’t get much sounder than that.

I especially liked this quotation from Walter Bagehot provided by McCrum:

One thing is certain, that at a particular time a great deal of stupid people have a great deal of stupid money.

Bitcoins Are Tanking Today

Published January 14, 2015 bitcoins 6 Comments
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Bitcoins opened today at $226.04. As I write this, they are now trading at about $178. So they have lost about 25% of their value today, and its only 1PM EST.

Here’s a chart of what’s happened today.

coindesk-bpi-chart

Over the last month, bitcoins have lost nearly half their value. Bitcoins were trading at about $350 on December 15.

Here’s a chart of what’s happened over the last month.

coindesk-bpi-chart-1Last April, I wrote a post asking why bitcoins aren’t a bubble. Some people, including me, didn’t take that post too seriously, but I still don’t understand why bitcoins are worth anything. I seem to have more company now.

PS I have been spending a lot of time over the last 10 days thinking about the 1920-21 depression. I hope to post something later today or tomorrow on that topic.

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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