Archive for the 'fiat money' 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.

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.

Neo-Fisherism and All That

Published July 24, 2015 expectations , fiat money , John Cochrane , Michael Woodford , Neo-Fisherism , Nick Rowe 64 Comments
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A few weeks ago Michael Woodford and his Columbia colleague Mariana Garcia-Schmidt made an initial response to the Neo-Fisherian argument advanced by, among others, John Cochrane and Stephen Williamson that a central bank can achieve its inflation target by pegging its interest-rate instrument at a rate such that if the expected inflation rate is the inflation rate targeted by the central bank, the Fisher equation would be satisfied. In other words, if the central bank wants 2% inflation, it should set the interest rate instrument under its control at the Fisherian real rate of interest (aka the natural rate) plus 2% expected inflation. So if the Fisherian real rate is 2%, the central bank should set its interest-rate instrument (Fed Funds rate) at 4%, because, in equilibrium – and, under rational expectations, that is the only policy-relevant solution of the model – inflation expectations must satisfy the Fisher equation.

The Neo-Fisherians believe that, by way of this insight, they have overturned at least two centuries of standard monetary theory, dating back at least to Henry Thornton, instructing the monetary authorities to raise interest rates to combat inflation and to reduce interest rates to counter deflation. According to the Neo-Fisherian Revolution, this was all wrong: the way to reduce inflation is for the monetary authority to reduce the setting on its interest-rate instrument and the way to counter deflation is to raise the setting on the instrument. That is supposedly why the Fed, by reducing its Fed Funds target practically to zero, has locked us into a low-inflation environment.

Unwilling to junk more than 200 years of received doctrine on the basis, not of a behavioral relationship, but a reduced-form equilibrium condition containing no information about the direction of causality, few monetary economists and no policy makers have become devotees of the Neo-Fisherian Revolution. Nevertheless, the Neo-Fisherian argument has drawn enough attention to elicit a response from Michael Woodford, who is the go-to monetary theorist for monetary-policy makers. The Woodford-Garcia-Schmidt (hereinafter WGS) response (for now just a slide presentation) has already been discussed by Noah Smith, Nick Rowe, Scott Sumner, Brad DeLong, Roger Farmer and John Cochrane. Nick Rowe’s discussion, not surprisingly, is especially penetrating in distilling the WGS presentation into its intuitive essence.

Using Nick’s discussion as a starting point, I am going to offer some comments of my own on Neo-Fisherism and the WGS critique. Right off the bat, WGS concede that it is possible that by increasing the setting of its interest-rate instrument, a central bank could, move the economy from one rational-expectations equilibrium to another, the only difference between the two being that inflation in the second would differ from inflation in the first by an amount exactly equal to the difference in the corresponding settings of the interest-rate instrument. John Cochrane apparently feels pretty good about having extracted this concession from WGS, remarking

My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

And my first reaction to Cochrane’s first reaction is: why only half? What else is there to worry about besides a comparison of rational-expectations equilibria? Well, let Cochrane read Nick Rowe’s blogpost. If he did, he might realize that if you do no more than compare alternative steady-state equilibria, ignoring the path leading from one equilibrium to the other, you miss just about everything that makes macroeconomics worth studying (by the way I do realize the question-begging nature of that remark). Of course that won’t necessarily bother Cochrane, because, like other practitioners of modern macroeconomics, he has convinced himself that it is precisely by excluding everything but rational-expectations equilibria from consideration that modern macroeconomics has made what its practitioners like to think of as progress, and what its critics regard as the opposite .

But Nick Rowe actually takes the trouble to show what might happen if you try to specify the path by which you could get from rational-expectations equilibrium A with the interest-rate instrument of the central bank set at i to rational-expectations equilibrium B with the interest-rate instrument of the central bank set at i ­+ ε. If you try to specify a process of trial-and-error (tatonnement) that leads from A to B, you will almost certainly fail, your only chance being to get it right on your first try. And, as Nick further points out, the very notion of a tatonnement process leading from one equilibrium to another is a huge stretch, because, in the real world there are “no backs” as there are in tatonnement. If you enter into an exchange, you can’t nullify it, as is the case under tatonnement, just because the price you agreed on turns out not to have been an equilibrium price. For there to be a tatonnement path from the first equilibrium that converges on the second requires that monetary authority set its interest-rate instrument in the conventional, not the Neo-Fisherian, manner, using variations in the real interest rate as a lever by which to nudge the economy onto a path leading to a new equilibrium rather than away from it.

The very notion that you don’t have to worry about the path by which you get from one equilibrium to another is so bizarre that it would be merely laughable if it were not so dangerous. Kenneth Boulding used to tell a story about a physicist, a chemist and an economist stranded on a desert island with nothing to eat except a can of food, but nothing to open the can with. The physicist and the chemist tried to figure out a way to open the can, but the economist just said: “assume a can opener.” But I wonder if even Boulding could have imagined the disconnect from reality embodied in the Neo-Fisherian argument.

Having registered my disapproval of Neo-Fisherism, let me now reverse field and make some critical comments about the current state of non-Neo-Fisherian monetary theory, and what makes it vulnerable to off-the-wall ideas like Neo-Fisherism. The important fact to consider about the past two centuries of monetary theory that I referred to above is that for at least three-quarters of that time there was a basic default assumption that the value of money was ultimately governed by the value of some real commodity, usually either silver or gold (or even both). There could be temporary deviations between the value of money and the value of the monetary standard, but because there was a standard, the value of gold or silver provided a benchmark against which the value of money could always be reckoned. I am not saying that this was either a good way of thinking about the value of money or a bad way; I am just pointing out that this was metatheoretical background governing how people thought about money.

Even after the final collapse of the gold standard in the mid-1930s, there was a residue of metalism that remained, people still calculating values in terms of gold equivalents and the value of currency in terms of its gold price. Once the gold standard collapsed, it was inevitable that these inherited habits of thinking about money would eventually give way to new ways of thinking, and it took another 40 years or so, until the official way of thinking about the value of money finally eliminated any vestige of the gold mentality. In our age of enlightenment, no sane person any longer thinks about the value of money in terms of gold or silver equivalents.

But the problem for monetary theory is that, without a real-value equivalent to assign to money, the value of money in our macroeconomic models became theoretically indeterminate. If the value of money is theoretically indeterminate, so, too, is the rate of inflation. The value of money and the rate of inflation are simply, as Fischer Black understood, whatever people in the aggregate expect them to be. Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver. The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults. There was only an indirect connection – at least until the 1920s — between a central bank setting its interest-rate instrument to control its balance sheet and the effect on prices and inflation. The rules of monetary policy developed under a gold standard are not necessarily applicable to an economic system in which the value of money is fundamentally indeterminate.

Viewed from this perspective, the Neo-Fisherian Revolution appears as a kind of reductio ad absurdum of the present confused state of monetary theory in which the price level and the rate of inflation are entirely subjective and determined totally by expectations.

Hayek, Free Banking and Tax Payments

Published December 3, 2014 fiat money , free banking , Hayek 18 Comments
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Among the many interesting comments on my previous post about free banking was one by Philippe which provoked an extended (and perhaps still ongoing) exchange between Philippe and George Selgin. Referring to this assertion of mine,

if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies

Philippe made the following comment:

In “The Denationalization of Money” Hayek argued that you should be able to pay taxes with privately-issued currencies. However, this would in effect turn those ‘private currencies into’ de facto state currencies, or forms of government ‘fiat money’. For some reason Hayek chose to ignore this massive contradiction in his argument. Essentially, what he was actually arguing was that private corporations should be granted special state powers, i.e. the power to issue money backed by the state’s legal powers of taxation.

I thought that this was a very insightful observation by Philippe, though its significance for me may be somewhat different from its significance for Philippe. In my criticisms of Hayek’s free-banking position – I call it a free-banking position even though free banking may be a misnomer inasmuch as Hayek advocated banks’ creating new currency units not just allowing banks freedom to create a complete menu of liabilities denominated in existing currency units – my argument was that newly created currency units would be worthless unless the banks made them convertible into some outside asset not under their control. Or in Nick Rowe’s helpful terminology, Hayek advocated free-alpha-banking, while conventional free bankers advocate free-beta-banking. The reasoning behind my argument is that the value of a pure medium of exchange depends entirely on its expected value in exchange, so if a currency unit is not defined in terms of a commodity providing a real, valuable, service apart from being used as money, people will eventually realize that its value must go to zero. Any positive value that it may temporarily have is just a bubble, and, like every bubble, it will burst.

However, unlike the private issuer of a currency unit, a sovereign issuer can impart a real value to a fiat currency by making the currency acceptable for discharging tax liabilities, creating a real demand for the currency distinct from its use as a medium of exchange. Using this argument, I have suggested that bitcoins are a bubble, though it is possible that are some techie reasons that I don’t understand why bitcoins could provide real services that would allow them retain a positive value. At any rate, the point made by Philippe — that if governments were to accept newly created private currency units in payment of taxes – they could retain their value just as fiat currencies issued by governments do – is a point that had escaped me in my criticisms of Hayek. So, well done, Philippe.

However, Philippe seems to carry this valid point a bit too far, accusing Hayek of a massive contradiction in arguing that private corporations be granted special state powers. The problem with that argument is that it begs the question what is special about money that confers the sole power to issue money to the state. I actually once wrote a paper trying to answer that question (once again relying on an argument that I heard from Earl Thompson) published in a volume called Money and the Nation State. I summarized the argument in chapter 2 of Free Banking and Monetary Reform.

The short answer is that currency debasement may be necessary as a means of emergency taxation when a sovereign is faced with a hostile military force threatening its survival. To profitably debase a currency, you have to be the monopoly supplier. Ergo, sovereigns that monopolize the mint or the supply of currency have a better chance of surviving than sovereigns that don’t. Hayek was a staunch anti-communist, cold warrior, so the defense argument, at least on some level, would have appealed to him. But otherwise, it’s not clear to me why Hayek could not have said that, apart from certain national-defense functions, there really are no government services that may not be provided by private enterprise. After all, we do allow various services that were once exclusively provided by the government to be provided by private enterprise. I don’t say that this is always a good thing, but it doesn’t seem to me inherently unreasonable to believe that the burden of proof is on the one claiming that the state has an exclusive right to discharge a particular service, not on the one who questions that such an exclusive right exists.

Having said that, I will also say that it also seems perfectly reasonable for a government to say that a tax obligation that it legitimately imposes – I freely admit that I am now begging the question where this legitimate power comes from, but only libertarian fanatics dispute that power – can only be discharged in terms of a currency unit that the government itself specifies. And implicitly or explicitly, George Selgin and other free bankers — i.e., free-beta-bankers — seem to be perfectly OK with the government specifying the currency unit in terms of which tax obligations may be discharged. In other words, the government may impose a tax obligation on me that is specified in dollar terms. To discharge it, I have no choice but to pay the government the requisite number of dollars, either delivering the government’s own currency or delivering a private (beta-bank) money denominated in dollar terms.

The peculiarity in Hayek’s argument is that he was proposing that governments impose a tax liability in, say, dollar terms, and then accept payment in some other currency unit without specifying any method by which an obligation specified in dollars would be discharged in terms of another currency unit. Any creditor is free to specify at the time an obligation is created the terms on which the debt will be discharged (subject of course to legal tender laws, but for purposes of this discussion I am ignoring legal tender laws which are not the same as tax acceptance). The government is not just any creditor, but there doesn’t seem to me to be any compelling reason why a government should not be entitled to say we have created this obligation in terms of dollars and it must be discharged in terms of dollars. And, if I am right in asserting that acceptability in payment of taxes is a necessary condition for an inconvertible fiat money to retain value, there does seem to be something funny about Hayek’s argument for the creation of private fiat moneys, even if it is not a flat-out contradiction as Philippe claims.

What is funny is the degree to which the viability of a Hayekian private fiat currency is dependent on its being accepted by the state as payment for taxes. Moreover, Hayek’s argument was that there would be a discovery process in which many competing currencies would vie for acceptance with the market eventually choosing one or a few currency units as somehow being the most desirable. Hayek thought that the currency unit with the most stable value would eventually capture the largest market share. There are lots of problems with the argument, especially that it ignores the network effects that tend to produce an entrenched monopoly, and the extreme path dependence of such outcomes, but on a practical level, it seems almost unimaginable that a government would, or could, allow any number of distinct competing currency units to be simultaneously acceptable in payment of taxes.

I do not mean to be overly critical of Hayek, for whom I always have had the greatest admiration, but he had an unfortunate tendency to get carried away with certain utopian ideas and proposals, for example his idea of separating the law-making power from the governing function of parliaments into two distinct bodies, going so far as to propose a method for selecting members of the law-making body under which people at the age of 35 would each year elect a number of their contemporaries to serve a 15-year term in the law-making body, the law-making body being composed entirely of people between the ages of 35 and 50. He presents the idea in volume 3 of Law, Legislation and Liberty, a wonderful book of great philosophical depth and erudition. But it is amazing that Hayek felt that such an idea could ever be implemented. I don’t like to think so, but it occurs to me that his toleration for certain dictators might have had something to do with his imagining that they could be persuaded to implement his ideas for political and constitutional reform. His Denationalization of Money was a similar flight of fancy, based on some profound insights, but used as the basis for practical proposals that were fantastically unrealistic.

 

OK, Tell Me — Please Tell Me — Why Bitcoins Aren’t a Bubble

Published April 18, 2014 fiat money 64 Comments
Tags: ,

It’s customary at the Passover seder for the youngest person in attendance to ask four questions about why the first night of Passover is different from all other nights. For some reason, at my seder a different question was raised as well: what are bitcoins all about? I guess everybody wants to know about bitcoins now. Well, how embarrassing is that? Not only do I not understand why bitcoins have spectacularly increased in value since their inception (though the current price of a bitcoin is less than half of what it was last December), I don’t even understand why the market price of a bitcoin is now, or ever has been, greater than zero.

Here’s a chart showing how the value of a bitcoin has soared over the past two years:

 bitcoins

Why am I so perplexed about bitcoins?

The problem I have is that bitcoins can’t be used for anything except as a means of payment for something else. Bitcoins provide no real service distinct from being a means of payment. Think about it; if a bitcoin can’t be used for anything except to be given to someone else in exchange, that means that someday, someone is going to be stuck holding a bitcoin with no one left to give it to in exchange. When that happens, that stinky bitcoin won’t be worth a plum (or plugged) nickel, or a red cent. It will be as worthless as a three-dollar bill.

Now I grant you that that final moment of clarity might not happen for a long time – maybe not even for a very long time. But if anything is certain, it is certain that, sooner or later, such a moment must certainly come. But if it is certain that ultimately no one will accept a bitcoin in exchange, then it follows that no one forseeing that inevitable outcome would accept a bitcoin in exchange prior to that moment unless he or she is confident that there is some sucker out there who will accept in the interim. But since when does a theory of asset valuation premised on the existence of an unlimited supply of suckers count as an acceptable theory? Under the normal rationality assumptions that economists like to use, it is not possible to rationalize a positive price for a bitcoin at any point in its history.

So if, as the above chart so dramatically shows, bitcoins are in fact trading at a positive price, how does one avoid concluding that bitcoins are a massive bubble, a Ponzi scheme that must inevitably collapse, as soon as people realize where things are headed? To see just how massive a bubble bitcoins are, compare the above chart to this one constructed by Earl Thompson from actual prices in tulip contracts during the Dutch tulip mania of 1636-37. Compared to bitcoins, the tulips were barely more than a blip.

tulip

Now one could respond that if bitcoins are a bubble, then so is fiat currency. That is a pretty good response, and the positive value that we typically observe for most fiat currencies is far from unproblematic. But, as I have pointed out before on this blog (here and here), it is possible to account for the positive value of fiat currency by reference to its acceptability in discharging tax liabilities to the government. The acceptability of fiat currency in payment of taxes is a real service provided by fiat currency that is conceptually distinct from, though certainly facilitated by, its acceptability as payment in ordinary transactions. So, as long as one expects the government issuing fiat currency to remain in power and to be able to punish tax evasion, there is a rational basis for the positive value of a fiat currency. The backward induction argument that establishes the worthlessness of bitcoins does not apply to fiat currency.

Another possible explanation for the positive value of bitcoins is that they are very useful to those wanting to engage in illegal transactions on line, because, unlike other forms of electronic payment, payment via bitcoin is hard to trace. That is certainly a good reason for people to want to use bitcoins in certain kinds of transactions. However, the difficulty of tracing transactions via bitcoin is not an explanation of why bitcoins have a positive value in the first place, only an argument why, if they do have a positive value, the demand for them might be greater than it would have been if it were not for that advantage. Without an independent explanation for the positive value of a bitcoin, you can’t bootstrap a positive value for bitcoins by way of the difficulty of tracing bitcoin transactions.

So there you have it. As far as I can tell, the value of a bitcoin should be zero. But it’s obviously not zero,and though falling, the value of bitcoins is showing little sign of moving rapidly toward its apparent zero equilibrium value. There seem to be only a couple of ways of explaining this anomalous state of affairs. Either I have overlooked some material fact about bitcoins that might impart a positive value to them, or there is a problem with the theory of valuation that I am using. So I ask, in all sincerity, for enlightenment. Help me understand why bitcoins are not a bubble.

HT: Dana Dachman

There’s a Whole Lot of Bubbling Going On

Published October 22, 2012 expectations , fiat money , P. H. Wicksteed 47 Comments

Noah Smith picked up on the following comment, made in passing by Stephen Williamson in a blog post mainly occupied with bashing his (Williamson’s) nemesis, Paul Krugman. Maybe I’ll come back with further comments on the rest of Williamson’s post anon, but, then again, maybe not; we’ll see. In the meantime, here’s Williamson on how to identify a bubble and pointing to money as an example of a pure bubble:

What is a bubble? You certainly can’t know it’s a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset’s “fundamental,” which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset’s actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are “spending too much,” would we?

Noah (I actually don’t know Noah, but since he has written a few complimentary posts and tweets about me, I consider him one of my best friends) was moved to write a whole blog post about this paragraph. But before quoting Noah’s response, I will just observe that what Williamson describes as a bubble is what Keynes described as a liquidity premium. People are willing to accept a lower rate of return on money than on other assets that they could hold, because, at the margin, money is providing them with valuable liquidity services. The reduction in the rate of return that they are willing to accept is achieved by bidding up the value of money until the expected service (liquidity) yield on money just compensates for the reduced pecuniary rate of return associated with holding money compared to alternative assets. This liquidity premium, by the way, is a result of the real quantity of money being less than optimal. If the real quantity of money were optimal, the liquidity premium would be zero, but a zero liquidity premium would not imply, as Pesek and Saving notoriously argued about 40 years, that the value of money would be annihilated. I don’t think that Williamson is making the mistake that Pesek and Saving made, but he is (to engage in a bit of metaphor mixing) skating on thin ice. Anyway, now to Noah:

Can this be true? Is money fundamentally worth nothing more than the paper it’s printed on (or the bytes that keep track of it in a hard drive)? It’s an interesting and deep question. But my answer is: No.

First, consider the following: If money is a pure bubble, than nearly every financial asset is a pure bubble. Why? Simple: because most financial assets entitle you only to a stream of money. A bond entitles you to coupons and/or a redemption value, both of which are paid in money. Equity entitles you to dividends (money), and a share of the (money) proceeds from a sale of the company’s assets. If money has a fundamental value of zero, and a bond or a share of stock does nothing but spit out money, the fundamental value of every bond or stock in existence is precisely zero.

Noah is making a good argument, a sort of reductio ad absurdum argument, but I think it’s wrong. The reason is that what Noah is looking at — the real value of non-money assets — is really a ratio, namely the nominal value of an asset divided by the price level measured in terms of the money (unit of account) whose value is supposedly a bubble. Noah says OK, suppose Williamson is right that money is a pure bubble. What would happen once people caught on and figured out that the money that they used to think was valuable is really worthless? Well, when money becomes worthless, the price level is infinite, so the real value of any asset must be zero. Really? I don’t think so. Noah is making a category mistake. Not all financial assets are alike. Some financial assets (bonds) are claims to a fixed stream of payments. But other financial assets (stocks) are claims to a variable stream of payments. Certainly bonds would become worthless as the price level was expected to rise without limit, but why would that be true of stocks? The cash flows associated with stocks would rise along with the increase in the price level. What Noah is doing (I think) is evaluating a ratio, the price of a stock relative to the general price level, as the price level (the inverse of the value of money) goes to infinity. If the denominator is infinite, then the ratio must equal zero, right? Not so fast. Just because the value of the denominator of a ratio goes to infinity does not mean that value of the ratio goes to infinity. That’s a fairly elementary mathematical error. To evaluate the ratio, if both the numerator and denominator are changing, you must look at the behavior of the ratio as the value of the denominator goes to infinity, not just at the denominator in isolation. For a stock, the numerator would go to infinity as the price level rose without limit, so you can’t infer that the real value of the stock goes to zero.

So the way to do the thought experiment is to ask what would happen to the value of a stock once people realized that the value of money was going to collapse. The answer, it seems to me, is that people would be trying to exchange their money for real assets, including stocks, as a way of avoiding the loss of wealth implied by the expected drop in the value of money to zero. Under the standard neutrality assumptions, a once and for all reduction in the value of money would imply a proportional increase in all prices. But the bubble case is different, inasmuch as everyone is anticipating the loss of value of money before it takes place, and is therefore trying to switch from holding cash balances to holding real assets. The value of real assets, including financial assets like stocks, would therefore tend to rise faster than the prices of the anticipated service flows embodied in those assets. Asset and stock prices would therefore tend to rise even faster than the general price level, which is to say that the real value of those assets would be rising, not falling, let alone falling to zero, as Noah suggests. So I am sorry, but I don’t think that Noah has succeeded in refuting Williamson.

But in a sense Noah does get it right, because he goes on to question whether there is any meaning to the whole notion of “fundamental value.”

So what is “fundamental value”? Is it consumption value? If that’s the case, then a toaster has zero fundamental value, since you can’t eat a toaster (OK, you can fling it at the heads of your enemies, but let’s ignore that possibility for now). A toaster’s value is simply that it has the capability to make toast, which is what you actually want to consume. So does a toaster have zero fundamental value, or is its fundamental value equal to the discounted expected consumption value of the toast that you will use it to produce?

If it’s the latter, then why doesn’t money have fundamental value for the exact same reason? After all, I can use money to buy a toaster, then use a toaster to make toast, then eat the toast. If the toaster has fundamental value, the money should too.

Well, the problem here is that the whole question is whether you will be able to buy a toaster with money once people realize that the true value of money is zero. The toaster will remain valuable after money becomes worthless, but money will not remain valuable after money becomes worthless. Nevertheless, the value of a toaster to you is itself not invariant to the tastes and preferences of people other than yourself. Toasters have value only if there are enough other people around that demand sliced bread. If the only kinds of bread that people wanted to eat were baguettes or matzah, your toaster would be worthless. The only goods that have unambiguous consumption value are goods for which there are no network effects. But there are very few such goods, as my toaster example shows. If so, the consumption value of almost any good can be negatively affected if the demand for that good, or for complementary goods, goes down. What you are willing to pay for any asset embodying a future service flow depends on your expectations about the value of that flow. There is no way to define a fundamental value that is independent of expectations, or, as I have previously observed, expectations are fundamental. That is why Keynes’s much reviled comparison, in Chapter 12 of the General Theory, of the stock market to predictions about the outcome of a beauty contest, while surely a caricature, was an insightful caricature.

Noah’s post prompted Paul Krugman to weigh in on Williamson’s assertion that money is a pure bubble. Invoking Samuelson’s overlapping generations model of money, Krugman rejects the notion that fiat money is a bubble. It is rather a “social contrivance.” Social contrivances are not bubbles; they depend on a web of conventions and institutions that support expectations that things will not fall apart. Similarly, Social Security is not, as some maintain, a grand Ponzi scheme. Krugman concludes on this note:

[T]he notion that there must be a “fundamental” source for money’s value, although it’s a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy — full stop.

I agree with this in spirit, but as an analytical matter, we are still left with the problem of explaining how fiat money can retain a positive value, based on the expectation that someone accepting it now in exchange will, in turn, be able to purchase something else with it further in the future, even though there is a powerful logical argument for why the value of fiat money must eventually fall to zero, in which case backward induction implies that its value falls to zero immediately.  Krugman actually alludes to one possible explanation for why the value of fiat money does not immediately fall to zero: the government makes it acceptable as payment for the taxes it imposes, or actually requires that tax obligations be discharged using the currency that it issues. By putting a floor under the current value of money, the creation of a non-monetary demand for money as way of discharging tax liabilities excludes the class of potential equilibria in which the current value of money goes to zero. Brad DeLong spells this out in more detail in his post about Noah Smith and Stephen Williamson.

So what is my point? Yes, I agree that money is not a bubble. But merely asserting that money performs a useful social function from which everyone gains is not enough to prove that it is not. That assertion doesn’t explain why that high-value social contrivance is robust. Expectations about the value of money, unless supported by some legal or institutional foundation, could turn pessimistic, and those pessimistic expectations would be self-fulfilling, notwithstanding all the good that money accomplishes. Optimistic expectations about the value of money require an anchor. That anchor cannot be “fundamental value,” because under pessimistic expectations, the “fundamental value” turns out to be zero. That’s why the tax argument, as the great P. H. Wicksteed eloquently explained a century ago, is necessary.

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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