Digital Currency

Time for a little Bitcoin discussion

Bitcoin-accepted-hereIf I had a Bitcoin for every time a journalist has called in the last couple of months wanting to ask me about Bitcoin, I’d be very rich today and rich with variance tomorrow. The reason they come a-calling is because of this paper I wrote with Hanna Halaburda that discusses digital currencies while avoiding all meaningful discussion of Bitcoin. Anyhow, as I continue to see much that is written that is actually incorrect, I thought I’d wade in here with some thoughts.

Thought 1: Is Bitcoin money?

Absolutely and so are chocolate Hannukah coins, casino chips, monopoly money and your frequent flyer miles. The traditional way of defining money is as a unit of account, medium of exchange and store of value. The problem with this definition is that it describes an equilibrium outcome not a given characteristic of something. What do I mean by that? Basically, if you want to count, exchange and hold on to something you can’t just will it to be so. Instead, you need others to believe it to be so. So with monopoly money, everyone playing the game has agreed that money has value. But everyone also knows that it has a floating exchange rate. There are times when it is better to have property than money and that changes depending upon the stage and circumstances of the game. So everyone must agree sufficiently that money has value in exchange but at the same time disagree enough about that value to actually have exchange take place. It is the kind of thing that simultaneously blows your mind and sends you fleeing to a fixed point theorem for comfort.

What the definition obscures that there are other things that go hand in hand with making money a means of transmitting value over time. An obvious thing is some sort of stability in value. If you get paid by someone in the hopes of paying someone else, you have to worry about what happens to the value of the money you hold in the interim. Put simply, ideally you want stability so that you don’t have to gamble at the same time as transacting. However, because prices are flexible in market economies, you never get that. But some money is more stable than others. That gives them an advantage in transacting and hence, reinforces their equilibrium value.

I believe that a better way to think about what is money and what isn’t is to think about these things as platforms. The Canadian dollar is the instrument of a platform. You can pick up a Canadian dollar and take it to Toronto and use it to buy things. It works because people in Canada make it work. To be sure, you can do that with other things too. For instance, with the assistance of a debit or credit card, you don’t need Canadian dollars at all. Instead, you can access the Canadian dollar platform through an intermediary. Sometimes, you can even use other currency directly. However, as the Canadian dollar has a better network base, it usually wins out and is a more efficient competitor in platform competition.

Bitcoin is money. You can store some wealth in it. But how does it stand up as a platform competitor in payments? On the stability front, it is pretty awful. The Bitcoin exchange rate with other currencies and also with other prices is terrible. I have not found a place where prices are denominated in Bitcoins. For instance, Cloud Sky Leatherworks (to pick a random example) accepts Bitcoins. The prices are denominated in US dollars. If you buy something with Bitcoins you can but the price is given at the checkout time according to the current Bitcoin/USD exchange rate. So while technically you can buy something with Bitcoins, no merchant is willing to fix a price in Bitcoins. In that regard, it is less of a payments platform than most state-sponsored currencies. Of course, that is also why gold these days fares poorly as a payments platform.

However, it does have some other features. First, it may actually be a better platform in some countries than others. This is why the demand for Bitcoins is heavily related to the stability of other currencies. Where US dollars are hard to come by, Bitcoin can offer a safer haven for wealth.

Second, you can potentially deal in Bitcoins and exchange them with others without going through a financial institution or holding cash. That makes them potentially useful for operating outside of the watch of governments. This can be a benefit or a curse. If you want to operate without being watched, it is hard to reverse some contracts for non-performance. Enforcement can be useful even if it removes anonymity. However, when you understand the operation of the Bitcoin ‘network’ it is apparent that anonymity could be an illusion. In this, Michael Nielsen has written a very illuminating exposition of how the Bitcoin protocol actually works. Anyone interested in this topic should absorb it immediately. But here is what he says about anonymity:

Many people claim that Bitcoin can be used anonymously. This claim has led to the formation of marketplaces such as Silk Road(and various successors), which specialize in illegal goods. However, the claim that Bitcoin is anonymous is a myth. The block chain is public, meaning that it’s possible for anyone to see every Bitcoin transaction ever. Although Bitcoin addresses aren’t immediately associated to real-world identities, computer scientists have done a great deal of work figuring out how to de-anonymize “anonymous” social networks. The block chain is a marvellous target for these techniques. I will be extremely surprised if the great majority of Bitcoin users are not identified with relatively high confidence and ease in the near future. The confidence won’t be high enough to achieve convictions, but will be high enough to identify likely targets. Furthermore, identification will be retrospective, meaning that someone who bought drugs on Silk Road in 2011 will still be identifiable on the basis of the block chain in, say, 2020. These de-anonymization techniques are well known to computer scientists, and, one presumes, therefore to the NSA. I would not be at all surprised if the NSA and other agencies have already de-anonymized many users. It is, in fact, ironic that Bitcoin is often touted as anonymous. It’s not. Bitcoin is, instead, perhaps the most open and transparent financial instrument the world has ever seen.

Suffice it to say, you can bet the NSA and anyone else spending their time chasing the money is aware of this. The entire history of transactions you have engaged in may be transparent. In this respect, Bitcoin may change from an ‘under the radar’ instrument to perhaps one of the more contractually friendly payments platforms — but more on this below.

Thought 2: Will Bitcoin collapse?

The reason Bitcoin has managed to establish an equilibrium, despite volatility, in the payments platform market is because it was designed to be limited in supply. At its essence, the easiest way to lose as a payments platform is to not control supply. Monopoly money works so long as there isn’t another monopoly set in the house whose cash can be accessed. The US dollar works because the Fed controls the money supply and is concerned about platform competitiveness. And Bitcoin works because its aggregate supply is limited by the amount of mining that goes on. As Nielsen points out, that mining is progressively costly but also performs a useful function of validating transactions within the Bitcoin network — something you should read but I am in no position to describe here.

The point is that — given sufficient demand (an assumption that requires discussion below) — the exchange rate of Bitcoin will be bounded by the cost of mining (mainly computing power plus energy). When the (expected) value of a Bitcoin is below the cost of mining it, none will be produced and the value of Bitcoin will rise. The reverse happens if the (expected) value of a Bitcoin exceeds mining cost. So if you want to predict the long-run value of Bitcoin, calculate the cost of mining.

The same logic applies to gold. As Paul Krugman pointed out yesterday, mining Bitcoins or gold is driven by the same essential calculus. But he actually misses one important bit: gold can add to a miner’s wealth without mining while Bitcoins can’t. These days, mining engineers know how much gold is in a mine before they start digging. So why dig at all? Why not sell off the rights to the gold in the mine and save those costs? The answer surely lies in a weakness of property rights rather than a need to mine per se. With the gold still in the ground, property rights may be less secure and so it is hard to write instruments based on your holdings. Better to dig it all up and move it somewhere ‘safe’ even if that is just another holding in the ground. In other words, gold mining is all about ownership claims.

By contrast, you actually have to do some work to get Bitcoins. They are created out of thin air as payment for that work. There is no other way to produce new Bitcoins. You can’t easily write a contract on that work because the work as to be done for Bitcoins to enter the system. If you were a payments platform designer from outer space, one suspects the Bitcoin network would look far more sensible than the gold platform.

But to understand whether Bitcoin will collapse or not, we can’t ignore demand. In the platform business, this is Bitcoin’s weak point. Unlike the US dollar, it does not have a guaranteed demand. The US government says that it will only accept US dollars as taxes. That means there will always be a minimum demand for US dollars. Bitcoins have no similar commitment and in a platform market that represents risk.

That said, the traditional government-sponsored currencies have not been as innovative in the payments business. To be sure, we can now settle things digitally without actually handling cash but we all know that even that is surprisingly costly. At least a percentage point and perhaps as much as three percent goes to facilitating each transaction. The costs are nowhere near that so that is a problem for demand on those platforms.

Bitcoin is transactionally costly too but that comes because it has issues with stability. Otherwise, it holds the promise of virtually zero percent transaction fees. This is a huge opportunity not just for Bitcoin but for other platform entrants as well. For instance, Ripple is trying to replicate these features of the Bitcoin network to open up low transaction fee payments.

Thought 3: How significant an innovation is Bitcoin?

Having read Michael Nielsen’s essay, it is incredible just how clever and well-executed Bitcoin is. The elements that it gets in place requires an appreciation of monetary economics far exceeding any academic knowledge I am aware of. The achievement is phenomenal. Whatever else Bitcoin is, demonstrating how to get the ‘ducks in a row’ to launch a platform based on no owned infrastructure — the first payments platform I am aware of that has ever achieved this — is one of the most significant monetary innovations we have seen. I am awestruck by it.

What worries me is that we have not identified the innovator? As an economist, I would be so disappointed if the person who came up with this did not, at the same time, work out how to make a ton of money from it. That would likely be done by holding Bitcoins in reserve and eventually cashing out. But it may be some other way. Hopefully, we will eventually find out. For the moment, you can see how a return might arise through the example of Ripple. They’ll launch a zero transaction fee platform but hold money back for the purposes of improving monetary stability (changing demand as shocks arise) and also for some cashing out. As that model now makes sense, those who currently profit from transaction fees on other platforms should be worried.

But as Nielsen points out “Bitcoin is programmable money.” You can use it to write algorithms not possible in an open and transparent way with traditional currencies. Who knows where that innovation may lead.

25 thoughts on “Time for a little Bitcoin discussion

  1. “So if you want to predict the long-run value of Bitcoin, calculate the cost of mining.”

    That’s making the presumption of no substitutability. Because digital currencies can be replicated ad nauseum, the cost of mining in alternative digital currencies would limit the value of Bitcoin. There are already numerous other digital currencies, and at the very least Bitcoin could be replicated as Citcoin, Ditcoin, Etceteracoin as much as anyone wants. There is only an illusion of scarcity in Bitcoin. It is a hi-tech Beany Baby fad.

  2. Informative on bitcoin, but GOLD mining is not so simple as the author implies. From a “soil anomaly” bearing traces of gold to a producing mine is a long, torturous and costly path.

    Specialists say that 1 “prospective” land package in 3,000 will yield a profitable mine. IF there is a “discovery hole” there must be much more drilling and modelling to size a deposit, metallurgical studies to understand whether and, if so, how the metal can be liberated from host rock. Then economic studies and mine plans, financing efforts, and inevitable surprises and delays till the “barbarous relic” is produced.

    Also different from bitcoin in that gold has been prized across cultures and millenia. It’s said that one ounce bought a top-quality Roman toga, and now buys a savile row suit.(By contrast the US$ has lost 97% of its purchasing power since the FED was founded a hundred years ago.)

    As gold has been mined for millenia,the easy deposits have been found — is there an analogy to the future mining of the last few “bitcoins”? In fact, gold production in recent years has NOT been rising (in part due to “resource nationalism”).

    While western interest in gold has (temporarily) dipped with the (not historically unusual) 30% price decline, China has become both the largest gold producing nation AND the largest gold buying nation. India’s Central Bank (under the direction of an indian-american Univ. of Chicago professor) has recently imposed import taxes on gold — which has not ceased to occupy a key cultural position in India.

    As sure as western demand is fickle, EASTERN demand supports the saying “gold is forever”. It SEEMS quite likely that explicit or implicit gold-backing is a key element in China’s strategy to make the yuan a (the?) global reserve currency. Perhaps this is one reason the Chinese gov’t has just moved against bitcoin.

    And while there may be in future many “sons of bitcoin” diluting the original digital currency’s value, there will NEVER be “another gold”. If you doubt this, have a look at an Indian bride, or have a look at Europe’s gold-leafed spires. Have a look at pre-colombian art, or the film “treasure of Sierra Madre”.

    There IS something powerful and mysterious about gold, which extends far deeper than the question of who invented bitcoin or what it actually is …..

  3. I am afraid this article does not even begin to address the true nature of money. Modern money is equivalent to obligation or debt. The US dollar bills represent debt by the the Federal government, which is backed by our obligation as citizens to pay taxes. The state and Federal governments are obligated to accept your dollar bills as payment for your tax obligation such as property or income tax. No such obligation exists for anyone to accept bitcoins or gold for that matter. I have some more thoughts on the true nature of money and the bitcoin here

    1. Early coins were easier to mine than today’s. Wouldn’t satoshi, as a homo economicus, have mined a huge stash, and gradually sold into a rising market? Have highered an expert chart reader to time his sales?

      Knowing that other smart geeks could follow in his footsteps, he might well have concluded that, as bit coin succeeded, it would attract imitators creating more refined successors. He won’t likely have expected that his stash would be a long-term hold – like gold.

    2. Yes, the analyses of the blockchain show a whole lot of early bitcoins that are still in the original wallets, presumably under Satoshi’s control. But one detail that analyses of Bitcoins usually miss is that it is very hard to turn them into real money in any volume. The total volume at MtGox is about $1M/day which means that you can’t sell large amounts without moving the market, and even once you’ve sold, it takes about a month for them to wire you the money, if they don’t have yet another crash or DDoS in the meantime.

  4. “When the (expected) value of a Bitcoin is below the cost of mining it, none will be produced and the value of Bitcoin will rise.” Non sequitur.

      1. That’s true. It is also true that cessation of bitcoin production is not sufficient to cause a rise on the value of bitcoins.

  5. If your definition of “money” leads you to believe that chocolate Hannukah coins, casino chips, monopoly money and frequent flyer miles are money, then you need to seriously re-examine that definition, because it is obviously wrong. None of those things are money and neither are bitcoins.

    1. It depends on how you choose to define money. For some commenters here, Bitcoin cannot be money because money can only be issued by a government or meet some other fairly narrow definition. Others will accept a wider definition of money. While chocolate Hannukah coins stretch the definition, casino chips can function as money within a casino, losing their value outside the casino, just as government issued currency functions as money within the nation issuing the currency (and often loses its value outside that nation).

      But again, it depends on your definition of money.

  6. Hi,

    Bitcoin is a digital currency that is designed for global commerce in the modern age, with the ease of a credit card but without the high fees. You can acquire Bitcoins by buying or trading for them from local vendors, or accepting them for your business instead of cash or credit.
    To use Bitcoin at a more advanced level, an exchange connects you to people all around the world buying and selling Bitcoins. Exchanges offer both a web wallet for storage and management, and an easy way to trade using major currencies.
    CryptoCafe is going to be big in the world of Bitcoin, be sure to sign up for the big release announcement. The website is owned by a public company called Myriad Interactive, the stock symbol is MYRY and its predicted to be very big!

    Myriad Interactive Media Begins Development of Bitcoin Platform

    Happy Trading 🙂

  7. So let’s start with the substitution argument. Can we really substitute one brand for another just because they are digital? I’ve heard this every time there’s a new IT cycle. In the early days of my career it was folks telling me Microsoft was just some joke of a startup. The argument returned with the web – for example lots of people laughed at putting a valuation on ebay. “Anyone can build a substitute. Anyone can build an auction site. People buying shares in these things are just throwing their money away.” Not so fast.

    So, what makes the difference? Start by looking up what “first mover advantage” translates to in the marketplace. It’s not just being first – it is being the first trusted brand and with adherents, support services, items for third part suppliers to build a market around. BTC hasn’t fully sealed victory, but BTC has an ecosystem, customers and users.

    Either you get why folks still buy MS Word when there are free alternatives, buy and sell on eBay when there are cheaper auction sites, use BTC because it has a serious grip on virtual currency … or you don’t. Admitting in public that you don’t get why ditcoin and citcoin might be different means you need to do some work here. It’s certainly not something to be proud of.

    1. I love contemplating the situation where someone who insists on total anonymity, who has attracted money launderers, drug dealers and other figures who need to go outside existing socially-accepted systems, is more “trusted” than democratically-elected governments, to give me IOUs.

      I am all in favor of people keeping all the privacy they choose, but that doesn’t mean I want to trust hundreds, or hundreds of thousands of my past earnings to somebody who insists on it.

      Going back to Adam Smith and the metaphor of the invisible hand, we see that his economic beliefs were predicated on reputation and concern for the well-being of his fellow countrymen. Applying those beliefs without the foundations is an invitation to disaster.

      There’s a lot of genius in Bitcoin, and we may find it helpful for broad society. But just because it’s new and not government-sponsored doesn’t mean that it’s exempt from the ills of commercial enterprise that for example, brought us the 2008 financial collapse, a collapse brought on by over-enthusiastic money-making efforts at “shadow banks” that thought themselves exempt from ordinary banking prudence. Anybody experienced in banking or financial economics could make a long list of Bitcoin’s vulnerabilities and it’s very likely that the clever scam artists have already done so.

  8. Recycled: that’s a good point about what I think we can call network externalities. However, those same networks can incorporate citcoins and ditcoins just as easily as they manage bitcoins. They can be Ebays of digital coin products. There are already exchanges for those currencies, and they might well sweep aside exchanges that specialize in bitcoin. Why would an exchange want to limit itself to bitcoin?

  9. @Brian – ““When the (expected) value of a Bitcoin is below the cost of mining it, none will be produced and the value of Bitcoin will rise.” Non sequitur.”

    If there were no underlying growth in demand – yes I agree. However, markets are growing for BTC. The huge runs in volatility are bad for the stability of the currency, but generate large jumps in awareness. The growth in demand underpins the long term trend to the cost of mining.

    The issue for now is that the price has far outrun the cost of mining, in a volatile financial marketplace with almost no depth or maturity. Looks like we’re in for a fun ride.

  10. “[W]e can’t ignore demand…this is Bitcoin’s weak point.”

    Not only can’t it be ignored, all the excitement about the innovative supply mechanisms have really obscured that almost all of the volatility (read, “uncertainty”) of a Bitcoin’s value comes from its very sporadic, sentiment-driven demand. Libertarians are thrilled to have a government-free currency; technophiles like the cutting-edginess of them; as the article notes, people hoping/needing to opt out of their governments’ laws on prohibited transactions are natural customers.

    But the other 99% of the population might wonder why they would want to hold such a hot potato, not knowing whether the market is already saturated, and when the time comes to spend their money, whether anybody will want to take them.

    My initial concern about Bitcoin was whether it was a very bright Ponzi scheme, demanding anonymity to cover a plan where they endowed themselves, at very low cost, with many millions, even billions of dollars’ worth of Bitcoins, which they would sell to other users, who would eventually realize that the demand was entirely comprised of speculative or banned activities, which would lead to a collapse in the price.

    But that concern was superseded by the realization that the originators could be perfectly well-motivated, but when the time came for them to retire to a nice little villa in Thailand, the result could be identical to the evil Ponzi scheme. A lot of the evidence suggests that most Bitcoins are held, and transacted by, a tiny number of very large holders, and if changes in preferences, Chinese currency regulations or money-laundering enforcement happened, the currency would be subject to a run on the bank. Those happened with distressing frequency before the FDIC, and while Bitcoin proponents may note that Bitcoins are not subject to the same types of runs, they cannot deny that if suddenly, none of the existing holders had any use for them, the value could go all the way to the fraction of a penny that the first ones transacted for.

    So I have no reason to believe that it’s a scam, but more scarily, I’m not clear that the outcome would be any different whether it is or not.

    1. Hi, I really appreciate your comment, you show some valid concerns. I am very interested in Bitcoin in general and couldn’t help to notice you pointed ” A lot of the evidence suggests that most Bitcoins are held, and transacted by, a tiny number of very large holders…” I have not been able to find a whole lot of evidence in holdings of Bitcoin, so I was wondering if you don’t mind sharing that information with me? I would really appreciate having that or any info, as I am currently running a research on Bitcoin for my University, thanks a lot

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