If 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.