Since the Cyprus crisis the price of Bitcoins has rapidly increased. Felix Salmon wrote one of the better articles about this. But the article has its problems.
He opens by talking about someone who lost all his Bitcoins when his computer was hacked. This is avoidable by storing funds in an off-line wallet, which is just a file containing a private key used to transmit funds. It is not much different from storing gold, except that it takes up less space, backups can be made, a thief would need to both steal your wallet and know your password, and it is possible to pay money in to an off-line wallet. You only need to expose your wallet to the Internet to pay money out of it. All this requires a certain amount of skill and knowledge but so does any method of storing value.
Salmon uses the word “anonymous” carelessly. Bitcoin is not anonymous and not intended to be. It is pseudonymous. Every transaction is visible, and it is possible for the government to find out, for example, which bank account was used to buy some Bitcoins. You can probably take steps to make this so expensive that law enforcement could not afford it. But that is a practical point, not a mathematical one, and it would be a mistake to think that anonymity is built in.
Salmon complains that Bitcoin needs too much technical expertise to use. But not everyone need use Bitcoins directly for them to serve as a store of value, any more than people need to handle physical gold themselves. That one has the option to do so if one does not trust others is nice, but trusting others for convenience is possible too. If Bitcoin were widely adopted, I would expect to see secondary currencies backed by Bitcoin to be used as cash, and the equivalent of Visa and Paypal to be implemented by someone.
Salmon points out that the value of Bitcoin is very volatile and closely tracks media coverage of it. This is because there is a fixed supply (there will only ever be 21 million Bitcoins) and new people are still discovering the currency. After every media report the number of people who want Bitcoins increases. Once everyone knows about it who would want to buy it, the price should settle down as the overall demand for money is not so volatile.
Salmon’s main point is that Bitcoin is doomed to fail because as it is adopted its price will increase rapidly, which hyperdeflation will mean no-one spends it. But such a situation can not persist; as soon as the price settles spending will resume.
Although I am optimistic, there are plenty of ways it could fail. Something better might come along, or governments may attempt to put a stop to it and may succeed enough to make it fail.
Or in twenty years’ time you could find yourself having bought one 21-millionth of the global money supply for a very good price. 😉
That’s what you think! I’ll bet Australia has undiscovered mountains of Bitcoinium, just waiting for us to sell to China!
Get digging, Nick!
There is a deadly problem for Bitcoin: the planned restriction (in the end absolute) of supply means that this is an inherently deflationary currency. Given that, its recent rise is a classic bankers’ ramp.
In the end, every currency has to make an awkward straddle between a) acting as a store of value and b) acting as a medium of exchange. If, as Bitcoin has chosen, you prioritise the first role you will certainly compromise the second. Even now, if you had a Bitcoin account, would you be spending it now? This dilemma is known as the Triffin paradox, and I can’t see that it’s easily dodged. Bitcoin has simply ignored it, preferring simply a bankers ramp. A shame, really.
Reconstruct: surely it is not the fact of deflation but the rate. Given a fixed supply of money, deflation should equal growth. We have growth and yet people buy things. For example they buy a computer today knowing they can buy the same one for less in a few months’ time.
It is likely and I think inevitable that even if Bitcoin prospers, it will be one of many such crypto currencies. If Bitcoin becomes deflationary, people will offer similar alternatives. These will likely have different limits on the speed at which money can be created, and different rules with respect to how money creation stops, if it does. (There is no obvious reason why the money supply should tend to a finite amount of money – there just need to be well understood rules restraining how fast it can grow). Then we can have trading between Bitcoin and the new currency or currencies. People can choose which currency they want to use.
Two questions on which I would welcome responses from more erudite and well read Samizdata readers than myself:
1) I get that deflation isn’t an economic problem if the prices of goods fall. There will always be buyers today for useful products and services even if the price is expected to fall in the future and to the extent that some potential buyers delay comsumption now they will be saving and hence be investing in capital good production elsewhere in the economy, which has got to be better than everyone getting in debt as we have now! The problem in my mind with deflation is not economic but political. One of the prices that will fall in a system with a fixed money supply is the price of some labour. It seems to me to be a significant political challenges to get some potentially quite large groups, since relative prices will always be fluctuating, to accept that they shouldn’t be worried about their wages falling because the prices of many of the things they want to buy are falling faster. Any thoughts on how to overcome that?
2) There is a very interesting critique of BitCoin on today’s Mises Daily https://mises.org/daily/6401/Bitcoin-Money-of-the-Future-or-OldFashioned-Bubble . It makes the point that even as the BitCoin money supply stops expanding this does not stop other similar virtual currencies being created so the total supply of all things which could be used as money continues to grow. The fact the BitCoins have stopped expanding doesn’t mean there will be no inflation if other moneys are expanding rapidly. If this argument holds water it seems equally valid a criticism of any free banking system, whether virtual or institutions issuing their own commodity backed paper money, or whatever. The key virtue of a gold standard seems to be that there is pretty much a fixed quantity of money – end of story. Do free bankers assume that any free money system will converge on a non-fractional reserve gold standard? If so, why? If not, what stops “rogue” currencies creating inflation across the economy no matter how well other currencies are managed?
“Given a fixed supply of money, deflation should equal growth.”
I think in theory deflation should equal that portion of growth captured by capital (i.e. productivity improvements could either lead to higher wages or lower prices).
The amount of gold that can be used in practice as money is not constant, but to increase the supply a fair amount of expense must be incurred in terms of resources for exploration, mining, etc. Bitcoin attempts to to replicate this by requiring computational effort to “mine” new bitcoins, and the amount of effort increases over time and tends to infinity as the maximum number of possible bitcoins is approached.
I am not sure this is actually a very good replication of the situation with gold. I am not sure that the cost of mining gold actually is increasing over time. The cost of mining many other resources is decreasing due to improved technology, and I see no reason gold should be different. (Scenarios in which extraction or production of gold becomes trivially easy to the extent that a gold currency undergoes hyperinflation are not unimaginable). There are plenty of historical instances where the local supply of gold or silver has led to this precise problem, and either the balance in use between gold and silver has shifted or some other scarce resource has come into general use as money. This is a real problem, and dealing with it is one of the chief justifications for the growth of fiat currencies. (Of course, what governments and bankers ultimately do with fiat currencies is far worse, so it certainly doesn’t on its own make them a good idea).
It seems reasonable to me that if this problem exists for crypto-currencies, additional currencies with greater money supply will come into use alongside bitcoin. The question is, if almost anyone can create a crypto-currency, how do we decide which ones will be assigned value and which ones won’t.
One (possibly unpopular here) possibility is that we use the ones backed or authorised by governments. “Because they are backed by government” is why people use specific currencies now. Some government introduces an open sourced crypto currency with a money supply that grows at a maximum of 2% a year and which cannot be debased. Some might like this.
Or it may simply be that herds are good at reaching consensus on which crypto-currencies they assign value to, and market forces ensure that the number that gain value is roughly right for the needs of the people using them. This probably means there will be booms and busts and runs and the like, occasionally, and people may flock to the oldest and best regarded crypto currencies in times of panic, but that is not a worse situation than now.
It may also be that what we really need is competition between currencies, however they are constituted. This is something that our politicians and central bankers will try to do almost anything to stop, I think.
A few words about deflation, for Rob Fisher and Alistair James. I think you are too complacent about the impact of deflation on economies. To understand why, try thinking at the micro / corporate decisions level. For companies, the problem is that although deflation cuts the price of output goods, the stock of capital which produces them is not so deflated. In short, you get falling asset turns (total sales/assets) which in turn virtually ensures falling ROC and ROE. And in due course, this also means the investment cycle is disrupted and fails. This happens even when managements are behaving in all ways responsibly: indeed, it is quite measurably what is happening now in Japan. And, of course (and linked), the value of debt goes up and up and up, so deleveraging also kicks in and stays in. None of this is good for real growth, or, for that matter, for innovation and productivity gains.
The interesting question about Bitcoin is this: has it been ‘discovered’ because a) of its bankers ramp deflationary design? or b) because, actually, it allows liquidity in markets other currencies can’t reach (ie, historically it is believed to have serviced the drug trade?). My guess is that, actually, both elements have been important (worth reading the literature on this one http://eprint.iacr.org/2012/584.pdf). But is it ironic, or just plain bad, that its (temporary) escape from the Triffin paradox has been contingent precisely on it providing last-place-to-hide liquidity for illegal businesses/services?
Reconstruct, the flaw in your description of the effects of deflation is that you overlook the fact that capital assets used for production are themselves consumed over time. We attempt to reflect this in depreciation. So in your formula of (total sales/assets), when the nominal value of total sales goes down as a result of deflation (all else being constant), the denominator also goes down via depreciation. I won’t argue that the two move in perfect tandem; that’s a function of many variables which are unique to each individual case. But in general (and assuming rational depreciation rules) the ratio should remain relatively constant. Rob’s observation that deflation should equal growth is basically correct.
I would also note that in a fixed-quantity-of-money world, secular deflation would be quite predictable and would be factored into the acquisition price of the capital assets, just as today we factor in (less-predictable) inflationary expectations. The result would be a decrease in the cost of capital goods, which also helps to preserve ROE. I would encourage you (and anyone else who hasn’t read it) to read Detlev Schlichter’s “Paper Money Collapse”. In it he provides a very careful and precise description of how and why secular deflation is perfectly benign, and why there is no need (or market demand) for an expanding money supply. Within reasonable limits, any quantity of money in circulation can support a healthy and growing economy. This is why limiting Bitcoins to 21 million would not be a problem.
As to the observation that the success of Bitcoins would likely spur the development of competing crypto-currencies, it’s possible but not certain. There is a value to being the first to create a market, and with something like Bitcoins once it gains widespread acceptance it would be difficult for competitors to gain market share. There is a reason Paypal doesn’t have a lot of competition, and Bitcoin could find itself in the same position. Also, even if additional crypto-currencies should arise, in their immediate aftermath there would also arise exchange mechanisms for people to capitalize on temporary divergences in their relative values, i.e., arbitrage opportunities. The market would punish weak competitors and keep the others in check. Having competing crypto-currencies would be no more a problem than having dollars, euros and yuan in circulation. What matters is not so much how many competitors there are but rather that they are transparent and are not government-controlled.
Laird,
Something that puzzles me:
I thought we laissez-faire, truly-free-Free-Market types argue that natural monopolies, if they arise, won’t last long because some bright guy will quickly come up with a way to provide the same product or service more cheaply, or a better version at the same price?
Also, would you please explain:
Which is…?
Laird, Paypal is a system of exchange, not a medium of exchange. Bitcoin is presenting and structuring itself as a commodity style medium of exchange. Whenever a commodity is perceived by the market to be too costly for the benefits, either more is made or an alternative is found. If bitcoin functions as the commodity it intends to emulate, it will face the same factors.
Never underestimate the power of arbitrage markets. I imagine the various iterations of bitcoin will be arbitraged just as the various fiat currencies are in the forex markets and commodities are in the futures markets.
Julie, the reason Paypal, eBay, Amazon, have such market share is that systems benefit from ‘one stop shopping’. The variety is in their products, not in the system of exchange. Already aggregators are making it possible to break into the big guys’ market shares by allowing one stop shopping on an auction (for one example) aggregator that visits multiple auction sites.
Many aggregators, like search engines, can compete side by side in the market place. But each consumer will only want to deal with one portal. That is why Paypal etc have such market share. For now.
Hm. Have to think about that, Mid…it will take awhile to sink in. Thank you for the info. 🙂
Mid, I know what Paypal is; I was merely using it as an illustration of a company which had managed to secure a dominant place in its market because it got there first and functioned well. Facebook would be another. Julie, that’s the answer to your question: With some sorts of services there’s value in everyone using the same service once it’s established as long as it continues to meet the market’s needs and doesn’t try to take undue advantage of its customers. If Paypal started charging unreasonable fees or its service quality slipped it would undoubtedly face competition, but for the moment there’s no perceived need. I suspect the same would be true for Bitcoin. It doesn’t cost anything to use and the system is (apparently) secure. Unless there is some radical advance in the technology it uses (encryption or whatever), what is the incentive for anyone to either create or use a competitor?
But Laird, bitcoin is not presenting itself as a service but as a commodity. Facebook will never sell out of Faces, Paypal will never sell out of account numbers. As you say, provided they keep the customers satisfied, they will remain dominant.
Bitcoin is an entirely different business model. Bit coin is like a syndicate with fungible shares. Once the shares are fully distributed, the nature of the enterprise changes fundamentally. At that point it will either be deflationary (by division of the coin) or another syndicate will form. Since that deflation is “found money” for the early investors, once the market growth exceeds the bitcoin growth (which they state will happen with a certainty), there is a strong market incentive to start another syndicate.
I’ll try to put this simply. Deflation is a profit for owning bitcoins. No profits will be left unchallenged in a free market. There will be challengers.
Laird,
The thing is, if there ARE “natural” monopolies (i.e. not helped by government, and also non-coercive, which includes honest dealing) that remain so for a very long time–in some cases perhaps a century or longer–then we cannot in good conscience claim that no monopoly can remain such for long without government’s help.
. . .
But as a matter of fact, it seems to me that PayPal is a close cousin of the credit card. As I remember it, at first there were Diner’s Club and American Express, but with American Express at least there was a fairly modest limit and you had to pay up every month. And think Diner’s Club was the same.
It seems to me the first “mass” credit card was Master Charge, which pretty much held the field for quite a few years–then I think VISA came along to challenge it, and Master Charge became MasterCard around the same time. The point of similarity with PayPal is that the CC’s (especially MC and, now, VISA) and PayPal are both almost universally accepted “like cash”–most real stores (and even most on-line businesses) accept MC or VISA, and PayPal is widely accepted by online businesses (especially, of course, eBay). Since competitors to Master Charge did eventually show up, it seems likely that there will eventually be a real competitor for PayPal–absent government props, of course, which is a huge caveat.
Julie, there is Google checkout. However, as Laird says, there is that first-out-of-the-gate advantage which is typically only lost if and when a company starts misbehaving (in fact, Paypal was not the first to be providing that kind of service, they just got “it” right and wiped out the competition). Bitcoin may be the next big competitor. I’d like the be a fly on the wall at Paypal HQ right about now.
Mid, don’t get Bitcoin wrong, it’s not presenting itself as anything. Right now, it’s showing as more of a commodity because governments are being stupid and it’s early days for many services to have been created. But it’s a false dichotomy. It’s a service and a commodity like an electron is a wave and a particle.
And please, once again, let us understand something about deflationary currencies. If a currency is not deflationary, it is inflationary (OK, given that it might be possible to devise a currency that was neither but it would be *very* hard). Inflationary means the government is printing up a pile of money and giving it to someone. This is wrong and in other contexts would be called stealing as it takes value from people who have earned and gives it to those who have not (Though there is an argument that it would be preferable if the government did this rather than taxation). With a deflationary currency, the wealth is retained by those who earn it. Any growth in value should be considered a reward for having contributed in the growth of the economy. The deflationary spiral is a lie. Plain and simple nonsense to anyone who cogitates rather than regurgitates.
Laird, Of course I understand that in a thorough-going (and universal) deflation, then the price of capital goods will deflate too. That, unfortunately, does not solve the problem as you assume. And that’s partly because the movement of relative prices (consumer goods vs capital goods) does not, and for accounting purposes cannot, adjust at the same rate. Once you’ve stuck the asset on the balance sheet, it’s going to depreciate at a certain and basically unalterable rate. As a result, balance sheets end up adjusting far slower – decades slower – than they need to, with the result that asset turns basically never recover, and the capex cycle is delayed indefinitely. Indeed, there’s no reason why this can’t go on for decades. This is, after all, precisely what has happened/is happening in Japan. Your virtuous deflationary model rather reminds me of simplistic Keynesian two-state models: you get this, and then you get that. Doesn’t work for Keynes, doesn’t work for your deflationary model either, I’m afraid. (And all that’s before you get to try and work out how to price capital goods under a deflationary expectation).
Richard Thomas,
My goodness, you are assertive: ‘The deflationary spiral is a lie – plain and simple nonsense to anyone who cogitates rather than regurgitates.’ If assertion could do it, you’d have won the argument.
But sadly, it can’t. I am very sympathetic to Bitcoin, and wish it could be other than it is, but . . . i) it clearly is a deflationary ramp, ii) deflation is rarely benign (see responses to Laird for why) and iii) even if it was, you’d still end up trying to figure out a way round the Triffin dilemma. At the moment, because Bitcoin is so impossibly hard, everyone’s hoarding, rather than using it for transactions (surveys suggest about 70% of Bitcoin balances are idle, even though they carry no interest rate. Of course.)
Your observations about central banks and inflation are correct. The solution to the problem, however, is recognizing the fundamentally and impossibly (and uselessly) improper nature of the commercial bank as a commercial entity. What made sense in the 17th century (very high information costs, very high transport costs of money) make no sense at all in the 21st century (virtually zero info costs, virtually zero transport costs of money). The key to getting rid of the evils of inflationary central banks & govts is not, I’m afraid, Bitcoin, but in swapping commercial banks for universally distributed money market mutual funds. Ie, you’re looking at the wrong institutional error.
I don’t understand the debate about depreciation of capital goods. Surely this is just an accounting convention. Whilst it will impact accounting profits, management motivation etc, it is just an accounting convention (and as such could be changed). It seems to me that the strength of a going concern can be found by focussing on the cashflow statement rather than the p/l.
More generally I find it suspect when there is an implicit criticism of an arrangement that would come about through the free association of individuals.
Agree on Reconstructs last point. I suppose the bank branch network could be retained as a source of origination for loans (without the extension of credit)to go into the money market funds. If you could use iShares (say) as a medium of exchange what else do you need? Comments about ‘how we need to get the banks to start lending again’ are strange to me. Why exactly? Wasn’t debt the reason we got into this mess and shouldn’t we try and move to an equity based economy? If you can’t run your business without an overdraft then…. well frankly that says more about the state of your business than anything else.
Lastly, couldn’t Bitcoin just start selling newly created Bitcoins at the going rate, buy some gold and sundry assets and stick them in a reserve fund? This would address the supply issue and also make the currency more attractive. Might make it more currency like and attract the attention of the regulators though.
PeterT,
If we’d reacted to the 2008 financial crisis by mutualizing deposits and letting the bank shareholders/bond holders go and work out the real value of CDSs, we’d not only now have a properly operating credit system funding the UK economy now, we’d have avoided impoverishing pensioners and savers, and we’d also have re-invented the City for the 21st century, with models that could then have been exported globally. The opportunities presented by this crisis have been absolutely and utterly wasted.
Reconstruct, I agree with your last two points (concerning the institution of commercial banks and the failure to properly react to the collapse in 2008). However, with respect to the issue of deflation, I think we’re talking about different things. I am talking about what Schlichter refers to as “secular deflation” (not sure if he invented the term, but his was the first usage of it that I saw), which is the natural tendency of fixed-quantity money to appreciate in value along with the economic growth of a society. That’s a slow, steady process, which for capital goods purposes could easily be accommodated by using a proper rate of depreciation (which, as PeterT points out, is merely an accounting convention and readily subject to adjustment to reflect changed conditions). You seem to be thinking of more rapid deflation, perhaps even explosive deflation, which is the consequence of governmental mismanagement of monetary policy (and generally, but not necessarily, follows a period of hyperinflation). I agree with you that explosive deflation is bad for nearly everyone, but at this point in the game (with all global currencies having been so badly mismanaged for so long) we’re likely to see it anyway, whether or not it is preceded by hyperinflation. At which time the best possible outcome would be a return to commodity money of one sort or another (not necessarily, or only, Bitcoin, but that seems to be a strong candidate).
Reconstruct: You’re not incorrect to call what I said an assertion, it certainly is. But it is mostly in response to the commonly regurgitated assertions about deflation. My aim is not to convince but to challenge people to think about their claims. Most have fallen for what is little more than barefaced rationalization for theft.
As for your statement about the solution to central banks and inflation. Well, quite. Unfortunately, any such attempted movements in such a direction always run into the fact of politicians. Quite simply, trying to correct things through the system has not worked, is not working and likely will never work. Bitcoin, should it succeed or fail, is an outcome of this fact. When your lift doesn’t turn up, you catch the bus or walk.
Richard Thomas,
I’m much less pessimistic about persuading politicians to dump banks and go for universal money-market funds. It could be (and should be, logically), the successor to privatisation. I can even imagine the advertising slogan: ‘Tell Sid to award himself the bonus!’
Reconstruct: I sincerely hope you’re right.
Richard Thomas,
There was an illuminating discussion on Channel 4 News last night. It was a pretty obvious set-up: Jon Snow had got a Conservative member of the Banking Committee (name?) ‘on the right’ and ‘on the left’ someone from the New Economics Foundation. Anyway, Jon Snow, as you’d expect, was keen to pin the global financial crisis on Big Bang generally and M Thatcher in particular. But the subsequent debate absolutely didn’t plan out as expected: both the others zeroed in on the monopoly structures which had been allowed to encrust the city and distort prices and industry product. Jon Snow, bless him, literally didn’t manage to catch on quick enough to the radical agreement which had suddenly emerged before his eyes. Very hopeful sign: doesn’t matter if you’re from right or left – what matters is whether you can spot a monopoly/oligopoly at work. So, yes, I think there’s hope.