Saturday, April 6, 2013

Bitcoin is no Great Mystery

To cut a long story short, Bitcoin (or BTC) looks more and more like a quasi-financial asset in a bubble every day to me.

And Bitcoin is nothing like a real asset like a house or property; and it only roughly fulfils the definition of a financial asset. But a quasi-stock market is a good analogy for one main activity associated with Bitcoins: the exchange of them for local currencies.

Some intellectually interesting points are these: is a Bitcoin some kind of “produced” good, or more like a type of financial asset; and does the Bitcoin as a means of payment violate Mises’s regression theorem?

Some quick background. Bitcoin is a “decentralized digital currency” arising from, and depending on, an open-source, peer-to-peer internet protocol. It made its appearance in 2009. Bitcoin has an ambitious claim to divisibility: one Bitcoin can be subdivided into 100 million smaller units called “satoshis.” The stock of Bitcoins is increased by people downloading certain software and (generally) joining Bitcoin “pools,” in which they earn Bitcoins by making their computers solve algorithms. But the new number of Bitcoins created in the future will diminish and drop off. Eventually, there will be a fixed and finite supply of 21 million Bitcoins. But, notably, there are already issues of fraud in the manipulation of Bitcoin software.

But, for those who are not tech savvy, creating Bitcoins looks like a confusing, time-consuming, and exhausting business, not worth the effort. (Also, I notice that to ensure that Bitcoins are not lost if your computer crashes, you must print out or have some copy of the “wallet.dat” file.)

There are about 11 million Bitcoins in circulation, according to this graph.

But, curiously, it is not the daily number of transactions in Bitcoins (which rose from about 4000 in late 2012 to 7000 in April 2013) that has soared recently, but the price of Bitcoins measured in other currencies.

Has price stability of goods available in Bitcoins been observed since 2009? Apparently not. Bitcoin land had a kind of hyperinflation in 2011, set off by the bursting of the first bubble and loss of confidence when hackers stole many Bitcoins. Now essentially deflation in goods priced in Bitcoins is going on. While supporters might argue the latter is a good thing for Bitcoin holders (sure, it is), that was not the issue at hand: did price stability result? No.

If Bitcoin ever wants to be a real currency in the future, it must consider the needs of hypothetical Bitcoin debtors. For example, would you want to take out a loan in Bitcoins and then get hit by debt deflation? And apparently real world Bitcoin debtors do exist (as to the scale of Bitcoin lending, I have no good data.) In short, with no relative price stability, there will be no significant demand for Bitcoin loans, so you can say goodbye to serious and economically viable debt/credit developments within Bitcoin!

There is also another issue about the nature of Bicoins. Is a Bitcoin a consumption good or was it originally a consumption good? No, it was not. People do not produce Bitcoins to just “consume” them on their computer. Certainly, Bitcoins are not like some perishable consumer good, in the way a carton of milk or loaf of bread is.

Are they a durable consumer good? That looks false too. What use is a Bitcoin if you just hold it, never intend to sell it or use it in some exchange? How does it function as durable consumer good? It does not. Nor is a Bitcoin a capital good.

There is a twofold explanation of what Bitcoins actually are. First, if the people who first held them expected to derive indirect utility from Bitcoins by buying goods with them in the future, then they were being treated as if they were money from their inception. (If people derived direct utility from them by thinking that Bitcoins would provide them with future liquidity, then they also fulfilled the function of money from their inception, though I think this is less likely.) Secondly, if people had the expectation that Bitcoins would rise in monetary value, then Bitcoins also look like a type of speculative asset, or, better, a speculative digital asset (as opposed to a real or financial asset), but one not tied to any company in the way a private stock or bond is.

Bitcoins were obviously created to be “decentralized digital currency,” a type of money to be used as a medium of exchange and store of value. That is how the Bitcoin software was “advertised,” if you like. But a Bitcoin is not tied to some real commodity like gold at a fixed conversion rate. One wonders why any libertarian would get excited about it (as it turns out, most do not!).

A Bitcoin is backed by no commodity whatsoever: just like a stock or share, whose value is subjective and whose price is just determined by supply and demand on a stock market. The value of Bitcoins in goods or other currencies might crash tomorrow (and so might gold, but at least we have industrial uses for gold and uses in jewellery, etc.).

At the moment, the supply of Bitcoins might be regarded as somewhat elastic, if subject to diminishing future elasticity, and eventually zero elasticity. So, in the long run, there will be a finite supply of Bitcoins and an inelastic supply.

Here is the crucial point: a money facing a long-run inelastic and fixed supply is not much use for a real world economy, in my opinion. It will be useful mostly as some kind of a speculative asset.

Perhaps some kind of Bitcoin fractional reserve banks might emerge offering what standard fractional reserve banks offer: a mutuum contract where you sell your Bitcoins to the bank in return for a financial instrument or Bitcoin “demand deposit” (that is, Bitcoin debt money). But any run on these banks would likely cause utter collapse, as the base money of Bitcoins is so inelastic. Who will be the lender of last resort in a Bitcoin bank run? The answer: nobody.

If one wants to be ultra-cynical, Bitcoins are just another speculative activity for those producing and buying them. It is just another type of gold buggery – except even more ridiculous. It also has the potential to be exploited by criminals, and is therefore of questionable social value.

The whole Bitcoin phenomenon is like a decentralised operation to produce quasi-financial assets like stocks or shares, except you get no ownership stake in anything (except individual Bitcoins) and no dividends, only an alleged digital “currency” of marginal use in purchasing real goods, whose value is subject to wild fluctuations just like stocks and shares. There might be some transactions demand and (more likely) a speculative demand for holding them, but so what?

If you want to say that Bitcoins are nothing but a quasi-financial asset (without even many of the other properties of a financial asset), then (from the libertarian perspective) Bitcoins are just inherently worthless digital code, just as the physical paper record of a promissory note or share is virtually worthless. But just like a share, you can expect value fluctuations in the price of a Bitcoin.

Now a different issue. Austrians in general seem quite hostile to Bitcoins. Why? The reason is that they appear to violate certain Austrian theories about money.

First, Menger’s theory of money’s origins requires that a commodity emerges in the market as a real and actively exchanged good in spot barter trades. It then attains a “virtually unlimited saleableness” and thereby emerges as the dominant medium of exchange. But Menger’s theory does not really say much about the emergence of new “money things” in a society already dominated by money.

While Menger’s theory of money may be of questionable relevance for the subject of Bitcoins (I am undecided on this question), Mises’s regression theorem looks relevant, especially the strident, dogmatic statements made by Austrians like Rothbard:
“[sc. Mises’s] Regression Theorem also shows that money, in any society, can only become established by a market process emerging from barter. Money cannot be established by a social contract, by government imposition, or by artificial schemes proposed by economists.” (Rothbard 2009: 61).
What does Rothbard mean by “money”? If one wants to take “money” as just a widely-used medium of exchange, then the existence of numerous transactions in which Bitcoins are exchanged directly for goods means that Bitcoins are becoming a type of money (and there seem to be many places where you can buy goods directly with Bitcoins).

But a barter process presupposes that any “money thing” was previously exchanged in spot trades as a good, whether a capital good or consumption good, before becoming money. Yet I find it impossible to accept that Bitcoins were an “economic good” in either sense before rising to the point of being used in exchange.

While I would not press my conclusions here too far (since I have not studied the Bitcoin transactions for real goods in great detail), it looks like Austrians should explain why the use of Bitcoins as money does not violate their Regression Theorem. (This is somewhat of a waste of time, however, given that the Regression Theorem is trying to solve a pseudo-problem. Money has direct utility, and its value does not consist just in its current purchasing power.)

In short, let me conclude by saying that heterodox Keynesians or advocates of MMT face no theoretical difficulty explaining the emergence of Bitcoins. Our theory says that money can be created by anyone (think of debt money such as negotiable bills of exchange, or promissory notes), but the problem is getting it accepted (Papadimitriou and Wray 2010: 9). Bitcoins, for various reasons, have won some degree of acceptance. But, without relative price stability and an elastic supply, Bitcoins are not a viable monetary unit for any large capitalist system.

Any serious form of money ultimately develops into mere “money base” in a fractional reserve banking system with further credit money pyramided on top of it (just as gold did). But a Bitcoin fractional reserve banking system is not viable without an elastic supply, nor would a system of lending denominated in Bitcoins be realistic without relative price stability.

And last but not least: if you cannot pay your taxes in Bitcoins, then Bitcoins will never, ever displace real-world, national fiat currencies.

Meanwhile you might like to gamble in Bitcoins, or for that matter in stocks or shares, or in gold, but you might lose your shirt too.

“Money Has Direct Utility,” October 25, 2012.

“Mises’s Regression Theorem: A Critique,” January 13, 2012.

Matias Vernengo, “More deflation in Bitcoinland,” Naked Keynesianism, February 19, 2013.

Matias Vernengo, “Hyperinflation in Bitcoinland,” Naked Keynesianism, January 1, 2012.

Papadimitriou, Dimitri B. and L. Randall Wray. 2010. “Introduction: Minsky on Money, Banking and Finance,”
in Dimitri B. Papadimitriou and L. Randall Wray (eds.), The Elgar Companion to Hyman Minsky. Edward Elgar, Cheltenham. 1-30.

Rothbard, M. N. 2009. The Essential von Mises. Ludwig von Mises Institute, Auburn, Alabama.


  1. I don't know much about BitCoin but one of the most common uses of it that I have been hearing about regularly is purchasing drugs and other sorts of contraband without being caught. The hackers have also gotten their hands on the program. Fascinating analysis, LK.

  2. I think the supposed value people see in this currency is entirely premised on a confusion about how fiat money derives it's worth. Without a tax authority to guarantee the value of the coins by allowing people to retire tax liabilities with them, it is all built on sand. Scarcity alone is not enough! I can walk into my garden and find tons of rocks of unique shapes that are in principle scarcer than any exchange traded commodity. Doesn't mean anyone will pay for them or offer me goods and services in their exchange.

  3. Bitcoins seems to me as just another hype, I would compare bitcoins with "pet rocks" (see Like pet rocks, bitcoins have no intrinsic value and both derive their high value from a sudden demand for them.

    However, unlike bitcoins pet rocks cannot be lost due to computer crash.

  4. "a Bitcoin fractional reserve banking system is not viable without an elastic supply"

    I disagree with this statement. An FRB system with a fixed monetary base is viable. Banks would adjust the money supply to deal with fluctuations in demand for money and the price level would adjust to changes in the supply of goods. Many monetary theorists would think this the optimum system (see:

    BTW: In a free market for currencies I think your description of endogenous money would actually prove to be correct. The huge and monopolistic involvement of the state in the monetary system probably prevents alternative currencies that may better meet the needs of the economy than the current system from emerging.

    1. " Banks would adjust the money supply to deal with fluctuations in demand for money"

      And how would they do that with a fixed monetary base?

      How would they prevent a bank run, given that aggregate debts owed in the form of Bitcoin denominated demand deposits would vastly exceed actual Bitcoin base money?

      In a bank run, it is precisely base money that people want!

  5. "And how would they do that with a fixed monetary base?"

    In a FRB system the monetary base is (generally) fixed with the money supply "pyramided" on top of it - the lower the velocity of money the more the banks can safely lend out. When V changes the optimum reserve ratios change too.

    "How would they prevent a bank run, given that aggregate debts owed in the form of Bitcoin denominated demand deposits would vastly exceed actual Bitcoin base money?"

    They would minimize the possibility of a bank run by maintaining the appropriate ratio of reserves to loans and the appropriate time structure of loans to meet obligations.

    1. (1) You answered nothing. There is a fixed money base. If banks want more reserves where do they get them from? If they all increase demand for reserves, it means calling in loans or borrowing with excess demand not fulfilled.

      (2) This is absurdity. You cant predict bank runs. And changing the ratio of reserves just means calling loans or borrowing: in other words, signalling to people that they should panic. And where do they get the extra reserves?

      By contracting holding of money in the community, inducing deflationary shocks?

      (3) Even if they can borrow gold from foreigners, they must raise interest rates, most likely inducing recession at home and causing just more liquidity problems as people call in loans to repay debt.

    2. In any case, we were thinking of a Bitcoin FR banking system, so if there is a world wide financial crisis in a Bitcoin world where do extra reserves come from?

  6. I think we are confusing some different issues.

    1. An FRB system can work well on a fixed monetary base. Think of it this way: As long as bank customers are confident that the bank contains enough assets and enough liquidity to cover their deposits there is no reason for a bank run. If this is NOT the case then how will a flexible monetary base help ? Part of a banks strategy may indeed be to borrow from other banks to cover short term liquidity requirements but this fact does not make the monetary base elastic. Neither new customers nor other banks will lend to a bank that has not retained enough reserves or other assets to cover its liabilities - such banks run a high risk of runs.

    2. Bitcoin would probably not be a good choice for the monetary base of an FRB system but because its value is un-anchored and not because it is in fixed supply.

    3. While an FRB system can work on a fixed monetary base it may be the case that the demands of the economy are such that more money is needed. In a free market for money there is no reason why additional assets cannot be used to expand the monetary base. In this sense money would be endogenous to the needs of the economy.

    1. Rob,

      Your whole point is a truism and amounts to "Without runs on the banks there will be no runs on the banks".

    2. Not really: I'm saying that banks that lend unwisely or lend too much will end up with insufficient assets to cover their liabilities and customers will likely want to get their money out of such banks. This will be the case irrespective of whether the monetary base is fixed or flexible.

      Why is that a truism ?

    3. How would customers get their money out of a bank which could not meet its liabilities? Other banks are certainly not going to make loans to it, and its payments to those other banks will fail to clear, putting pressure on their balance sheets and creating panic amongst customers at nominally healthy banks. Bank failures create a ripple effect throughout the banking system, which is exactly why the pre-Federal Reserve era was so unstable.

    4. Free Banking solutions to preventing bank runs w/o LOLR:

      1) Option clauses on deposits

      2) Private liquidity insurance

  7. How do we know people won't be able to pay taxes in Bitcoin eventually?

    "E-Gov Link announces integration with Bitcoin in its popular E-Gov suite of products. Now municipalities can offer their citizens another option in paying for services."

    If bitcoin is purely a speculative bubble, how long do you think it will take to crash?

    1. That link shows no evidence at all of Bitcoin being used to pay taxes:

      Local governments who offer online payments can now provide their citizens with another choice of payment method. Integration with a backend payment processor provides the municipality with US Dollars that they expect. And the transaction costs are a fraction of traditional credit card purchases.

      Notice those words in bold?

    2. Yes, but the front-end payment would still be in bitcoin.

      Obviously, a municipality accepting bitcoins today would need to convert them to dollars b/c bitcoins aren't easy to spend. But if vendor acceptance and general usage were to grow, this would become less of a problem.

      I don't believe metallism and chartalism are mutually exclusive. If local govts accepted front-end tax payments in BTC, bitcoins would gain in "moneyness" and become even more widely used for transactions.

      What about the second question?

    3. One's " front-end payment " might be in Visa, Mastercard, and demand deposit money.

      "I don't believe metallism and chartalism are mutually exclusive. "

      Well, we can agree on this.

  8. Excellent article. I've added it to my Bitcoin index at the new Critiques Of Libertarianism.

    Oh, and BTW, many libertarians like Bitcoin because they think it is a thumb in the eye of governments, establishing yet another libertarian claim that government should be out of another business.

  9. I think that originally, bitcoins were a sort of commodity, albeit of a reified and intangible sort. Participation in the bitcoin scheme yielded undoubtable utility to tech-nerd libertarians of the Pete Thiel type. Bitcoin owners experience warm fuzzies, of a "now we're gonna stick it to the Man with our futuristic stateless currency/suck on THIS statist liberals!" nature

    1. This is also explains why bitcoins will ultimately fail outside the environment of the die-hard libertarian nerds. You can make anything work within a small group of highly ideological believers, but as long as the ideas are not shared with the outside world they are worthless.

    2. I've seen libertarians who are even acknowledging that Bitcoin is a bubble on their blogs and YouTube videos. I thought this was an issue that both ends of the political spectrum were agreeing on. Good luck to the losers who blindly think the Bitcoin bubble will be sustainable.

  10. Hi LK,

    these stats might interest you:

    US life expectancy fell from 44 to 39.4 years between 1870 and 1880. Both before and after this period US life expectancy increased in every decade. 1870-1880 is the only decade in which it fell. US average height also fell markedly during this period.

    1. That's remarkable, and confirmation that this era was one of the worst ever in US modern history in economic and social terms.

  11. Hello all,

    I suggest you seeing another idea.
    It is TOTALLY DIFFERENT from Bitcoin.
    It is about real official money (Euro, US$, GBP, Yen, etc) exactly as it is and functions today, just with banknotes not in circulation and use any more.
    It seems it solves a great deal of problems.
    Will be happy to have any comments and arguments, for or against.

  12. BitCoin will fail. But it's successors won't.

    Lord Keynes, you must know that the end of your reign is near. We are fast approaching the inflection point of history where decentralization outpaces centralization. It's coming is as inevitable and absolute as the progression of time itself.

  13. A very good read but it does seem to have one blind spot - essentially undervaluing stocks by comparing these to bitcoin: " just like a stock or share, whose value is subjective and whose price is just determined by supply and demand on a stock market."

    Stocks actually represent claims on real assets (plants, land, machinery etc) and a stream of earnings and related dividends. Ultimately this is what determines the long term value of stocks, While it is true that the immediate price of stocks is determined by supply and demand, that also holds true for all other liquid assets and commodities,

    My point is that comparing bitcoins to stocks does great disservice to stocks.

  14. @Roberto Severino: It looks like you haven’t seen the positive side of bitcoin. Bitcoin is used by several small and large companies worldwide as one of their mode of payment. Businesses accepting bitcoin are continuously rising. Read more about it here: