Beat Weber
Bitcoin is a fascinating example of innovation and collaborative online work. Its popularity also reflects a widespread uneasiness about the financial crisis and the policies adopted in response to it. Since 2008, the way the monetary system is perceived to be working is subject to public debate of an intensity unprecedented in recent times. Some people have also started looking for ways to exit from their entanglement in the prevailing monetary system, for instance, by exploring non-monetary assets like gold as store of value. Taking up these motives, Bitcoin has portrayed itself as an alternative monetary system. For some it is meant to serve a parallel online p2p economy. For others it even poses a challenge to the established monetary system. We concentrate on the claim for Bitcoin as a possible replacement of established money and derive implications about the possible coexistence of both later.
Force versus spontaneity?
“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve” (Nakamoto cited in p2p foundation n.d.). Bitcoin does not do away with trust. Instead of trust being invested in the institutions governing conventional money, Bitcoin asks for trust in technical design to govern the behaviour of its users. But if Bitcoin fulfilled all its technical promises, would it be viable money?
Many Bitcoin proponents buy into the story of the spontaneous emergence of money from a situation of barter, upheld by orthodox economics. According to this story, after an initial period of pure barter, one among many other commodities assumes the role of medium of exchange due to its superior saleability and its scarcity, durability and portability, thereby facilitating exchange. Only in a later stage, institutions emerge which transform money into its current form in a step-by-step approach (Menger 1892). The problem is that there is no historical evidence to support this story, and while other schools of thought present selective evidence that speak for the emergence of money from credit and involving the state (Ingham 2004), the true origins of money are lost in the mist of time. The Bitcoin project seems to assume that its own take-off can be modeled along the story portrayed above: After launching a scarce commodity in the market, this commodity can gain value and evolve spontaneously into money when market participants come to recognize its attractive features. But even if that story were true, there is a decisive difference to the present: Today, money is already invented. A new currency has to compete against an established monetary system.
A monetary system can be conceived as network, where the benefit of using the network rises with the number of participants (Dowd/Greenaway 1993). In such a case, members of established networks only switch to a different network when they expect most of their transaction partners to do that as well. Having become accustomed to calculating in one currency and having invested in currency-specific payment and pricing technologies also implies switching costs. Both factors lead to lock-in effects in existing currencies which are only overcome when the expected benefits of the new network significantly dominate the costs of switching, or if there is an institution organizing collective switching (e.g. the Euro introduction).
Bitcoin supporters seem to assume that switching would be a mass phenomenon if the state would not force its currency on users, and imagine that their project offers technological means to circumvent this monopoly. It is certainly illegal to use an alternative currency for tax evasion, money laundering or other illegal activities, and – contrary to many techno-utopian prophecies – the state sure has the means to enforce these laws to a considerable extent also in ‘cyberspace’. And the fact that the state exclusively accepts payments denominated in its own money as discharge of tax liabilities certainly favors state-backed money. But in most countries there is no law against two transaction partners agreeing payment in another medium than the official currency. So lock-in – a market mechanism – is the decisive factor for inertia in currency use, not state force. The core question then is this: Is Bitcoin attractive enough to overcome lock-in in currency use?
Bitcoin and money: The differences
Economists define money by three functions: unit of account, medium of payment and store of value. There is a deliberate limit to the “money supply” enshrined in the Bitcoin architecture (21 million), in order to make it attractive to users. The fact that a considerable amount of people have engaged as miners, buyers and traders of Bitcoin in recent years shows that, at least for these people, it is indeed attractive. The result has been a significant upward movement of Bitcoin’s exchange rate with other currencies over time. Periodically, there have also been many sellers, therefore the exchange rate has been very volatile. But while exhibiting a volatile upward trend makes for an interesting asset for speculative traders, it is not a feature conducive to such a quasi-commodity becoming money.
Most activity in Bitcoin seems to be in trading, not in its use as a means of payment for legal products and services. Most of the released Bitcoin stock is obviously not used for any current activity at all, but held in dormant accounts (Cohen-Setton 2013). The expectation that limited stock will meet growing demand, leading to appreciation, is the strongest economic motive to acquire bitcoins. People thereby motivated will periodically jump on and off the currency depending on the state of expectations about its future development. But such a constellation is detrimental to the development of a unit of account: As a result, sellers of goods and services currently do not display prices in Bitcoin only. Usually, prices for products and services which can be paid with Bitcoin are denominated in a different currency. Payment in Bitcoin can be made according to the exchange rate prevailing around the day of payment, meaning that the Bitcoin price varies whereas the price in the unit of account stays constant. For individual sellers, pricing their products in Bitcoin would involve costs and risks, because as long as all costs (for production inputs, personal consumption etc.) have to be paid with official currency, accepting Bitcoin in sale of production output involves an exchange rate risk and conversion costs. Being a tiny market with substantial volatility, Bitcoin trades against other currencies with a bid/ask spread.As long as prices are denominated in Euro, Pounds or Dollar, the most convenient and cost-efficient way to pay for goods and services is in those currencies.
Consumers on the other hand face strong incentives to hold on to any Bitcoin holdings instead of spending them: As long as supply is limited and demand for the currency grows, holders can expect appreciation of their Bitcoin stock. So Bitcoin’s supply limit leads to volatility and hoarding incentives. These features have negative implications for the prospect of fulfilling the three core functions of money: Volatility prevents Bitcoin from developing into a unit of account. Hoarding prevents Bitcoin from developing into a widely used medium of payment. The hoarding incentive implies features of a store of value, but volatility implies uncertainty of future value, therefore its core characteristic is that of a speculative asset. In conclusion, Bitcoin’s development into full money is undermined by its own design as much as by the presence of a strong incumbent.
With conventional currencies, the unit of account is established by being declared legal tender (which means that it will be used in payment of taxes and other transactions with the state, and in private contracts unless mutually agreed otherwise). A central bank acts as a market maker in charge of stabilizing the system against disruptions from inside or outside the currency area. Such an entity is deliberately avoided in the Bitcoin world because it would entail a centralization of power and this is considered problematic. But this centralization of power is overemphasized in Bitcoin’s critique of the current system, and the problems resulting from doing away with it remain underappreciated.
The way the current monetary system is often described in the Bitcoin community makes it resemble old style monarchist coin based systems: Like the king of old age who would secretly manipulate the precious metal content of coins and thereby regularly debase the currency, modern governments are thought to be able simply to print paper money and thereby create inflation any time. But the current monetary system is not based on pure fiat in this sense. It is based on credit and an integration of private and public actors (Bindseil 2004). Central banks are producers of “money proper”, which they bring into circulation by granting credit to banks against collateral, or by buying securities. Based on central bank credit (“reserves”), private savings of customers and loans from other financial market actors, private banks themselves then extend credit to customers according to an assessment of the latter’s creditworthiness. The electronic bookkeeping entries thereby created are used alongside money proper in modern payment systems, where customers regularly make payments more often by transferring electronic bank bookkeeping entries than by cash. The relationship between public and private money can be interpreted as a pyramid, where public money stands on top of the hierarchy (Mehrling 2012). This means that banks among themselves settle their balances with “money proper” (i.e. central bank reserves) and the public acceptance of private money substitutes issued by banks is conditional on a belief in the stability of the banking system by the public. In times of crisis, intervention by the top layer of the hierarchy can be needed in order to stabilize the system.
From this short description of the current system, one can see the following: Predominantly, money issue is not subject to the dictatorial decision making of a ruler, but tied to credit creation in the banking system, influenced by interest rates set by the central bank. Credit is mostly granted against collateral and is subject to an assessment of whether the borrower is either using the credit for profitable activities or is able to pay back the loan from income derived from such activities. Usually, the money supply only increases when borrowers demand credit and banks grant credit, based on a positive outlook on expanding production of resources. In this way, the system establishes a link between variations of the money supply and variations in the outlook for the production of goods and services based on the assessment and decision making of a variety of public and private actors. Of course, many things can go wrong in this process: The future may turn out worse than expected, borrowers can become insolvent, banks can fail, fraud and misjudgement can happen. Capitalism is not known to be a very stable system. In a crisis, views favoring a stabilizing role for the public sector clash with views which see a downward adjustment of the economy as unavoidable. The former view favors an expansion in the supply of “money proper” in order to compensate a crisis-induced breakdown in the supply of private bank money, as embodied by “unconventional” monetary policy measures adopted by many central banks in the recent years. But to focus only on the expansion of money proper and fearing an automatic rise of inflation implies a neglect of the compensating movement of private money substitutes and of the deflationary tendencies inherent in the current economic situation (see Gagnon 2013, Cour-Thimann/Winkler 2012).
Bitcoin and the economy
Bitcoin is deliberately decoupled from credit. Supposing Bitcoin were successful in replacing current money: What would that mean for the economy? Bitcoins are created as rewards for participants contributing computer power to transmit payments between users in the system (Nakamoto 2009). Thereby the Bitcoin payment transfer system is cross-subsidized until the upper limit of available bitcoins is reached. In contrast to the established monetary system, money creation is not coupled to economic production.
The quantitative limit set by Bitcoin’s designer/s on the amount of currency available implies a deflationary effect on the economy. In a growing economy with fixed stock of money, prices will have to fall. Most economists infer from the great depression that a deflationary spiral is the worst situation for an economy (Fisher 1933). Only a few libertarians disagree: According to Hülsman (2008, 26), deflation does not undermine investment horizons and profitability, because “profit does not depend on the level of money prices at which we sell, but on the difference between the prices at which we sell and the prices at which we buy. In a deflation, both sets of prices drop, and as a consequence for profit production can go on. There is only one fundamental change that deflation brings about. It radically modifies the structure of ownership” (because some businesses fail and are bought by new owners). This argument neglects the fact that firms face initial costs and contract commitments at today’s prices, which they need to recover with profits in tomorrow’s (lower) prices, which adds to uncertainty unless perfect foresight is assumed. In consequence, a number of investment projects who are only merely profitable at roughly stable prices will not be undertaken. And the remaining projects are clouded by the uncertainty about exactly how much prices will fall tomorrow. In addition, consumers face hoarding incentives in a deflationary environment, so any investor faces additional uncertainty about whether sales volumes within the investment horizon will be high enough.
Falling prices are of course convenient for those who dispose of ample monetary wealth, but all those who depend for their income on current economic activity are hurt by the depressing effect of deflation on economic activity.The deflationary effect could be mitigated if a fractional reserve-based credit money would be allowed to develop on the basis of Bitcoin. Paper claims on Bitcoin could circulate alongside “real” Bitcoins, just like private banks started with fractional reserve banking on the basis of coins and gold centuries ago (Ugolini 2011). And absent any authority, who is to prevent the development of trade credit among regular trading partners? While there is no technical barrier against such a repetition of monetary history, Bitcoin’s initial concept is completely at odds with such a development. It follows a line of thinking that ignores trade credit relationships and conceives of fractional reserve banking based credit money as a kind of fraud assisted by government. It supposes that without government interference credit would and should consist in transfer of hard currency between lender and borrower only. In such a scenario, credit would be extremely limited and only available against collateral or among people acquainted to each other. Starting a business that involves larger upfront outlay costs without ceding ownership to external equity holders would only be possible for people who are already wealthy.
Establishing money that is unable to adapt to changing circumstances implies that the whole economy has to adapt to the monetary standard. The costs of this adaption can be considerable (Eichengreen 1992).
A Bitcoin niche?
In the future, Bitcoin may continue to serve as a speculative asset but it is not a viable alternative to the current monetary system. What are the chances of its survival as a parallel currency in a niche? As a medium of payment, Bitcoin has potential wherever transaction partners are willing to incur the extra costs involved in using Bitcoin in order to avoid unwanted implications of transacting in official currency, i.e. make transactions that are illegal and avoiding taxes. When such activities cross a certain threshold, authorities will intervene.
To grow beyond that, a significant number of actors from all sectors of the economy would have to be prepared to risk huge losses for a considerable time by posting prices of their products and services in Bitcoin only in order to establish a critical mass for a parallel economy in the long term, and then continue to deal with instability and deflationary pressure. Such efficiency neglecting behavior might be conceivable in tight communities with strong dedication for the common cause and high intensity of trust which enables coordinated behaviour (Benkler/Nissenbaum 2006). But it is at odds with the assumptions about user behavior implicit in the Bitcoin framework, which stress mutually distrustful homo oeconomicus-type actors in a setting of anonymity.
References
Benkler, Y./Nissenbaum, H. (2006): Commons-based Peer Production and Virtue, in: The Journal of Political Philosophy 14/4, 394–419.
Bindseil, U. (2004): Monetary policy implementation. Theory, past and present, Oxford, Oxford University Press.
Cohen-Setton, J. (2013): Blogs review: Understanding the mechanics and economics of Bitcoin, www.bruegel.org, April 10, accessed on 17 July 2013.
Cour-Thimann, P./Winkler, B.(2012): The ECB’s non-standard monetary policy measures: The role of institutional factors and financial structure, in: Oxford Review of Economic Policy 28, 765-803.
Dowd, K. /Greenaway, D. (1993): Currency competition, network externalities and switching costs: Towards an alternative view of optimum currency areas, in: The Economic Journal 103/420, 1180-1189.
Eichengreen, B. (1992): Golden Fetters: The gold standard and the great depression, 1919-1939, Oxford.
Fisher, I. (1933): The debt-deflation theory of great depressions, in: Econometrica 1/4, 337-357.
Gagnon, J.E. (2013): Misconceptions about Fed’s bond buying, Bloomberg Op-Ed, September 2.
Hülsmann, J. G. (2008): Deflation and liberty, Auburn, Ludwig von Mises Institute.
Ingham, G. (2004): The nature of money, Cambridge, Polity Press.
Mehrling, P. (2012): The inherent hierarchy of money, in: Taylor, L./Rezai, A./Michl, T. (eds.), Social Fairness and Economics: Economic essays in the spirit of Duncan Foley, Oxon/New York, Routledge, 394-404.
Menger, C. (1892): On the Origins of Money, in: The Economic Journal 2, 239-55.
Nakamoto, S. (2009): Bitcoin: A Peer-to-Peer Electronic Cash System, http://bitcoin.org/bitcoin.pdf, accessed on 9 July 2013.
P2P Foundation (n.d.): Bitcoin, http://p2pfoundation.net/bitcoin, accessed on 9 July 2013.
Ugolini, S. (2011): What do we really know about the long-term evolution of central banking? Evidence from the past, insights for the present, Norges Bank Working Paper 15/2011