November 5, 2016    11 minute read

Bitcoin: A Crowd-Pleaser Once Again

A Historical Overview    November 5, 2016    11 minute read

Bitcoin: A Crowd-Pleaser Once Again

Money has been around a long time, at least conceptually, with economic historians broadly agreeing that the earliest recognisable form of money was livestock in the period 9,000-6,000BC. This choice made perfect sense considering the six now universally-agreed prerequisites of money.

  1. Store of value
  2. Durable
  3. Divisible
  4. Portable
  5. Uniform
  6. Credible

Commodities have a natural scarcity – their supply is finite – and there is an associated cost of production/extraction. These two characteristics alone make them attractive by satisfying the “store of value” attribute listed above (arguably one of the most famous of the six).

However, because commodities are also useful articles of trade, by definition they have used other than as a medium of exchange. This is a distinctly useless feature for any money because it means that monetary shocks can arise from changes in the non-monetary demand for the commodity. Similarly, commodities are also vulnerable to supply shocks, such as finding new sources of higher-grade metal ores (throughout history gold and silver have been the most attractive commodity monies) and cheaper extraction methods.

In light of this apparent deficiency, and concomitant with increased financial sophistication, money has evolved into a more abstract form. Today what one considers to be money is either central bank issued notes and coins or electronic deposits held at commercial banks (the latter accounting for the overwhelming majority of transactions in modern economies).

That said, the transition from commodity or commodity-backed monies to the present fiat money system was neither swift nor smooth. Indeed, there is a rich history of failing fiat monies dating all the way back to the 17th century.

Cheap Money

The fundamental problem with fiat money is that it is not backed by anything other than the credibility of the issuing authority. And, because the marginal cost of production of fiat money is negligible, issuers face strong incentives to increase the supply of money until its market value falls to the (very low) cost of production. This is true even when the issuing authority is the government – or government agent in the case of a central bank.

Indeed, there are numerous examples for government-issued fiat money having failed with fiscal overspend the common cause of the failure. Simply put, governments faced with escalating expenditures face a stark choice: raise funds by increasing taxes (very transparent and politically unpopular) or fire up the printing press (much more subtle). Debasing one’s currency has disastrous long-run consequences, as the Weimar Republic amply demonstrated in the early 1920s, but numerous precedents suggest it is often the better short-term choice politically.

Hence, while both real commodity and pure fiat money systems have benefits, they also have significant shortcomings that explain why neither system has proved historically robust. However, this bipolar characterization of money is no longer all-inclusive in light of the innovation of digital currencies, notably Bitcoin.

Eliminating The Third Parties

The underlying rationale for Bitcoin, as outlined in the first few paragraphs of Satoshi Nakamoto’s 2008 seminal white paper, is – like all great ideas – simple. Despite the surge in commerce over the internet, the system still relies almost exclusively on financial institutions acting as “trusted third parties.”

The key innovation of Bitcoin is that it does away with the need for a central issuing body by using complex encryption technology to make transactions “computationally impractical to reverse”. So, rather than relying on a central authority to verify every transaction to ensure there is no double-spending, Bitcoin does it via an open network, thereby creating a decentralised money system that allows transacting parties to conduct business bilaterally.

The other design feature of Bitcoin that is ingenious, and which provides the greatest source of intrigue to economists, is that the supply of Bitcoins is predictable and eventually finite. Bitcoins can only be mined at a pre-specified growth rate that will steadily decline until the total amount is capped at 21 million. To ensure that the production of Bitcoins is in line with the release schedule, the degree of difficulty in “mining” or verifying existing transactions is variable and a function of the number of “miners” or computer power employed. Hence, even if some individual, or more likely organisation, were to operate supercomputers to maximise their mining success, this would simply affect the share of Bitcoins mind, not the total amount.

To think about how Bitcoin fits within the spectrum of money classification types consider the following table, which is contained in a working paper on counterfeit commodity currencies published by Selgin (2013).

Base Money Types

Screen Shot 2016-11-04 at 20.24.28

What is clear from the above table is that Bitcoin manages to combine the pros of a commodity-based system, as its scarcity is – by design – absolute, and a fiat-based system, because just like bank notes or electronic bank deposits Bitcoin has no known (at least as far as one is aware) non-monetary uses. So, theoretically, it represents a significant improvement over the two money-types that have been used during the entirety of human existence.

Before going on to discuss several drawbacks with Bitcoin, one should first dismiss one often-stated criticism of the virtual currency, namely that it is nothing more than a sophisticated Ponzi scheme. The analogy stems from the fact that Bitcoin pays no interest rate. Hence, it is argued, making a profit from investing in Bitcoin relies on other investors purchasing it later at a higher price.

Superficially, the analogy seems valid. It does not require much reflection to realise that it is flawed. Bitcoin is a fully functioning (albeit virtual) money that allows anyone to make transactions – it is no more a Ponzi scheme than any other form of fiat money. Moreover, assuming the supply is eventually capped at 21 million, Bitcoins should – at a minimum – continue to rise in line with inflation, if not nominal GDP growth, as there is no reason to expect its purchasing power to diminish. For both reasons even late adopters (the suckers in a pure Ponzi scheme) still benefit.

Bitcoin’s Credibility

A more well-founded drawback relates to the credibility of Bitcoin’s founder, the infamous Satoshi Nakamoto. The real identity of Satoshi is unknown and subject to intense scrutiny and speculation in the media. This anonymity naturally raises doubts about Bitcoin’s credibility. However, when considering this question it is worth also reflecting on the following corollary question: Who would you rather trust? A tech geek who has promised to limit the supply of its virtual money in a highly visible manner, or central banks mandated by their government to issue money in quantities sufficient to ensure its real purchasing power steadily declines.

When considered in this light the answer to the trust question is not so obvious. Moreover, this was the greatest risk to Bitcoin at its inception. Now the virtual currency has become, in some sense, more established, this concern is somewhat diminished.

Another widely discussed drawback to Bitcoin is that the price is very volatile. Indeed, in 2013 it rallied by nearly a factor of 50. The reason why Bitcoin has such high price volatility compared to other money forms (instability of money can be thought of as the inflation rate or the exchange rate versus other currencies) is that the price is purely market driven. There is no market-maker to smooth out short-term imbalances between demand and supply.

Over the very long-term, Bitcoin’s price volatility will tend to dampen down as the combination of increased supply (as a result of mining) and – ironically – a higher rate means that the Bitcoin market becomes increasingly liquid. That said, until such time, Bitcoin’s price lies hostage to the vagaries of crowd sentiment more than other global currencies.

As can be seen in the chart below, the crowd-sourced sentiment indicator towards Bitcoin has tracked its price movements reasonably well over the past several years. The first wave of crowd positivity towards Bitcoin began in early 2013 when several factors combined to boost the currency’s legitimacy – even former Fed Chairman Bernanke acknowledged that it “may hold long-term promise” – and, as the price started to rise, public awareness of Bitcoin surged, all of which culminated in a huge price spike.

Slide1-8

(Crowd-Sourced Sentiment and dollar Price – Bitcoin; Source: Infotrie and Amareos)

Even though the second wave of optimism that begins in May 2014 preceded a modest rebound in Bitcoin’s dollar price, the hangover from the earlier price spike and the well-publicized bankruptcy of one of Bitcoin’s largest exchanges Mt. Gox in February 2014 proved dominant. As crowd positivity began to wane, Bitcoin’s price resumed its downward slide – a trend that persisted until the last summer when sentiment hit its lowest level since the data have been available.

This low point in sentiment marked the completion of a two-year long post-spike consolidation phase in the Bitcoin price and the start of a more steady uptrend (at least in comparison with the 2013’s price spike). Looking at the right-hand side of the above chart, crowd sentiment towards the currency remains constructive suggesting that there remains more upside in Bitcoin’s price.

As to the question of how much upside there is for Bitcoin’s price, this is subject to heated debate. After all, how does one even go about providing a fundamental valuation for a virtual currency that generates no cash flow? Surely it is impossible. Well, it is an intriguing question for economists, and they are not ones to back down from a challenge. So, consider the following thought experiment.

Bitcoin Vs Fiat Money

At a global level, the total stock of outstanding fiat money is approximately $50trn. Assuming no decline in the stock of money, which would be deflationary and economically toxic given the extremely high levels of debt (public and private) globally, if Bitcoin were to replace fiat money completely, then the 21 million Bitcoins that will be produced must equal the global supply of fiat currency. This implies that each Bitcoin would be worth a staggering $2m.

Now one admits that the assumptions are brave, but even if one applies colossal margins of error around this valuation, it strongly suggests that around the $650 mark (at the time of writing) Bitcoin is significantly undervalued. For those readers who think that such a high valuation makes Bitcoin totally impractical to use, they should note that it has been designed to be divisible to eight decimal places. This degree of divisibility means that even if each coin was valued at $2m payments equivalent to penny transactions could still be made.

At this point one should add a huge caveat to the above analysis – one that highlights another serious risk to Bitcoin. The $2m valuation for Bitcoin is premised on it replacing all existing fiat currencies. This is never going to happen, although one is still a long way off from this being acted upon.

Governments enjoy monopoly rights to print their currencies, and they can force its usage by requiring taxes be paid it in. This is a huge advantage, and they will not give it up. Combined with the ability of Bitcoin transactions to be made anonymously, there are incredibly high incentives for lawmakers to try and regulate Bitcoin, or in extremis, try to shut down the entire system.

Moreover, if Bitcoin were to become the predominant money of the global economy, there would be no role for central banks as the need for a single transaction-verifying institution would cease. This, combined with a seeming desire to eradicate cash so as to enable them to remove any lower bound on nominal interest rates, probably explains why central banks are utilising resources to understand digital currencies better.

Finally, this might seem like an economic anarchist’s utopia, but it is worth remembering the words of Milton Friedman, who wrote the following in his 1962 publication In Search of a Monetary Constitution:

“Money is too important to be left to central bankers”.

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