State of Innovation

Patents and Innovation Economics

Bitcoin: One of the Greatest Economic Experiments of All Time

Whether you love or hate Bitcoin and cryptocurrencies you have to admit that it is one of the greatest economic experiments of all time.[1]  It is very rare in economics to have a well-defined and controlled experiment.  I learned about this experiment in a decentralized private currency with a limited supply by 2012.  At the time it was not clear if this experiment would ever really get off the ground.  Bitcoin was valued at about $13, with a market capitalization around $15 million.  In addition, it was difficult to buy and sell Bitcoins.  Despite this I had conversations with people about the questions Bitcoin posed, particularly about the nature of money.  There had been other cryptocurrencies before Bitcoin and when they got traction governments shut them down.

Now it is clear that Bitcoin, cryptocurrencies, and the underlying technology (decentralized, trustless, blockchains) are here to stay.  A single Bitcoin is valued at over $6,300.00 and the total market capitalization of cryptocurrencies is around $181 billion.  This is small compared to the FOREX market, but too large to ignore, which means the economic experiments will be played out.  Here are just some of the questions posed by this experiment.

 

1) What is money?

Bitcoin and most cryptocurrencies do not actually have a physical or even computer coin or token.  They are in fact just ledgers where the “coin” is the unit of value.  The ledgers show who paid whom what and a positive account shows that you have provided value and are owed (or at least hope to) obtain value from the community in the future.  If Bitcoin is successful it will show that money is not a thing, it is really just an accounting system that is it is just information.

It will also show that money is technology.  Andreas Antonopoulos points out that the last real upgrade to that technology was the credit card, introduced by Dinner’s Club in 1950.

2) Does Money Have Inherent Value?

Or stated another way does money need to have an inherent value?  Bitcoin does not have inherent value and in fact nothing has inherent value.  For something to have value means it has to have value to someone.  Value cannot be separated from the valuer.  The only things that even come close to having inherent value to humans are food, water, and air.  If Bitcoin succeeds it should settle the question of inherent value.

3) Do We Need Legal Tender Laws for Money to Work?

Most people seem to assume that money must be backed by a government or it will not work.  Legal tender laws are laws that state you must accept the legal tender as settlement for any debts public or private.  Of course, there are many examples in history where people used gold and silver as money that was not endorsed or backed by any government.  The United States did not have any legal tender laws from the Constitution until the Civil War.  If Bitcoin succeeds then it will be clear that money can be private, i.e., not backed by a government and legal tender laws.  If you want to know more about legal tender laws in the U.S. see Money and Banking.

4) Is a Low Rate of Inflation Good for the Economy?

The Federal Reserve and most central banks argue that a little inflation is good for the economy.  We are warned that without inflation we might fall into deflation, which caused the Great Depression.  In the United States the target inflation rate is 2% per year, which means the purchasing power of a dollar today would be ¼ of what it will be in 70 years later.  Even Milton Friedman argued that the money supply should grow at the same rate as the economy.  According to Friedman this would keep the value of the dollar stable.  This means if the economy grows at 3% per year then according to Friedman the money supply would grow at 3% per year.  One question Friedman does not answer is who benefits from this growth in the money supply?  The answer is the Federal Reserve and the U.S. government, essentially get 3% of the value of the economy in this example for doing nothing.  Also note that the U.S. was in a deflationary period in the 1880s and 1890s and it was a time of extraordinary economic and technological growth.

Bitcoin has an inflation rate (supply increase) that is used to pay the miners during the start-up years.  Presently the supply increase is about 4% per year.  In order to convert this into an inflation rate the way the term is commonly used in the United States, we would have to subtract out the growth rate of the economy.  The expected growth rate of the U.S. economy this year is 2.7%.  Thus the inflation rate for Bitcoin is 1.3%, which is less than the Federal Reserve’s target rate.  Also Bitcoin’s inflation rate slows down overtime and the total number of Bitcoins that can ever be produced is 21 million.

If Bitcoin succeeds, we will see whether a little inflation is good for the economy.  We will also see if private citizens prefer to hold a devaluing currency or value increasing currency.

5) Do We Need Central Banks?

Central Banks are a fairly recent phenomenon.  The United States did not have a central bank until the creation of the Federal Reserve in 1913.  The U.S. did have national banks, but these were not central banks.  A central bank has control over the currency of a nation and through convoluted processes creates and destroys money to “manage” the economy and to fund the government.  For more see How Central Banks Create Inflation.  The record of the Federal Reserve of “managing” the economy is very checkered including the Great Depression, the inflation and high unemployment of the 1970s, and losing 95% to 97% of the purchasing power of the dollar during its existence.

If Bitcoin succeeds, it will end the power of or at least significantly diminish the power of central banks.  We will then see if a central bank is necessary to create prosperity and smooth out the ups and downs of the economy.

6) Do We Need Securities Regulations – the SEC in the U.S.?

Securities like stocks and bonds were mainly regulated by common law fraud and contract law until the 1920s in the United States.  The justification for securities regulations have always been to protect investors.  There have been a number of studies on point and not one of them has shown that investors have done better because of securities laws and some have shown they do worse.

Bitcoin’s technology has the potential to create stocks, bonds and other securities.  However, it is not as clear that these can escape the regulatory rules in the way that Bitcoin can.  Already we have seen crypto-assets created that bypass both Venture Capitalists, Wall Street, and securities regulations.  Before the creation of the SEC in the United States in the 1930s this was quite common.

If Bitcoin’s technology can escape securities regulations, we will see if securities regulations help investors or if they just entrench large Wall Street banks.

7) Is a Financial Sector that Takes Up 20% of the GDP Good for the Economy?

Cash is almost dead in most modern economies, which means we pay for goods and services with credit or debit cards.  This “convenience” costs at least 3% of the transaction price assuming the bill is paid immediately.  It also puts the banks and government in between almost every transaction.  Securities regulations and banking regulations are so complicated that people are forced to use financial intermediararies for almost any financial transaction.  In 1947 the financial sector was only 10% of the United States GDP.  Finance does not create wealth, it just greases the wheels of transactions.  For instance, money is just a way for one person to sell their “time” and buy goods.

Bitcoin and Bitcoin’s underlying technology if they succeed may significantly shrink the financial sector.  For instance, by allowing everyone to be their own bank or credit card company or loan originator the fees to the financial sector will be severely undercut.  If Bitcoin succeeds we will see if the large financial sector was creating wealth or consuming it.

8) Do We Need Income Taxes?

Bitcoin has the potential to severely undermine income taxes and capital controls.  Do people think they get value for their income taxes?  Are income taxes a method of raising revenue or a system for punishing the politically un-connected or unpopular?

9) Can Bitcoin Decentralize the Internet?

The Internet was built on a series of decentralized technologies.  Because of the inefficiencies of our financial sector, the only way to monetize the Internet was with centralized systems like Google, eBay, Youtube, Amazon, etc.  Efficient micropayments that can be implemented using Bitcoin technology have been postulated as a way to decentralize the Internet and return it to its origins.  Only time will tell.

10) Do We Need the NSA to Protect Us?

The technology behind Bitcoin has the potential to store and transfer information that is not trackable and cannot be hacked.  These systems are just being developed.  If they are successful, we will find out if the NSA was just a boondoggle or if it was truly protecting us, not the government.

 

 

[1] Unless you are an Austrian Economist and then you do not think experiments and therefore observation are relevant to economics, which means you are not doing science.

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October 31, 2017 Posted by | -Economics, -History | , , , , | 1 Comment

Ayn Rand Was Wrong

Rand in The Virtue of Selfishness states that a breach of contract is the use of force, like fraud is an indirect use of force.

A unilateral breach of contract involves an indirect use of physical force: it consists, in essence, of one man receiving the material values, goods or services of another, then refusing to pay for them and thus keeping them by force (by mere physical possession), not by right—i.e., keeping them without the consent of the owner.  Fraud involves a similarly indirect use of force: it consists of obtaining material values without their owner’s consent, under false pretenses or false promises.

“The Nature of Government,” The Virtue of Selfishness, 111

This is incorrect and to the extent Objectivists accept this they hurt themselves and their psyche.  A simple example will illustrate the flaw in the above statement.  Assume a musician contracts to play at a venue a month from now.  Then the day before the concert he is killed in a car accident.  The musician certainly cannot fulfill the contract, so he is in breach of the contract and it was unilateral.  The venue and promoter will certainly lose money because of this.  Should the promoter be able to sue for breach of contract and recover damages?

A contract is a legally enforceable promise.  In any immediate contract, such as buying food, contract law is boils down to fraud protection.  It ensures that the purchaser does not take the goods and not pay for them or that the merchant does not take the money and not hand over the goods.  For immediate contracts Rand’s statement above is true.

Long term contracts that are carried out over several days to several years can easily have extenuating circumstances that mean a breach is not an indirect use of force.  Remember a contract is a legally enforceable promise.  This promise cannot take every circumstance into account.  One way lawyers try to account for unforeseeable circumstances in a contract is by inserting an “act of god clause”, also known as a force majeure clause.  When these clauses are used in insurance contracts they lead to a contradiction.  The whole purpose of insurance is to protect against unforeseen events.  They are bad clauses in any contract because they are inherently vague and subject to widely varying interpretations.

When a contract is in dispute the role of the court is to discern what the parties intended.  If the parties did not take something into account, such as the musician dying in a car accident, then the court has to decide what the parties would have done if they had thought about the issue.  In the case of the musician, the “breach” was not intentional.  I doubt that the intention of the parties was to hold the musician financially responsible if he dies in a car accident the day before the concert.  Lawyers can try to anticipate every circumstance but this leads to long unread contracts, where the parties really did not agree to obscure clauses.  It also leads to what is called the battle of the forms, where each party tries to get the other party to agree to their form just as the deal is closed.  Clauses that are not discussed or agreed to explicitly defeat the real intention of contracts and should be viewed with skepticism by courts.

Government imposed clauses, such as the Uniform Commercial Codes’ (UCC) implied warranty of merchantability should never be allowed.  The implied warrant of merchantability “is a warranty implied by law that if a seller knows or has reason to know of a particular purpose for which some item is being purchased by the buyer, the seller is guaranteeing that the item is fit for that particular purpose.”[1]  There is no need for the implied warrant of merchantability if that was intended by the parties and if it was not the intention then it should not be enforceable.  This “implied warranty of merchantability is why software was licensed and not sold.  Software could not meet the implied warrant to merchantability in its early days.  This lead to a number of other problems that still afflict us in the software space and is an example of the unintended problems that occur when the law is stretch outside of its logical framework.[2]  Note that a contract to commit a tort (crime) is not and should not be enforceable.

Long term contracts, such as thirty of even forty year mortgages, are fraught with unforeseeable circumstances.  We cannot know the future that well.  In cases like these even intentional breaches are not necessarily the use of indirect force.  Many long term contracts have termination clauses to account for this and to an extent invoking the termination clause is not a breach.  However, most termination clauses have a part that covers a breach and how it is handled.  For instance, a long term contract to supply say gas to a business on the first of the month, might be breached if the supplier’s truck(s) is broken down on the first of the month.  Technically the supplier is in breach of the contract.  Most termination clauses will allow the breaching party to cure the breach within a period of time.

What if the supplier’s wife is murder and he becomes depressed and chooses not to deliver gas anymore.  The supplier is intentionally breaching the contract, but has he used indirect force against the customer?  Most likely the customer has not paid for the gas yet or has only paid for one month in advance.  A contract cannot be used to turn someone into a slave.  Because of this, all long term contracts have an implied termination clause.  It is also why we have bankruptcy laws.  It is also important to note that you do not have right to a risk free life and law cannot and should not be used to remedy every small harm that happens to people.

Mortgages are an interesting long term contract and of course in the news after the financial crisis in the U.S. in 2008.  People have the mistaken impression that a mortgage is like a personal loan between friends.  The bank does not give the house buyer money out of its coffers, it creates the money.  The bank collateralizes the house, much like a bond issuer creates the bonds “out of thin air”.  The bank takes legal title to the house either directly or indirectly as security that the loan will be paid back.  If the “home owner” cannot or does not pay the mortgage the bank asserts its legal ownership of the house and sells the house to extinguish the money created in the mortgage contract.  Note I did not say pay back the mortgage.  The money is literally destroyed, just like a bond that has been paid off no longer exists.  If the home owner purposely breaches the mortgage, did they use indirect force?  One answer is no because the mortgage contract implicitly includes a termination clause that the bank takes legal control of the house if the mortgage is not paid.  In other words the bank made a deal that if you payoff the mortgage you get legal control of the house and if not the bank gets or keeps legal control of the house.

So how should we think about long term contracts?  First of all we should understand that all long term contracts have an implied termination clause.  Second, we need to remember that contracts cannot be used to turn people into slaves.  Third, we should remember that contracts are an agreement between two parties.  As long as the parties are getting along there is no reason for the government to be involved even if the parties are not following the contract.  The main reason for most long term contracts is to provide a roadmap of how the two parties are going to do business together.  As a result, courts should be skeptical of clauses in contracts that were not discussed.  Not doing so turns contracts into a lawyers game of gotcha and does not fulfill the purpose of contracts.  Most long term contracts are used by the parties to show their intention at the time the deal was made.  This usually comes up when one of the parties is unhappy.  A good contract should help resolve these issues.  In fact, that is the most important purpose of a long term contract.   However, sometimes the issues between the two parties are too great to be resolved.  In that case the termination clause, whether implicit or explicit, should kick in.  If the termination is too burdensome then bankruptcy laws should kick in.  Both parties should be aware of this possibility.

Except for immediate contracts Rand’s statement that unilateral breach of a contract is an indirect use of force is incorrect.  This just proves that Rand was human and not an expert in law.

Libertarians make the mistake of trying to base property law on contracts, when it is the other way around.  Contract law presumes that both parties own themselves (have legal control over their actions) and often presumes that one or both of the parties have property rights in something.  But libertarians like Rothbard try to turn things around and create property rights out of contracts.[3]  Reversing cause and effect leads to all sorts of problems.  However this mistake by libertarians is based in the fact that they do not understand property rights.  In fact, libertarians do not “believe” in property RIGHTS they believe in property privileges that solve the economic problem of scarcity.

A proper understanding of property rights and contracts is essential for a free society to exist.  Contracts presume property rights and ownership of one’s self.  Long term contracts cannot be used to turn people into slaves or to commit a tort.  Objectivists hurt themselves when they treat contracts like Christians treat the Ten Commandments.

[1] https://en.wikipedia.org/wiki/Implied_warranty, accessed 10/1/17.

[2] This is related to the legal saying that “hard cases make bad law”.  https://en.wikipedia.org/wiki/Hard_cases_make_bad_law

[3] https://www.libertarianism.org/columns/libertarian-views-intellectual-property-rothbard-tucker-spooner-rand, accessed 10/8/17.

October 8, 2017 Posted by | -Legal, Legal Philosophy | , , , | 2 Comments