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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 | , , , , | Leave a comment

“Bitcoin is Evil”

This is the title of a Paul Krugman New York Times blog article from 2013.  Krugman writes for the New York Times and is a Nobel prize winner in economics.  He soft pedals his complaints about Bitcoin, but high on his list are that Bitcoin could undermine the ability of the Federal Reserve (and U.S. Treasury) to manipulate the money supply to “manage” the economy.  Not surprisingly, many Libertarians like Bitcoin for exactly the same reasons Krugman hates it.  However, not all libertarians and Austrian Economists like Bitcoin.  For instance, Peter Schiff is no fan of Bitcoin, he thinks “Bitcoin Is A Speculative Frenzy.”

Bitcoin is commonly described as a digital currency.  But what does that mean?  The US dollar and the currencies of all major economies are also digital currencies, at least in the sense that most US dollars are just digital entries.  As I showed in the article “What is Money”, money is just an accounting entry (computer entry) and a generalized I Owe You.  Bitcoin however is not a government created or backed currency and the total number of Bitcoins that can ever exist is mathematically limited to around 21 million.  On the other hand nothing stops the United States (or other governments) from creating an unlimited number of dollars.

There have been other attempts to create private digital money, however most of them suffered from being centralized.  When digital currencies have a central location, such as a central server, they become targets for hackers and governments.

Satoshi Nakamoto published a paper laying out the Bitcoin technology in 2008 and released open source software to implement Bitcoin in 2009.  Nakamoto’s paper lays out a peer-to-peer or decentralized digital ledger, meaning there is no central point of failure or place to attack.  The technology is not really about coins so much as it is about a public accounting ledger that keeps track of all these Bitcoin IOUs.  In Bitcoin the transactions are encrypted, but more importantly new transactions are linked to the earlier transaction and the ledger is encrypted. This is called block chain technology.  Bitcoin has never been hacked.  Some exchanges that trade Bitcoin have been hacked, but not Bitcoin.  If you want to understand the underlying technology better see “How Bitcoin Works.”  One of the interesting facts about Bitcoin is that no one knows who Satoshi Nakamoto is to this day, despite efforts to find him.

A number of complaints have been raised against Bitcoin.  Perhaps the most prevalent is that Bitcoin has no inherent value.  In my article “What is Money”, I show that no currency has inherent value.  However what people mean by this statement is that Bitcoin is not backed by some physical asset.  Of course this is true of almost all government currencies today.  Many gold bugs have been critical of Bitcoin, arguing that is speculative and that gold has real value.  However, almost no one has a real use for gold and you cannot eat or drink gold.  The gold is just a way to have a claim on future goods and services that many people recognize.

Many Bitcoin advocates call Bitcoin “digital gold”.  Gold advocates will point out that Bitcoin has been around less than a decade and people have been using gold as currency for at least three millennia.  It is interesting to compare and contrast Bitcoin with gold.  Bitcoin’s total quantity is limited mathematically.  Gold is limited and very hard and expensive to mine.  Gold is durable.  Bitcoin’s peer to peer network is likely to be as durable as the Internet.  Gold is easily divisible.  Bitcoin can be divided down to eight decimals.  Bitcoin transactions can be fairly anonymous and this is true of gold transactions in person, but not of international transactions.  There are advantages and disadvantages to both.

Gold bugs have been telling us at least since 2009 that gold and silver are going to appreciate because of the inflation created by central banks.  However gold prices are essentially the same today as they were in 2009.  This is not because there has been no inflation in the United States for instance.  Some people claim there has been central bank manipulation of the gold market or other conspiracy theories.  I believe a close look at gold production explains why this is occurring.

Chart from https://www.goldbroker.com/news/above-ground-gold-stock-how-much-is-there-why-does-matter-546

From this chart we can see that the total amount of gold mined is increasing over time.  This is most likely because new mining technology has made it less expensive and faster to mine gold.  The result is that gold prices have been held in check by this ready supply of new gold.

As opposed to gold’s increasing production over time, Bitcoin’s production of coins is declining over time as the chart below shows.

Chart from https://bitcoin.stackexchange.com/questions/161/how-many-bitcoins-will-there-eventually-be

 

From these charts I think it is clear why Bitcoin is going up in price and gold is holding steady.  Of course competitive crypto-currencies can and are being created.  Not all of these other so-called crypto-currencies have the same goals as Bitcoin.  Many use the same basic technology, called “block chain” technology, to issue coins that act like a stock or a bond.  Other coins are designed to store and record information securely, such as property deeds, votes, medical records, or other ledgers.  Still other coins are designed to create digital contracts.  Perhaps the easiest way to understand this is to think of them as a digital escrow.

Recently there have been a number of companies that are using this block chain technology to secure computer files.  If you store your files using this technology, your files are inherently backed up all over the internet, can be reached all over the internet, and your information is stored more securely than previous encryption techniques.

Many block chain enthusiasts think that this technology is in its infancy and that it will have a huge impact on the economy.  They make an analogy to the Internet in say 1993.  Libertarians argue that Bitcoin has the potential to undermine all fiat currencies and end central banks.  Some people fear that if this happens that the valuable function that banks perform in aggregating loans and freeing up capital will be lost.  These people are mistaken.  There are many ways that Bitcoin or related coins can fulfill this function.  One of the easiest is to have a debt coin (often alternate coins like this are called colored coins) that represents a portion of a mortgage (group of mortgages) or a car loan(s).  The debt coin is issued in exchange for Bitcoins to buy a house and the market decides whether people want to fund this loan.  When the loan is paid back the debt coin ceases to exist, just like a bond that has been paid off.  If the debt holder(s) are paying on time, these debt coins can circulate as a currency.  A real life example of this was the Bitfinex BFX token which was used to make customers’ accounts whole when Bitfinex was hacked and some of the Bitcoin they were holding was stolen.  This allows the supply of digital currencies to expand and contract with the assets in the economy.  Bitcoin however is like gold was, it does not expand and contract with the economy.

A number of countries have declared Bitcoin as a legal currency, including Japan and South Korea.  Australia seems likely to follow.  None of these countries have declared Bitcoin legal tender, but their laws will treat Bitcoin as a currency instead of an asset.  This is important because if a country treats Bitcoin as an asset, then you have to calculate a profit or loss on your Bitcoin for every transaction.  This makes it pretty painful to use Bitcoin to buy a cup of coffee or even to pay the rent.

Will Bitcoin live up to the libertarian utopia of killing off fiat currencies and central banks?  Is block chain technology the next disruptive technology wave?  We will have to wait and see

 

 

 

August 22, 2017 Posted by | Uncategorized | , , , | Leave a comment

Did Midas Mulligan Run a Fractional Reserve Bank?

Was Midas Mulligan, the hero banker in Atlas Shrugged, running a fractional reserve bank?  There has been much criticism of the Federal Reserves’ handling of our money supply and its effect on the economy.  Much of this criticism has been led by Ron Paul and the Austrian school of economics.  Some critics, including Ron Paul and Thomas E. Woods, author of Meltdown, have further argued that fractional reserve banking should be outlawed.  Fractional reserve banking is how all modern banks (since at least 1750s) operate.  Wikipedia defines a Fractional-reserve banking as a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loan to other customers. This means that available funds (called bank reserves) are only a fraction (called the reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

Ayn Rand clearly would have been against the Federal Reserve system, which her protégé Alan Greenspan headed for over a decade.  The Federal Reserve is a government institution that prints money at will and manipulates the money supply for the benefit of government looters and Wall Street looters.  In Atlas Shrugged, Rand rails against paper money and in Galt’s Gulch they use gold for their currency.  However, to the best of my knowledge, she never addressed the issue of fractional reserve banking directly.  The history of fractional reserve banking starts with the concept of an exchange bank.  I explain in my book, The Decline and Fall of the America Entrepreneur: How Little Known Laws and Regulations are Killing Innovation:

Modern banking started in the early 1600s with the Bank of Amsterdam.  Merchants could deposit coins with the Bank of Amsterdam and use this account to pay for transactions.  Using checks, a merchant’s account was debited and another merchant’s account was credited.  This meant that coins did not have to be transported from one merchant to another with the attendant risk of theft and loss or the cost of transportation.  The Bank of Amsterdam was just an exchange bank that facilitated transactions between merchants.  Next came the Swedish Riksbank established in 1656.  The Riksbank was not only an exchange bank, it also lent money making it the first modern fractional reserve bank.  Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.  Commonly, loans are made against collateral such as land or jewelry.  … Some people believe fractional reserve banking creates money out of thin air, but what really happens was the money for these loans were backed by some collateral other than coins or bullion.  The downside of other types of collateral is they are not as liquid as species (coins, bullion).  As a result, if large numbers of customers of a fractional reserve bank wanted species (currency) at the same time, the bank would not able to fulfill all its customer’s demands.  This is a classic run on a bank.  A run on a bank is a cash flow issue.  A sound bank may have plenty of collateral and performing loans, but if most of its customers demand species at the same time it will not be able to fulfill these requests.  Fractional reserve banks free up capital from low performing assets so that they can be invested in higher performing assets.  For example, if you owned a large tract of ranching land that was not highly profitable but represented a large amount of capital and you want to invest in an oil well, without fractional reserve banking you would have to sell some of the land in order to invest.  With fractional reserve banking you could convert your land into a generally accepted form of money, by pledging your land as collateral to a bank for a loan.  In the modern world, the loan to you is just a computer entry in your bank account.

It is clear from history that fractional reserve banks are not some sort of government institution, like the Federal Reserve.  Rand’s philosophy was that people are free to contract with each other for anything that does not involve fraud or the use of force.  A fractional reserve bank meets this requirement, with the one possible caveat that a bank should disclose this information to depositors so that the customer understands and assents to the use of his money this way.  Since most people do not know what a fractional reserve bank is, including many bank employees, I am not sure that this caveat is met.  I assume that when you open a new account banks provide you with information that they are a fractional reserve bank, but I have not been able to prove this.  Without fractional reserve banking it would be very difficult to securitize (Collateralize) many assets, such as houses and land.  This would significantly impede the economic growth of a country.

 

July 17, 2011 Posted by | -Economics | , , , , , , , , | 5 Comments