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.

Advertisements

October 31, 2017 Posted by | -Economics, -History | , , , , | Leave a comment