Thursday, October 18, 2012

Bitcoin steps on the toes of a few popular monetary theories

In the name of monetary experimentation I bought some bitcoins a while back and have been watching them fluctuate in value. Bitcoin is a digital form of exchange created back in 2009 that has since grown to considerable proportions. One bitcoin is worth around $11 these days, up from a fraction of a penny just two years ago. With around 10.2 million coins outstanding, the entire value of bitcoin stands at around $120m. That's small fry compared to $1 trillion paper US dollars in circulation, or the $5 trillion or so worth of gold, yet it's big enough to deserve attention.

Bitcoin creates problems for two theories that attempt to explain why a new fiat money might gain traction and continue to have value - the Regression Theorem and chartal theory of money.

In order to delve into these two theories, here's some data on the debut of bitcoin as a currency that should help out. Back in March 2010, someone tried to offer bitcoin for pizza in but never managed to get a bid. Later in May a bitcoin user named Laszlo finally managed to trade 10,000 BTC for a pizza. Given that the pizza was worth $40, this valued bitcoin at around a half-a-cent each. But even before the famous pizza exchange there were trades going at the Bitcoin Market, a formal bitcoin exchanges. The first published trade from late April involved 1000 coins at 0.003, a princely sum of $3. Back in October 2009 New Liberty Standard began publishing an exchange rate based off the electricity cost of generating bitcoin, though there is no indication of how much trade was actually done.

The thinking behind Ludwig von Mises's regression theorem is that people's expectations "regress" into the past. An intrinsically worthless fiat token (like US dollars or bitcoin) trades at a positive value because it had a positive value yesterday, and it had a positive value yesterday because it did the day before. This regression continues until day 1 of the fiat money's debut. What on day 1 might have generated the positive value necessary to initiate this chain of cause and effect? Mises's answer: the token wasn't a money on day 1, it was already being traded for its non-monetary value. This initial positive value provides the seed that eventually leads to the phenomenon of fiat money. Along the way the money could lose its non-monetary use -- a gold linked currency could be decoupled from gold -- but it will continue to have a positive value.

Bitcoin challenges Mises's Regression theorem because bitcoin never had an initial non-monetary use. They are just bytes. You can't eat them, wear them, or decorate with them.

There are three ways you can proceed with this.

1. Actually, bitcoin did have an initial non-monetary use so the regression theorem still applies. In its initial form bitcoin was valued as a sign of geekiness, a demonstration of one's devotion to technology. Based on this initial non-monetary value, a Misesian progression could proceed. This explains why seemingly valueless bitcoin was eventually accepted in payment for a pizza and why it continues to be valued as money today.

2. No, Bitcoin never had a non-monetary use. It's intrinsically worthless. It's a ponzi scheme. In the short term, people can irrationally bid up the price to some non-zero amount. But in the long term the logic of the regression theorem requires that the price of Bitcoin fall to zero.

3. The regression theorem is wrong.

The second theory that Bitcoin challenges is the chartal theory of Georg Frederich Knapp. The chartal theory of money says that a fiat money gains value because a government places an obligation on its subjects (say a tax) that can only be discharged by payment of those fiat tokens. This generates a demand for the tokens so that they trade at a positive value in the market.

The obvious challenge to this theory is that bitcoin has emerged spontaneously. No government asks that its taxes or bonds be paid in bitcoin. Yet bitcoin is a positively valued money token.

You can go a few ways with this.

1. Bitcoin isn't money, it's purely anomalous. The chartal theory doesn't have to explain it. Bitcoin will fall to zero.

2. Chartalism is wrong.

3. The chartal theory of money can describe a few types of fiat money, and some monetary phenomena, but shouldn't be expected to explain other types of fiat money or phenomena.

I think both theories cut the cake in a way that prevents them from seeing from a better vantage point. They treat money as a noun, not an adjective. The problem with treating money as a noun is that it implies that somewhere along the line of its development, bitcoin crossed some invisible line from being a money to a non-money.

If you think of money as an adjective, then "moneyness" becomes the lens by which you view the problem. From this perspective, one might say that Bitcoin always was a money. A degree of moneyness was attached to it from the moment the first bitcoin user realized that their bitcoins could traded to another user for something else. Bitcoin's moneyness would have only increased as bitcoin became involved in more and more transactions.

If you treat money as an adjective, the regression theorem and chartalist theory are irrelevant. Whether moneyness gets attached to a fiat token issued by the government to discharge taxes, or whether it gets attached to an object valuable for religious or industrial purposes, is unimportant. The degree of liquidity - or moneyness - is the variable of interest.


  1. Bitcoin also steps on the toes of the backing theory, but only a little. We all recognize that in the old days, part of the value of gold resulted from its use as money. Apparently this explains most or all of the value of bitcoin. Then we see stone money on the island of Yap, monopoly money being used for years on Pacific islands after WWII, etc.

    The thing that normally prevents money from being valued more than its backing is the existence of rival moneys. The issuer of fiat money gets a free lunch from issuing the money. Rivals issue their own money to get a piece of that free lunch. This reduces the value of the first fiat money, with no stable solution short of the fiat money having zero value. This seems like a pretty powerful argument, and I have more faith in it than I do in the various theories of why bitcoin has value.

  2. Mike, back in the old days on the Mises blog (remember those huge dustups?) you used to say that the QTM was sufficient to explain commodity money. It would seem to me that if the backing theory doesn't have to explain gold's value, the onus isn't on it to explain bitcoin's either. But I'd be interested to hear what you have to say.

    Regarding bitcoin and rival monies, a few have sprung up. Namecoin is one, devcoin is another. There are no regulatory barriers, so I'm not sure why bitcoin's value hasn't already been driven down to 0. The link below goes to an exchange that facilitates the exchange of various bitcoin-like cryptocurrencies.

  3. Ahhh, the good old days.

    My take on this is to draw supply and demand curves for a commodity like gold and then recognize that part of the demand comes from its usefulness as money. The resulting premium on gold causes some inefficiency as certain marginal uses of gold become uneconomical at the higher gold price. The inefficiency is avoided by using tokens instead of actual gold, and I expect that this practice probably kept any commodity from ever developing much of a monetary premium. After all, if gold traded at a monetary premium, then anyone could issue gold tokens in the process of going short in gold. As the tokens spread, gold loses value, and the short seller can profit by buying gold at the reduced price and delivering on the gold tokens he issued.

    The backing theory does not explain why bitcoin has value, but then again if bitcoin is a pyramid scheme, (and I think it probably is) then it is outside the realm of monetary theory anyway. If someone offered me bitcoins for a pizza, my best reply would be "No thanks, but I would like to borrow them at 2% interest (payable in bitcoins) and buy a house with them." This borrowing would create hypothecated bitcoins and drive down the value of genuine bitcoins. Then I would sell my house for way more bitcoins than I borrowed, repay my loan, and profit from my short position in bitcoins.

  4. "After all, if gold traded at a monetary premium, then anyone could issue gold tokens in the process of going short in gold. As the tokens spread, gold loses value, and the short seller can profit by buying gold at the reduced price and delivering on the gold tokens he issued."

    That presumes that a short seller could measure gold's monetary premium. I'm not sure how they'd go about it.

    "The backing theory does not explain why bitcoin has value, but then again if bitcoin is a pyramid scheme, (and I think it probably is) then it is outside the realm of monetary theory anyway."

    Can I take that as your prediction? In the long term, bitcoin = 0?

  5. They wouldn't have to measure gold's premium. The short seller would just profit by however much gold falls. If they really wanted to know the premium, they could issue tokens until gold was no longer used as money. The resulting fall in gold=the premium,

    Prediction? Aw Jeez! OK, yes, long term bitcoin=0. Just don't ask me how long the long term is. (Of course, bitcoin might just have value as a curiosity, and in that case no rival currency would drive it to zero.)

  6. I'll have to think about the short-selling point.

    Re: bitcoin. Well, you're not alone, Mike. David Glasner says that I can mark him down for bitcoin=0 too.

  7. During the Classic Gold Standard before the American Civil War, free banks issued their own bills of credit payable in gold (often more than the gold they had available).
    Apparently these bills didn't caused the value of gold to fall, because other banks took up the duty to buy these bills (at a discount) and sent men to the issuing banks to cash the bills for gold.
    So these banks were forced to never issue more bills than the gold they had in their vaults. Every bank issuing too many bills for too much gold would be bankrupt by the rivals.

    The tokens are not substitutes of actual gold. And T-bills are a example.The US government was forced to suspend the convertibility of T-Bills in gold because they had no gold enough to take all of them back.

    Now, the gold price is suppressed using the future market. And this is possible only because they (probably) loan/sell gold to bullion banks to allow the suppression to work and they have "unlimited cash". The problem is how much gold they really have left in their vault to continue this play.