This is part 1 of a two part series on Bitcoin. Part 2 here.
Marc Andreesson and Matthew Yglesias had a recent twitter exchange about technology as a driver of deflation. While it may not be obvious, that deflation discussion has implications for the digital currency bitcoin, which is undoubtedly why Andreesson brought it up. If you haven’t been following the story, bitcoin is a cryptocurrency, a software based system for guaranteeing digital transactions that doesn’t require outside legal enforcement. More here. Deflation is a good illustration of why bitcoin makes a far better payment system than complete true currency. Think of bitcoin as being more like software powered gold than like the dollar. In economics jargon, bitcoin is a natural medium of exchange (what you pay with, say a check) but not a natural unit of account (what the price is set to, say x dollars). Since traditional currencies perform both functions, our intuition makes us think bitcoin will eventually become a unit of account and a store of value. But this may not be how it plays out.
Let’s start with Andreesson’s tweet:
Yglesias responded, and when the twitter discussion didn’t reach closure Yglesias decided to write a short blog post explaining things clearly. Setting a most excellent example if I may say so. Yglesias created a simple model of fisherman and farmers who trade with each other. Depending on fishing luck and farming weather the exchange rate between fish and wheat will vary. He goes goes on to say:
This means that if your society of fishermen and farmers chooses to use gold coins as its money, then good weather plus lucky currents will equal monetary deflation. But this is a choice. If instead they use a fiat currency (call it “dollars”) as their money, then good weather will cause the dollar-denominated price of wheat to fall unless the central bank prints more dollars. And lucky currents will cause the dollar-denominated price of fish to fall unless the central bank prints more dollars. So the combination of good weather and lucky currents will cause a general price deflation unless the central bank prints more dollars. Which is just to say that in a fiat currency system, the presence or absence of deflation is purely a question of central bank policy and has nothing to do with oversupply of cheap goods.
This is modern macroecnomics in a nutshell. Inflation is tied to the interest rate and money supply, which in turn is tied to central bank policy. And since inflation impacts savers differently than debtors, central bank policy is inherently a question of politics. More inflation of the Euro would be better for Greeks than Germans. The gold standard was ultimately abandoned for precisely this reason. There was no political outlet to manage inflation/deflation and price volatility. In fact, with a fixed supply of bitcoins and no central bank, Andreesson’s worry about technology inducing deflation would come true. Precisely what modern fiat money allows us to avoid. And it’s not just price stability that’s political. Making something the unit of account is tied to contracts, law, courts and police enforcement. A currency can only be a unit of account in a modern economy if it’s backed by a political system.
But the medium of exchange is another matter. Commonly tradeable commodities such as crude oil, coffee, sugar, and yes gold, can be mediums of exchange. Bitcoin can be thought of as “software powered gold” in this commodity sense. Note this usage of gold is different from Yglesias’ example above, which had a true gold standard with prices themselves given in gold. In the “software powered gold” analogy, we’re now considering gold as it exists today in our fiat money world. It’s a widely traded and highly volatile commodity that attracts speculative investments. We don’t price products in gold. Though it can make a useful payments system, especially if we invent a software powered version.
Also, full disclosure, this distinction between unit of account and medium of exchange is one which economist Scott Sumner is particular keen on. And as a big fan of Sumner I find it useful. But most economists are perfectly happy calling something money as long as it’s commonly used as a medium of exchange. Expecting the unit of account aspect to follow automatically. Here’s a good survey of economists on bitcoin as money: “Is Bitcoin Money?: What Economists Have To Say“. Note Sumner is in the minority. Nomenclature of what defines money aside, I think we’re firmly within the economic consensus by noting the problems with bitcoin as a currency of record are similar to those afflicting the gold standard. Which not coincidentally no country in existence is on. In contrast, bitcoin’s economic advantages as a guaranteed payment system are markedly clear.
Andreesson knows this of course. His recent essay “Why Bitcoin Matters” focuses almost exclusively on payments. But in a piece Andreesson mentioned favorably called “Could there be a $50,000 bitcoin?“, we see how much attention is currently given to bitcoin’s highly volatile value in dollar terms. Yet even that article mentions the scenario I’m arguing for here, if only as aside: “Because bitcoin, unlike paper money, is very low-friction, there’s the possibility of a very high-velocity bitcoin, if, for example, vendors or traders only held bitcoin very briefly, cashing it in and out to government currencies on either end of transfers. That, Athey says, would allow a small volume of bitcoin to process a large volume of payments, keeping the price of bitcoin relatively low.” Exactly. The costless guaranteed transaction model cuts both ways. Since you can get out of bitcoin for no cost, why hold such a volatile commodity with no central bank stabilizing the price? The end game here is nothing priced in bitcoin, but bitcoin payments moving money behind the scenes. Which makes it hard to avoid the conclusion that cryptocurrencies like bitcoin will become an economic commodity. Just like all other software based products. Bitcoin could be a massively disruptive money transfer and payments system, while simultaneously holding little innate value in and off itself.
This is part 1 of a two part series on Bitcoin. Part 2 here.