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:
https://twitter.com/pmarca/status/435914784962146304
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.
Praxtime by Nathan Taylor 
Nathan, some of the main conclusions in your post are that bitcoin is a roller coaster, but it still has some value as a money transfer means. I agree.
I do have a few issues with what else you wrote, however.
First, little nitpick: IMO, macroeconomics is mostly about employment control, and only mildly about xflation.
Next, regarding the 2nd half of your post, you quoted,
‘“bitcoin, unlike paper money, is very low-friction,”’
I’m not so sure. Did you ever read my comments and posts suggesting that the stuff pimped by the lamestream media which you apparently lap up is mere propaganda? (You not only apparently link to slate, you probably even read it. Need I say more?) From what I understand, it can take over 10 minutes for bitcoin transfers to go through. Can you imagine if each customer had to wait 10 minutes at the checkout line of a grocery store? They’d go out of business. It can take days to download the exponentially growing blockchain, now at 14GB. That’s a big deal. It means you can’t even directly trade bitcoins on a cell phone. You have to give money to a 3rd party who might do it for your phone. I’d guess that about 90% of bitcoin exchanges have lost bitcoins. Check the price of bitcoins on what was the #1 exchange last month, mtgox. A month ago it was at ~$1000. Now it’s at only ~$100, over $400 less than the rate at the lesser exchanges. That’s indeed friction, lack of liquidity, transaction fees of over $400 per bit coin, whatever you want to call it. Therefore, in my opinion, that above statement seems somewhat wrong. If my understanding of friction is wrong, please do correct me.
“…Bitcoin could be … holding little innate value in and off itself.”
The market cap of bitcoins is $6.9B. Is that really “little?” The silk road had a peak trading volume of only 1.2 million US dollars per month and was, arguably, the main “real” use of bitcoins. Assuming paypal’s 3-day bank transfer time, this equates to a “minimum liquidity tranfer float” of only 3 days / 30.5 days * $1.2M = $0.12M, or 6900/0.12= 58,000 times too large for you to be correct in an admittedly crude analysis easily off by a factor of 10.
Now, getting to the first half of your post, as I will need to use my just-defined phrase, you wrote,
“Deflation is a good illustration of why bitcoin makes a far better payment system…”
Firstly, it is worth knowing that this argument is actually an obscured justification for the fed to “print” money on the alleged basis that our economy would collapse without them to save us. I can’t hold that against you, as I myself don’t really understand what the fed does, and probably never will, given my past failed attempts. Luckily, to go there would be off topic, as the topic here is bitcoins, and I know you’d rather all commenters stay on point. But you missed the #1 issue with ecoins, which is that the inherent inflation of them would *generally* make them a bad investment, not a good investment, IF your conclusion, that the above-defined “liquidity float” is “somewhat” fixed, since bitcoins are mostly only good for transferring “real” money, is really correct.
So what. Well, I’ll tell you. If bitcoins are known to be a bad investment, people will eventually not want to hold them, and their desirability for use even in quick trades will also go down, as it is a hassle to keep a zeroed balance. This result contradicts your conclusion.
Except that the entire point should be moot. Why? The posts you are reading would, at first glance, seem to be outdated and/or irrelevant. Over 50% of the bitcoins that will ever exist have already been mined. The inflation rate in 2014 is only to be 10%, and will eventually become zero. So there won’t be *that* much deflation anymore, as recent “friction effects” which you deny exist caused 40%-90% swings, which is a >400% bigger worry. For bitcoins, inflation just isn’t the biggest issue anymore.
On the other hand, the posts you largely regurgitated might not be outdated. Why? Bitcoin might be replaced by one of the altcoins listed here, most of which have much worse inflation. Slate et al. might not have wanted to have mentioned this.
Just thought I’d point that out, if only to promote further thoughts.
Cheers