The world is neck deep in Bitcoin “content” these days and, as usual, the outcome is more heat than light.
I am planning to do something more substantial on BTC for paying customers in the future but I have several other pieces to finish first. Meanwhile, I have been wanting to join the crypto fray. The intention of this post is to address some of the most common economic confusions. It turned out to be longer than I expected, so I have broken it into three parts.
I will weave in a bit of my background or predispositions, mostly for the purposes of pre-empting counter-arguments of the “but-you-don’t-understand X!” variety.
What is BTC in economic terms?
I am familiar with the Austrian-school economics and libertarian philosophy that underpins the economics and normative objectives of BTC. I do not consider myself an “Austrian” (or a libertarian) but I share their view, at least in a modern centralized political environment, that central banking is the greatest device for large-scale social discoordination and mayhem yet devised by humans. Based on long experience as an analyst and advocate, I also share their extreme scepticism regarding the validity of mainstream economic methods. Lastly, I consider the Austrian emphasis on understanding the process of economic coordination, and thus on dynamics and disequilibrium, as far superior to the mainstream’s assumption of equilibrium and their emphasis on, in effect, judging or modifying the outcome of economic coordination.
Consequently, I am a fan of free-market or emergent money, of which BTC and other non-state-sponsored crypto-currencies are examples. I am particularly fond of free-market “base money”. Base money is a slightly nebulous term depending on whether it is being used in a fiat money context or not. For my purposes, base money is money which does not represent a claim on another asset or cash flow. Base money therefore does not represent, for example, the liability of a counter-party (as bank deposits or “bank money” does). Gold, not only under the gold standard but even now, can be thought of as base money.
(In the typical fiat context, money created by the central bank in the form of hand-to-hand currency or bank reserves is considered to be base money. It is a liability in an accounting sense but usually cannot be redeemed at the central bank for anything other than itself. And although the liquidity and value of central bank base money is tied to the liquidity and value of central bank assets, the base money does not represent a claim on those assets. Further, in the case of the US Federal Reserve, the assets which would purport to “back” the base money are simply claims on a future quantity of the base money itself. The purest case of this is when central bank assets consist only of its own government debt denominated in its own currency. Things get murkier, from the perspective of defining fiat base money, when the central bank holds either significant assets denominated in other currencies or financial assets issued by parties other than its own government. But we’ll leave all that for another day.)
BTC is thus designed or intended to be a form of base money. In a world of competing base monies, each seeks to become the numeraire and most stable store of value. While BTC is not far along that path, it is a potential path.
BTC, Transactions & Banks
While I share the Austrians’ view of central banking, I do not subscribe to the monetary views common amongst some of them that, in and of itself, fractional reserve banking (FRB) is bad, fraudulent, unstable or a source of excess credit growth or that a fixed money supply is necessarily desirable or optimal. Bitcoin reflects the latter view to the extent that it provides ultimately for a fixed upper limit on the quantity of BTC.
By comparison with previous forms of base money (e.g., gold or US$), secure storage of BTC of significant value by individual owners is less costly and more practicable. In addition, state seizure of base money is not unknown and BTC, by avoiding the need for centralized storage in a limited number of known secure locations (i.e., bank vaults), is assumed to reduce the risk of confiscation and, for similar reasons, to make it easier to circumvent capital controls. The blockchain also provides for direct payment between transacting parties, regardless of location, thus theoretically avoiding third-party payment media and, again, capital controls. These aspects, combined with early expectations that BTC would be extensively used for daily transactions, led to predictions that widespread BTC adoption would undermine banking and other payment processing systems.
At this point, however, it appears that BTC is evolving more toward an analog of gold bullion under the gold standard, as has been pointed out by Saifedean Ammous. In other words, it would primarily be a medium for making large scale payments, settling net flows amongst payment aggregators (like banks) and anchoring the liquidity of other payment systems with lower transactions costs. Both gold bullion and BTC are highly divisible so it is not indivisibility per se that would drive a settlement role. Rather, it would appear that a form of economies of scale might be the factor in limiting base money use to settlement. In the case of BTC, it would be economies of high value in a blockchain transaction. In the case of gold bullion, it would have been economies of high value in possession and presumably also in coinage (both in terms of the costs of producing the coin and the cost of use by transactors). Thus, in both cases, making frequent use of the inherent divisibility becomes uneconomic. I am also inclined to think that the settlement role and widespread adoption as free-market base money emerge together. In other words, while emergent base money can be used for daily transactions, that is probably not its ultimate, socially optimal role.
I will have more to say on BTC and transactions costs at a later date. Short version: mainstream economists do not understand transaction costs and their emergent quality. Transaction costs are themselves the result of economic coordination, market processes and exchange, not a barrier to them or source of market failure. More to follow.
The “settlement path” implies that BTC will gravitate towards parties that aggregate transactions, as gold did in the past. If BTC becomes the numeraire and a large-scale settlement mechanism, then a system of BTC-based IOUs or claims (similar to bank money) seems highly likely, if not inevitable. In other words, if BTC is to become the numeraire and a settlement medium, one needs a system to re-arrange claims on BTC between transaction aggregators as transactions occur while at the same time limiting BTC blockchain revisions to intermittent or periodic settlement. If all these payment-aggregating parties did was “store” BTC, in effect, and issue BTC bank money in the form of storage tickets, then one would have 100% reserve banking. However, FRB emerged in the past under free banking systems (i.e., systems without a central bank). (In fact, it is most stable under free banking due to the absence of moral hazard). It is not clear why FRB would not emerge again under any new system of free-market base money.
Consequently, a settlement role for BTC is not inherently inconsistent with the continued existence of banks, or some similar institution, although obviously they may take a different form than they do now. The lower costs of secure storage noted above could also conceivably reduce the scale of banking, whether fractional or 100% reserve.
Finally, it’s best not to get too hung up on the volume of transactions as a precondition to BTC becoming widely thought of as money or, put another way, as a causal source of BTC’s liquidity or usefulness as a store of value, for several reasons. First, causality in networks runs in both directions. Second, and more fundamentally, a given money’s usefulness as medium of exchange and store of value are themselves both driven by network adoption (as discussed in Part 2). Third, as implied above, there may well be an inverse relationship between emergence of a particular money as best store of value or numeraire and the volume of transactions actually involving exchange of the base money itself (as opposed to the exchange of claims on the base money). Monies that lend themselves to one role may not lend themselves to the other (no pun intended), leading to a monetary “division of labour”.
Continued in Part 2.
19 December 2017