Bitcoin's bootstraps

by Paul Conrad

When we talk about bitcoin, one thing we need to ask ourselves is this: can worthless things circulate and be accepted in trade? If so, how? And can this state of affairs continue indefinitely?

An intrinsically useless, unbacked, and costless fiat object might be accepted in trade, but only if it already has a positive price. A history of positive prices will generate sufficient expectations among potential acceptors that they will be able to trade that object on tomorrow. But how might our fiat object earn a positive price to begin with? If we reply that early adopters expected it to be widely accepted by others in trade, how did these early adopters ever form these expectations if that object didn't already have a positive price? We're dealing with a problem of circularity. There is no way to "break into" a dynamic that might generate a positive value for a fiat object. So logically, worthless things cannot trade in the market at a positive value.

However, fiat objects like dollars and yen do seem to have a positive value. Two types of economists, Austrians and MMTers, recognize the circularity dilemma that emerges when trying to explain the positive price of a useless fiat object. Both solve the circularity problem in different ways.

Austrians say that when early adopters first acquired the fiat object, it was not yet intrinsically useless, unbacked, or costless. Thanks to its original commodity nature, or perhaps its status as a backed financial asset, it already traded at a positive price. Even if that character is lost, the object suddenly becoming a fiat one, it may still be widely accepted in trade on the basis of people's memory of its pre-fiat price. Thus the circle can be broken into, and worthless bits of paper can legitimately have a positive value in trade. This is Ludwig von Mises's famous regression theorem.

MMTers solve the circularity problem by bringing in the tax authority. As long as some agency like the government imposes an obligation on people to pay taxes with these fiat objects, that will be enough to drive their positive value.

I should point out that I don't think we actually face a circularity problem with modern central banknotes since they aren't worthless bits of paper but rather exist as a liability of their issuer. But we do run into the problem with bitcoin. Here we have an unbacked, intrinsically useless, stateless fiat object trading at $950 or so, not to mention a legion of copycat coins trading at various positive prices. [1]

Austrians are all over the board on bitcoin. Because their solution to the circularity problem is to invoke the legacy commodity value of a fiat object, bitcoin poses some theoretical hurdles for them since it is by no means clear whether bitcoin ever had an original commodity value. Bob Murphy for one argues here that bitcoin may have earned its first foothold thanks to non-pecuniary ideological reasons. However, there seems to be no consensus among Austrians on that point. MMTers seem to genuinely dislike bitcoin since their preferred tax obligation story can't bear the load of explaining bitcoin's price. Here is L. Randall Wray who says that bitcoin is a test of the "infinite regress view of money", then gleefully points to its falling price as evidence that the taxed backed theory is the dominant theory (it later rebounded).

Let's move on from MMTers and Austrians. George Selgin recently came up with an interesting way to explain how bitcoin might have earned its all important original positive price:

Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

Here we have neat way to break into the circle. Have a group of insiders trade the fiat object amongst each other in order to generate an artificial history of positive prices, at which point outsiders will be willing to accept it in trade based on the expectation that others will repurchase it from them later.

Making "conspicuous leaps onto one's own bandwagon," as Selgin calls it, is a well worn tactic. In stock markets, the term wash trading refers to the illegal practice whereby an individual or group of schemers trade an illiquid, often worthless, stock back and forth among different accounts. The goal is to give the illusion of activity, thereby attracting innocent traders who would otherwise pass up the stock. A more colourful term for this is "painting the tape", which refers to the old ticker tape of yore.

Another way to paint the tape is to high close a stock. Using this technique, a trader or group of traders will buy a stock in the closing seconds of the day, pushing its price up. Since media outlets tend to focus on a stock's daily closing price, and stock charts depend on the daily close, high closing may be a cost effective strategy for traders to create and benefit from the positive price momentum that news of a high closing price engenders.

Auction markets, say in livestock or art, are sometimes populated with confederates—those who work in conjunction with a seller to provide fictitious bids so as to drive some object's price, say a dubious piece of abstract art, or a lame horse, far higher than it would otherwise be worth. Should the confederate's bid be the only bid, the worst that happens is that the schemers get their own painting or horse back, upon which they can try the same trick over again in the next auction. If their bidding excites someone else to add a bid, then they've succeeded in earning something for nothing.

In any case, all of these techniques can push a worthless object's price above zero, at which point that object may have generated enough of a history of positive prices that it will be valued by enough outsiders that it will join the mass of non-fiat objects in circulation. From nothing, our worthless item it has pulled itself up by its own bootstraps.

Which explains bitcoin's incredible volatility. A bootstrapped object can just as easily let go of its own straps and fall back to zero. Without some real use or backing, there's nothing to catch it on the way to $0. And at $0, there's no guarantee of re-bootstrapping bitcoin back to some positive price. As such, Bitcoin users justifiably expect incredible returns from bitcoin holdings in order to bear the risk of a zero-value equilibrium. Expected hyperdeflation is the carrot that must be proffered up for risky cryptocoins to be held. When those expectations of price appreciation aren't met, a large crash in the current price (relative to its future expected price) is necessary in order to tempt the next crop of speculators to hold it again. Thus bitcoin's pattern of incredible rises, or hyperdeflation, followed by 50% flash crashes, followed by the next round of hyperdeflation.

So if unbacked, useless, and costless objects can be imbued with a positive price via Selgin's painting-the-tape story, why isn't everyone doing it? But they are! Attracted by the potential for large gains, plenty of people are creating alt-coins, as I wrote here and here. In theory, their combined greediness should have the effect of swamping the market with fiat objects, driving their price towards the cost of production. The idea here is similar to the Somali shilling story, in which continual counterfeiting of old fiat shilling notes drove their price down to the cost of production, namely the costs of paper, printing, and shipment.

This hasn't happened yet with bitcoin, which is hovering at around $950. In my old post Milton Friedman and the mania in "copy-paste" cryptocoins, I hypothesized that the seeming inability of competitors to drive bitcoin prices down had something to do with the unassailable benefits that bitcoin enjoys as being the first mover, including superior security and liquidity. Tyler Cowen has some interesting thoughts on this. Bitcoin has a market cap of about $20 billion. As long as Bitcoin's entrenched advantages are so supreme that it would cost $20 billion to create a competitor, then there's no profit in tackling its niche. Cowen, however, thinks that the cost of mimicking bitcoin is far less than this. Rather than being in equilibrium, the cryptocurrency market is currently working itself via a process of "supply-side arbitrage" to a new equilibrium at which bitcoin will be worth far less.

On this same topic, Nick Rowe suggests that a BackedCoin might be one of the competitors capable of carrying of this feat. I agree with Cowen and Rowe —that's why I mostly sold out of bitcoin last year, and why I plan to eventually sell my litecoin. Of course, I'm the dummy who sold BTC back at $100, so my opinions should be taken with a grain of salt.

Where will the competition come from? Robert Sams makes a good argument for why bitcoin knock offs like litecoin, sexcoin, etc., though costless to produce, can't easily compete with bitcoin itself. The mining power that goes into maintaining the integrity of the various blockchains is in scarce supply. Merchants will always congregate to the blockchain with the most security, since that will be the coin that guarantees that the threat of double-spending is the smallest. While clones can be created with a few key strokes, good security can't be bought. Thus bitcoin's price can't be competed down to $0ish by alt-coins.

I think I buy Sams's point. However, he couches his argument within the existing universe of bitcoin and its clones. I'd make the argument that the crypto phenomena through which "supply-side arbitrage" will be carried out could be something entirely different than bitcoin, say Ripple or something we haven't yet seen. Ripple for one isn't constrained by the supply of existing mining power, or hashing, since the Ripple blockchain is maintained via consensus, not by hashing miners. Is this type of security cheaper? I'm no techie, so I won't speculate. But it is something different. And though it may take a while, at some point new and different will also be cheaper.

Another bonus of the Ripple system is that the crypto currency it creates are not bootstrapped assets, they are redeemable IOUs (let's not confuse Ripple IOUs and XRP!). In Rowe's UnbackedCoin vs BackedCoin world, Ripple IOUs are the equivalent of BackedCoin. It is their backing that should protect the exchange value of Ripple IOU from the threat of competition. This very same backing frees them from the hyperdeflation-crash-hyperdeflation patten that bootstrapped coins tend to display, stability being a desirable feature among  those who want to hold an inventory of media of exchange. As long as Ripple IOUs are just as transferable & secure as bitcoin and other alt-coins, this stability will be the edge that pushes them above the crypto competition.

So in sum, worthless assets can be kickstarted into circulation, say by a group of confederates who paint the tape in a way to attract outsiders. The riskiness of these bootstrapped assets requires that they yield incredibly high returns, or constant price appreciation. However, this state of affairs can't last forever since others will be eager to issue their own competing fiat objects, including superior non-volatile competitors. If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world.

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[1] Bitcoin may not be entirely intrinsically worthless. I have floated the idea before that bitcoin has commodity value as a symbol of geek cred.

Orphaned currency, the odd case of Somali shillings

A few weeks ago, David Beckworth egged me on to write about Somalian currency. I can't resist—it's a fascinating subject. The material I'm drawing on comes from Luther & White (2011), Luther (2012), Symes (2005), and Mubarak (2003)

Orphaned banknotes

When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.

The strange case of circulating Somali shillings forces us to ask some fundamental questions about money. If the Federal Reserve and all other branches of the US government were to be suddenly swallowed up into the sea, would Fed banknotes, like Somali shillings, continue to be used? What forces conspire to keep coloured squares of paper in circulation when their original issuer has long since expired?

According to Luther & White (2011), the shillings' continued circulation within the context of a collapsed state casts doubt on the universality of the chartal theory of money. According to chartal theory, the requirement that people pay taxes with government-issued bits of paper is what drives the positive value of these bits. Since a world with no state is a world with no taxes, the continued use of shillings means that something other than tax acceptance must be driving their positive value. [As an aside, I'd note that the ongoing circulation of bitcoin also contradicts the taxes-only theory of chartal money. After all, bitcoin isn't used to pay taxes, it's used to avoid taxes].

Luther & White give what seems to me to be a very Misesian explanation for the shilling's continued positive value: the "inertia of historical acceptance". According to Ludwig von Mises's regression theorem, outlined in Theory of Money and Credit (1912), people's expectations about the value of bits of paper may "regress" into the past. An intrinsically useless bit of paper is valued today because it had a positive value yesterday, and it had a positive value yesterday because it did the day before, all the way back to day 1 when that useless bit of paper was anchored to some commodity.

This process is described as a coordination game in Luther & White. Though the central bank had collapsed in January 1991, a Somalian trader might choose to still accept shillings the day after the collapse because he had accepted them the day before and he knew that others had accepted them too. In a self conscious manner, the trader would also know that other traders knew that he had accepted them. Expectations about expectations about expectations, a Keynesian beauty contest of sorts, was sufficient to drive the use of shillings beyond the day of the central bank's demise.

Counterfeit notes and contingent redemption

Let's add some more texture to our example. Not only did old shillings continue to circulate, but several new issues of counterfeit notes joined them. These counterfeit 1000 and 500 shilling banknotes were created by warlords and businessmen subsequent to the country's collapse. Although the counterfeit notes had the same design as the pre-1991 legacy notes, small differences allowed for differentiation. According to Luther (2012), of the five known forged issues, four have the date 1996 printed on them, long after the central bank ceased to exist. The counterfeits dated 1996 are signed by central bank governor Ali Abdi Amalow who, having been appointed in 1990, had never held office long enough to have his signature affixed to genuine Somali notes. Even without these imperfections, fake banknotes would have been instantly recognizable to anyone—they would have been crisp and clean relative to the limp and dirty legacy issue.

Despite being easily differentiable, Somalians willingly accepted counterfeit 1000 and 500 shilling notes. Not only did they accept them, they considered them to be fungible with real 1000s and 500s. In other words, the market refused to place a discount on the fakes.

Mubarak (2003) offers a few reasons for the acceptance of counterfeits. Any reticence the public may have had concerning the legitimacy of counterfeit note was overcome by A) coercion on the part of issuing warlord; B) a financial inducement to accept new notes including an initial 5% discount to the price of legacy notes, and C) the claim that new notes were liabilities of the Central Bank of Somalia. According to Mubarak the latter instilled a "general public belief that the forged... banknotes must eventually be upheld and honoured when effective national government comes to power."

This last detail is interesting because it might explain not only why counterfeits were accepted, but also why legacy Somali banknotes continued to circulate after the Somali state collapsed. Upon the eventual reconstitution of the Somalian state, a new central bank would most likely be created. This newly recapitalized Central Bank of Somalia would hold a stock of assets funded, say, by the IMF.  The central bank might take upon itself the original central bank's note liability No longer orphans, old banknotes could now be convertible into deposits held at the new central bank and, insofar as the central bank targeted inflation via open market operations, these deposits would in turn be convertible into genuine backing assets.

Thus the promise of redemption by a not-yet existing central bank may have been enough to give present shillings, both genuine and counterfeit, a positive value.

This means that any changes in the purchasing power of shillings might be due not only  to variations in the quantity of outstanding Somali media-of-exchange. Reassessments of the probability of a central bank both being created and honouring the previous note issue would also affect their purchasing power. For instance, should the Transitional Federal Government, a government in-waiting of sorts, succeed in consolidating its position in Somalia by winning a key battle, the odds of redeemability would increase, as would the value of shillings.

Historically orphaned currencies

This tension between fiat-paper-as-redeemabale-financial-asset and fiat-paper-as-medium-of-exchange is an old one. It was at the centre of one of the greatest monetary debates of the 19th and early 20th century, a dustup that involved luminaries like Irving Fisher, Knut Wicksell, Laurence Laughlin, Benjamin Anderson, Ralph Hawtrey, and Ludwig von Mises. The discussion centered on the irredeemability of US Greenbacks.**

Greenbacks, which had been issued in 1861 to pay for the Union Government's expenses, were initially 100% redeemable in specie. The redemption clause was suspended later that year and subsequent issues of greenbacks didn't even claim to be convertible into gold. Greenbacks quickly fell to a large discount relative to the metal. By August 1864 the discount had hit its widest point as the paper traded at 38 cents on the gold dollar.***

As with Somali shillings, economists were curious about these seemingly-orphaned liabilities. Why were greenbacks still accepted? What governed their value? Wicksell, Mises, and Hawtrey held that if there is a demand for the medium-of-exchange as such, this demand would be sufficient to give value to whatever instrument was established by custom as the medium-of-exchange. Thus the continued acceptance of greenbacks at positive values was mostly due their already-favorable marketability.

Countering this panel of illustrious economists was J. Laurence Laughlin. Though Laughlin doesn't attract the same brand recognition as do these other long-dead economists, in his day he was considered to be America's leading monetary economist. In his book The Principles of Money (1903), Laughlin outlined the view that greenbacks should be treated like non-dividend paying common stock. Just as a stock might have some positive value now due to potential dividends several years down the road, the continued positive valuation of greenbacks was due entirely to the possibility of their future redemption.

To illustrate his point, Laughlin drew attention to the market's reaction upon the success of the Union Goverment in the Battles of Gettysberg and Vicksburg. After these battles the greenback's discount to gold dramatically narrowed, presumably because these victories were perceived by the market as increasing the probability of future redemption of greenbacks in specie. Laughlin also mentions the passage of the Redemption Act of 1875, in which the government declared its intention to redeem all greenbacks come January 1, 1879. Though still trading at a discount to gold, greenbacks began to steadily appreciate towards par as this date approached, just like a t-bill approaching maturity. Thus Laughlin's redemption theory held up nicely to the evidence.

While Wicksell described Laughlin's theory as "perverse and fantastic," it was hard for Mises, Hawtrey, or Wicksell to deny that the expectation of future redemption didn't have at least some effect on greenback's value. In his book the Value of Money (1917), Benjamin Anderson struck a middle ground between all parties. Anderson held that Laughlin was right to treat greenbacks like any other asset whose value was dependent on eventual redeemability. But Anderson also thought that Mises and the rest were correct to put an emphasis on greenback's unique monetary function. Anderson combined these views by illustrating how greenback's "money-use" would be captured by the market as an extra bit of ascribed value on top of redemption value, or a liquidity premium.

Just to make things more complicated: New Somali Shillings

Back to the Somali shilling. The last feature of the Somalian monetary economy that I find interesting is the presence of yet another media of exchange — the "New Somali Shilling".**** Just prior to the January 1991 collapse, Somalia had been experiencing accelerating inflation. The Somali government drew up plans to replace existing shillings with the New Somali shillings. Each New Shilling was to be worth 100 old shillings, and notes were to be printed in 20 and 50 shilling denominations

 According to Symes (2006), the first shipment of New Shillings arrived in Somalia several months after the collapse of the state. Ali Mahdi Muhammed, a factional leader in Mogadishu, seized several billion of these official New Shillings and spent them into the economy in November 1991. While New Shillings did gain acceptance, their use was limited to a small area in North Mogadishu—the area controlled by Ali Mahdi Muhammed. Nor were they fungible with the legacy notes. 500 worth of New Shillings, for instance, was not worth 500 worth of old shillings. Nor did New Shillings circulate at the pre-1991 intended value of 100 old shillings to one New Shilling. At the time of Mubarak's article, a New shilling was worth only a third of an old shilling.

This challenges Luther & White's theory that Somalians accepted shillings because of their previous experience with them. Why did Somalians accept New Shillings at all if they were not accustomed to doing so? Why not refuse and continue to trade in legacy shillings? Legacy shillings circulated in Mogadishu at the time, so traders would have presumably had a choice. Why take a bet on an untested currency?

New Shillings also challenge the Laughlin-esque theory that redemption underpins the positive value of fiat paper. If Somalians universally valued shillings because of their future redeemability, why would they not place a higher value on New Shillings relative to old? After all, according to its stated plan, the Central Bank of Somalia was willing to convert 100 old shillings into 1 New Shilling. If it was believed that a newly chartered central bank would take on the liability of Somalia's counterfeit notes, wouldn't that same central bank uphold a commitment to value New Shillings at a far higher rate than old ones? Why then do New Shillings trade a third the price of old shillings rather than at a multiple of 100?

As much as I dislike to leave more questions than answers, that's about all I can do for the time being. One major data point is yet to come. What actually happens to legacy and counterfeit notes when a new central bank begins to operate? The Central Bank of Somalia's website says this:

Towards fully assuming its functional and institutional responsibilities, the Bank has completed the reconstruction of its Headquarters in Mogadishu while the branch in Baidoa has been established and is already functioning with personnel in place.

Perhaps we don't have long to wait.
_____________________________________________________

*Abduraham in Luther (2012)
**Debate also surrounded the irredeemability of Austrian gulder banknotes. The Revolution of May 1848 resulted in the withdrawal of the convertibility of Austrian gulden banknotes into silver. The discount on gulder notes relative to silver averaged around 15% for the first 10 years and then dipped to an average of 28% from 1859 to 1865. Laughlin pointed out that by the 1860s speculation began to grow that Austria would switch from the silver standard to a gold standard. If the banknotes, still irredeemable, were to be honoured, it became increasingly evident that redemption would be in gold, not silver. At the same time, large silver discoveries were driving down the value of silver relative to gold. As a result of these forces, the market value of notes rose back to par with silver. As the market became progressively more confident that the notes would be redeemed, and redemption would be in much more valuable gold, gulder notes eventually exceeded their stated silver value. Laughlin's theory seemed to be borne out by the facts--the value of orphaned notes was dictated by their future potential redeemability.
*** From A History of the Greenbacks (1903), by Wesley Clair Mitchell
**** Mubarak refers to this instrument as the Na' Shilling.

Explaining Stephen Williamson to the world (and himself)

Stephen Williamson catches a lot of flack on the net. Some is undeserved, some is deserved, but a big chunk is probably due to the fact that he and his fellow New Monetarists have a communications problem. People don't understand what they're up to. So here's my attempt to bring Steve down to earth and explain to the world the importance of the research being done by him and his colleagues. I'll go about this by adding a bit of historical context. After a quick tour of the history of monetary thought, readers will be able to see where in the greater scheme of things the New Monetarists fit. Now Steve doesn't know much about the history of economic thought - he thinks it's unimportant. So in a way, I'm explaining not just Steve to the world, but Steve to Steve.

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.

Questions for Bob Murphy and other Austrians on the inevitability of the bust

David Glasner had some recent posts (here and here) on Ludwig von Mises and Austrian Business Cycle Theory (ABCT). Bob Murphy pushed back here with a good rebuttal. But David's general point still stands: what necessarily forces a central bank that has adopted the practice of lending at a rate below the natural rate to ever cease this practice? Why does there have to be an inevitable bust?

I consider myself an Austrian in that one of my favorite economists is Carl Menger. I've also written a thing or two for the Mises Institute, my most recent being on Menger and Leon Walras and how the two would have differed on the phenomenon of high frequency trading. On the other hand, when it comes to macroeconomics, I remain a business cycle agnostic. I'm willing to be converted though. All you've got to do is answer a few questions of mine.

Say a central bank decides to reduce the rate at which it lends below the natural rate. Businesses can come to it for cheap loans -- and they do. Mises points out that as long as this differential exists it'll eventually lead to a "crack-up boom". The currency enters hyperinflation stage and, at its peak, people either turn to barter or dollarization occurs. Alarmed at this prospect, the central bank will probably increase rates in order to stave off the crack up.

But say the central bank and the currency users exists on a small island far from everywhere so dollarization can't happen. Say also that the police force is vigilant about preventing people from bartering. As a result, the currency issued by the central bank continues to be used, even during hyperinflation. The inevitable flight from money — the crack-up boom — can't occur. The currency perpetually falls.

So having assumed the crack-up boom away, why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.

So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?

To start off, one explanation for a bust occurring is that when rates are kept too low, excess resources are allocated to interest-sensitive distant projects and not enough to less interest-sensitive near-term projects. At some point there's a realization that not enough capital has been allocated to present needs and all those future projects suddenly collapse in value. Thus a bust. What causes this sudden epiphany? As David Glasner asks, are workers dying of starvation?  It can't be higher interest rates that render these projects unprofitable since, as I've already pointed out, the central bank keeps rates permanently low.

Even if capital begins to flow into projects that are only profitable at low rates, wouldn't the prices of materials required by those projects be bid up relative to other prices, thereby putting a quick end to the profitability of these distant projects? Wouldn't the relative prices of material required for near term projects fall, thereby increasing the profitability of near term projects? How can any significant capital misallocation proceed given these rapid relative price adjustments?

If you can answer all my questions, then you'll have successfully converted me.

Inflation as theft

Noah Smith writes a somewhat facile post targeting internet Austrians. They're too easy of a target - and I doubt that thinkers like Mises, Menger, or Hayek would disagree with any of Smith's facts and calculations.

They might disagree with the spirit of his post. His post paints a somewhat benign view of inflation. For instance, he pokes fun at the idea that inflation is akin to stealing by pointing out that a large component of the public (those with large debts) actually benefit from inflation.

The "inflation as stealing" meme is a very old one that predates Austrian thinkers, as I pointed out in my comment:

On a superficial level I agree with you.

On a deeper note, the idea that altering the value of money can be equated to stealing is a very old idea that predates Austrian economics, and in attacking Austrians you're also attacking thinkers like Adam Smith, ARJ Turgot, and Richard Cantillon who wrote along similar lines and were reacting to very real circumstances.

In medieval Europe, the sovereign was often the realm's biggest financial actor, controlled the mint, and by corollary set the definition of what constituted the unit of account. Debts were payable in these units. Prior to paying off its debts, the sovereign had a huge incentive to "cry up" the coin - reduce the amount of gold in the unit of account, thereby reducing the real amount the sovereign owed its creditors. On the other hand, when the sovereign was creditor and expecting payment, they had a huge incentive to "cry down" the coin, thereby increasing the amount of gold in the unit of account and increasing the real value of what they were to receive.

In short, there have been situations in which inflation and deflation "steal" the public's resources (the public being anyone who is not the sovereign). I would be hesitant to apply this to the modern western situation, but in analyzing the economics of modern third world dictatorships, it is important to understand how the dictator - much like a medieval king - might utilize the monetary system to redistribute resources from the public to his/her circle of cronies and thereby maintain a grip on power. I would strongly recommend most people from these sorts of nations to ignore your somewhat facile and euro-centric description of the effects of inflation and other forms of monetary confiscation, but I doubt they need my advice as they are probably more well-versed in the specifics than I.

In short, when the entity that is the largest debtor is also the entity that defines the nation's unit of account, and also controls the balance sheet of the nation's central bank, you have a significant conflict of interest. That doesn't mean that something conflicted will necessarily occur... but you might want to keep the potential for shenanigans in mind. In times past, conflicted sovereigns haven't always been hesitant to use their control over the monetary system to steal from non-sovereigns, and thus the meme "inflation is theft" has survived over the decades.


Here is Adam Smith, who in pointing out why the coin of the realm was below the original standard in weight, ascribed it to:

...the temporary and fraudulent views of the government, who found their interest at times to diminish the coin by adding a greater quantity of alloy, in order to pay off their various debts with a small quantity of silver and gold... in the 1st place, the creditors of the government are cheated of their money; if the coin be one half less they have but one half of the value that was given to the government, though they have in appearance the whole. To screen themselves also it is necessary that all debts in the kingdom should be paid by this money in the same manner as by the old money. So that all the creditors in the kingdom are in this manner defrauded of their just debts.

Two sources which are quite good on the method of augmentation and diminution of the coin of the realm. The first is from this chapter from Richard Cantillon's Essai sur la Nature du Commerce in Général, the second is excellent paper called Chronicle of a Deflation Unforetold by Francois Velde. The latter has another paper with Rolnick that describes the terminology of augmentation and diminution.


Here is a key for understanding the terminology:


Augmentation =  a way for the prince to reduce the real value of his debts owed by reducing the amount of gold in the nation's unit of account. An alternative way of thinking about this, the number of units of account that each coin could "purchase" was augmented.

Diminution =  a way for the prince to increase real income from debtors by increasing the amount of gold in the nation's unit of account

Debasement is a different term - it means to changing the physical constitution of the coin by reducing its gold content. The opposite of debasement is enhancement - adding precious metals to the coinage.  

Drachmas or not?

John Cochrane has had a few interesting comments on Greece leaving the Euro, here, here, and here.

Cochrane doesn't believe in the consensus view that a Greek default means a Greek euro-exit. He thinks Greece can default and stay in the Euro. He also makes the good point that Eurobonds already exist... in the form of Target2 transfers. His last post illustrates how difficult it would be to create a new drachma. I am sympathetic to many of his views.

I had an interesting debate in the comments section of his last post on the difficulties of creating a new drachma.

Market monetarists and endogenous money

Lars Christensen had some interesting comments and responses on market monetarism.

I pushed him on how far market monetarists departed from traditional monetarists in admitting that money creation was endogenous, not exogenous. ie. determined by the central bank. If this is indeed the case, than the market monetarists stand nearer to the middle of the historic currency vs. banking school divide than Milton Friedman did. The latter would be considered a pure currency school theorist. Same with Mises and the traditional Austrians, although the Austrian free-bankers are surely not currency school theorists.

The fact that market monetarists, according to Christensen, are willing to think about money endogenously, just as the banking school theorists did, is a healthy improvement.

Mises, Smith, and the origins of money

Lord Keynes continues to squabble with the Austrians on the origins of money in two separate posts, one on Adam Smith and the other on Mises's regression theorem.

The combativeness on the blog is unproductive, but I left a few comments anyways.

On Smith:

I don't really disagree with your claims, although I think you have to read the full Wealth of Nations in order to appreciate Adam Smith's theory of money. For instance, you are quoting from book 1 chapter 4, but Smith also has a very interesting (and much more extensive) chapter describing the complex workings of the system of bills of exchange, so he was by no means focused on gold and silver as money (See book 2 chapter 2). In this way he was different from Menger, who never discusses credit. Like Henry Dunning Macleod (who I see someone has already quoted), Smith was comfortable with credit as money.

 The existence of Henry Dunning Macleod, as well as George Berkeley and James Steuart, disconfirms the thesis that classical and neo-classical economists were uniformly metallists. All advocated to various degrees a credit theory of money. Jevons credits Macleod for laying the framework for marginal utility calculus, so he was surely neoclassical.

 The "origins of money" debate is interesting but I don't know how important it is. I think it's perfectly logical to adopt a Mengerian metallist approach and a Macleodean credit approach, modifying each just enough so that they can be amalgamated. Let the anthropologists take care of the chronological order of things.

On Mises:

But there is a severe flaw underlying Mises’s whole intellectual program in producing his Regression Theorem: the truth of the assumption that money only has indirect utility.... The view that money only has utility through its exchange value is also held by neoclassicals... This idea held by Austrians and neoclassicals should be rejected."

 I think you'll find that a number of Austrians already reject this. William Hutt's paper on the Yield from Money Held is a good example.

 http://mises.org/daily/3449

There are plenty of problems with Hoppe's article, but it is a good example of what I am talking about. Hutt was a fellow traveler of the Austrians and his paper is very popular in Austrian circles.

See an earlier post on Menger and the origins of money.