A Pick-Up Mini Internet Symposium: **More Than** Five Posts on BitCoin Triggered by a Question from Adrienne Jeffries of The Verge…
Tyler Cowen: On the future of Dogecoin, BitCoin, and other cryptocurrencies of the non-realm: “An email query from Brad DeLong reminds me of this old Bart Taub paper, “Private Fiat Money with Many Suppliers” (jstor):
A dynamic rational expectations model of money is used to investigate whether a Nash equilibrium of many firms, each supplying its own brand-name currency, will optimally deflate their currencies in Friedman’s (1969) sense. The optimal deflation does arise under an open loop dynamic structure, but the equilibrium breaks down under a more realistic feedback control structure.
There is also Marimon, Nicolini, and Teles (pdf) and the work of Berentsen., all building on Ben Klein’s piece from 1974. This literature has been read a few different ways, but I take the upshot to be that a) a monopolized private fiat money might be stable in supply, to protect the stream of future quasi-rents, and b) private competing fiat monies will not be stable in overall supply, for reasons of time consistency and also the competitive erosion of available rents. In other words, when it comes to the proliferation of cryptocurrencies, the more the merrier but not for those holding them.
Tyler Cowen: How and why Bitcoin will plummet in price: “My post from yesterday was perhaps not specific enough, so let me outline one possible scenario in which the value of Bitcoin (and other cryptocurrencies) would fall apart. For purposes of argument, let’s say that a year from now Bitcoin is priced at $500. Then you want some Bitcoin, let’s say to buy some drugs. And you find someone willing to sell you Bitcoin for about $500.
But then the QuitCoin company comes along, with its algorithm, offering to sell you QuitCoin for $400. Will you ever accept such an offer? Well, QuitCoin is “cheaper,” but of course it may buy you less on the other side of the transaction as well. The QuitCoin merchants realize this, and so they have built deflationary pressures into the algorithm, so you expect QuitCoin to rise in value over time, enough to make you want to hold it. So you buy some newly minted QuitCoin for $400, and its price springs up pretty quickly, at which point you buy the drugs with it. (Note that the cryptocurrency creators will, for reasons of profit maximization, exempt themselves from upfront mining costs and thus reap initial seigniorage, which will be some fraction of the total new value they create, and make a market by sharing some of that seigniorage with early adopters.)
Let’s say it costs the QuitCoin company $50 in per unit marketing costs for each arbitrage of this nature. (Alternatively you can think of that sum as representing the natural monopoly reserve currency advantage of Bitcoin.) In that case both the company and the buyers of QuitCoin are better off at the initial transfer price of $400 and people will prefer that new medium. Over time the price of Bitcoin will have to fall to about $450 in response to competition.
But of course the story doesn’t end there. Along comes SpitCoin, offering to sell you some payment media for $300. Rat-FacedGitCoin offers you a deal for $200. ZitCoin is cheaper yet. And so on.
Once the market becomes contestable, it seems the price of the dominant cryptocurrency is set at about $50, or the marketing costs faced by its potential competitors. And so are the available rents on the supply-side exhausted.
There is thus a new theorem: the value of WitCoin should, in equilibrium, be equal to the marketing costs of its potential competitors.
This theorem will hold even if you are very optimistic about market demand and think that grannies will get in on it. In fact the larger the network of demanders, the lower the marginal marketing cost may be — a bit like cellphones — and that means even lower valuations for the dominant cryptocurrency.
(It is an interesting question what fixed, marginal, and average cost look like here. Arguably market participants will not accept any cryptocurrency which is not ultimately and credibly fixed in supply, so for a given cryptocurrency the marginal cost of marketing more at some point becomes infinite. Marginal cost of supply for the market as a whole is perhaps the (mostly) fixed cost of setting up a new cryptocurrency-generating firm, which issues blocks of cryptocurrency, and that we can think of as roughly constant as the total supply of cryptocurrency expands through further entry. In any case this issue deserves further consideration.)
Note that the more “optimistic” you are about Bitcoin, presumably you should also be more optimistic about its future competitors too. Which means the theorem will kick in and you should be a bear on Bitcoin price. Arguably it’s the bears on the general workability of cryptocurrencies who should be bullish on Bitcoin price because a) we know Bitcoin already exists, and b) we would have to consider that existence an unexpected and unreplicable outlier of some sort. Yet the usual demon of mood affiliation denies us such a consistency of reasoning, and the cryptocurrency bulls are often also bulls on Bitcoin price, as too many of us prefer a consistency of mood!
In theory
Now, theoretically, you might believe that the current price of Bitcoin already reflects exactly those marketing costs of potential competitors and thus the current equilibrium is stable or semi-stable. Maybe so, but I doubt that. The current value of outstanding Bitcoin is about $20 billion or so, and it doesn’t seem it cost nearly that much to launch the idea. And now that we know cryptocurrencies can in some way “work,” it seems marketing a competitor might be easier yet. (You will note that by its nature, there are some Bitcoin imperfections permanently built into the system, imperfections which a competitor could improve upon. Furthermore the longer Bitcoin stays in the public eye, the more likely that an established institution will label its new and improved product LegitCoin and give it a big boost.)
You can think of that $20 billion — or perhaps just some chunk of that? — as a very rough measure of the prize to be won if you can come up with a successful Bitcoin competitor. Even a fraction of that sum will spur some real effort.
In short, we are still in a situation where supply-side arbitrage has not worked its way through the value of Bitcoin. And that is one reason — among others — why I expect the value of Bitcoin to fall — a lot.
Nick Rowe: BackedCoin vs UnbackedCoin: “Imagine there is competition between two currencies. The two currencies are identical in every respect, except one is backed by assets and the other isn’t. Which one would win the competition to become the preferred medium of exchange?
I think the one that is backed by assets would win. For two reasons:
The issuer of the backed coin could use those assets to help stabilise the value of the coins in response to fluctuations in demand. If demand falls, the issuer could use the assets to buy back some of the coins in circulation. If demand rises, the issuer could sell more coins in exchange for more assets. The issuer can make the supply curve of the coins more elastic, so that fluctuations in demand cause smaller fluctuations in price. Other things equal, people prefer a safer asset to a less safe asset.
The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return.
Other things equal, we would therefore expect to see competition between currencies lead to issuers of those currencies having assets backing those currencies, and paying out all the returns from those assets (minus administrative costs) to those who own those currencies. Free entry and competition drives down the profits from issuing currency to zero. Only currencies with 100% backing would survive.
But are other things equal?
There could be network externalities and a first mover advantage. Like Microsoft, VHS vs BetaMax, and the English language. If UnbackedCoin got on the market first, and if everyone wants to use the same coins as everyone else, and translation costs are high enough, it could survive against competition from BackedCoin. Customers cannot coordinate their simultaneous switch from UnbackedCoin to BackedCoin.
Hal Varian (2004): Economic Scene: Why Is That Dollar Bill in Your Pocket Worth Anything?: “One answer is that it’s valuable because it says it is. To the left of the portrait of George Washington, the dollar proclaims: ‘This note is legal tender for all debts, public and private’.
Dollar bills are “fiat” money – they are valuable because the government in power says so. People can, however, write contracts that specify payment in other currencies. If a contract specifies payment in euros, dollars will not fulfill the contract, despite what is printed on them.
A more profound, and perhaps slightly unsettling, reason that a dollar has value is simply that lots of people are willing to accept it as payment. In this view, the value of a dollar comes not so much from government mandate as from social convention.
In the jargon of economists, the value of a dollar is a result of “network effects.” Just as a fax machine is valuable to you only if lots of other people you correspond with also have fax machines, a currency is valuable to you only if a lot of people you transact with are willing to accept it as payment.
Indeed, one can have currencies that have no government backing. Gold has been used for centuries as a medium of exchange; cigarettes were used for payment in prisoner-of-war camps in World War II; and countless other goods, including cowrie shells and peacock feathers, have functioned as money throughout history. They were money because people were willing to accept them as payment for debts, public and private. Gold, cigarettes, cowrie shells and peacock feathers all have “use value” in addition to their “exchange value.” These items were originally valued for their utility or their beauty, and they became used as currency. It is rare to see a purely paper currency functioning as money without the backing of some government or financial institution.
Rare, perhaps, but not unheard of. Mervyn A. King, governor of the Bank of England, cited an interesting example – the Iraqi dinar – in the Ely Lecture delivered at the recent American Economics Association meeting in San Diego. (Mr. King’s speech can be downloaded from http://www.bankofenglandco.uk/speeches/speech208.pdf.)
Here is the story Mr. King told:
After the gulf war of 1991, Iraq was divided in two: the south ruled by Saddam Hussein, the north governed by the local Kurds. Mr. Hussein needed money to finance government spending, and in the time-honored tradition of dictators, created it himself.
The government could not import more of the bank notes then in use, because of United Nations sanctions, so Mr. Hussein ordered the local printing of a new currency. In May 1993, the Central Bank of Iraq announced that citizens had three weeks to exchange their old 25-dinar notes for the new “Saddam dinars,” which bore his portrait.
During the next few years, so many Saddam dinars were printed in southern Iraq that they became virtually worthless. The face value of cash in circulation rose from 22 billion dinars in 1991 to 584 billion in four years, and inflation averaged about 250 percent a year over that period.
Residents of northern Iraq could not exchange their notes. The 25-dinar notes continued to circulate and became known as the “Swiss dinars,” because they were printed with plates made in Switzerland.
The fact that the Swiss dinars continued to be used at all speaks to the power of social conventions. The Kurds in the north despised the Baghdad government, and would have much preferred to have their own currency. But there was no government in place powerful enough to mandate a currency change, so they kept using the old Swiss dinars by default.
The Swiss dinar was in fixed supply, while the Saddam dinar was flying off the printing presses, so it is not surprising that the Swiss dinar quickly became more valuable. By spring 2003, it took 300 Saddam dinars to buy one Swiss dinar.
The more interesting economic effect was the behavior of the Swiss dinar against the dollar. In fall 2002, as it became more and more likely that the United States would invade, the Swiss dinar became more and more valuable.
This appreciation was driven by expectations. If the Kurds had expected that they would once again fall under Saddam’s sway, the Swiss dinar would have quickly become worthless. As this became less likely, and the belief that future governments would accept the Swiss dinar became more widespread, the local currency became more valuable. Of course, every exchange rate movement can be interpreted in two ways: in the north, the Kurdish regional government initially interpreted the rise in the Swiss dinar against the dollar as a fall in the value of the dollar.
The government soon realized, however, that since the dollar was stable against other currencies, the correct explanation was that recounted above: the increasing belief that the Swiss dinars would, in fact, be honored by future governments.
The government was right. On July 7, 2003, the American occupation administrator, L. Paul Bremer III, announced the creation of a new Iraqi dinar that would be exchanged for the two existing currencies at a rate that implied that one Swiss dinar would be worth 150 Saddam dinars.
Interestingly, the currency markets valued the Swiss dinars somewhat higher than the official 150 exchange rate, primarily because many counterfeit 10,000-dinar Saddam notes were in circulation.
This story illustrates that paper currency can take on a life of its own, even in the absence of government backing. At the same time, it is clear that government backing makes a significant contribution to the value of paper currency: the more likely it became that the Swiss dinars would be valued by a subsequent government, the more valuable they became.
Brad DeLong:
Okay. Suppose that you’re on the island of Yap and it is the late 18th century…
You want to get richer. You can either work on Yap doing something useful, or catamaran over to Palau where the limestone is, carve a big piece of limestone into a disk, catamaran it back, and use it as money. If the value of stone money is too low, it won’t be worth anyone’s while to catamaran over to Palau. Thus the stone money supply will stop growing if the price dips. As long as the relative desire to use stone money does not shrink faster than per-capita income on Yap plus the population of Yap grows, the value of stone money on Yap will be determined by its cost of production–that is, the cost of catamaraning it over to Palau, carving the limestone disk, and bringing it back…
We can see this at work come the late 19th century. Europeans show up with steel tools that make it a lot easier to carve limestone disks on Palau. Thus there is a huge boom in the limestone disk-carving stone money-mining industry. And the value of stone money on Yap Falls as the money supply grows…
Now suppose that you were on the Internet and it is the early 21st century…
You want to get richer. You can either work doing something useful, or you can set up a botnet to mine BitCoins, or you can fork the code behind BitCoin and set up your own slightly-tweaked virtual cryptographic money network. Setting up a new, alternative network is really cheap. Thus unless BitCoin going can somehow successfully differentiate itself from the latecomers who are about to emerge, the money supply of BitCoin-like things is infinite because the cost of production of them is infinitesimal.
How can BitCoin successfully keep itself differentiated from the latecomer copiers?
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By asserting, over and over again, simply that it was first. And this might work. But I am skeptical.
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By stressing that it has a trustworthy track record of being a safe store of value–and thus appealing to a history that the latecomers do not have. This works until someday, for some reason, demand for BitCoins falls. Then supply and demand drives the value down. BitCoin is then no longer differentiated as a safe store of value. Then the people who were holding BitCoin because they thought it was a safe store of value dump it, its price falls even more, and so it becomes even more questionable as safe store of value. And the downward spiral continues.
Note that in these respects–unless it can successfully and permanently differentiate itself from other virtual cryptographic money networks–BitCoin is like fiat money, and unlike 18th and 19th century Yap stone money, in that its cost of production is zero.
So how do actual fiat moneys maintain their value? Well, they don’t always do so–cough Zimbabwe, cough Weimar Germany. When they do so, it is because a government (a) accepts its money in payment of taxes, thus giving people a reason to hold it, (b) doesn’t want the financial chaos that hyperinflation would generate, and so (c) sets its central bank the mission of being a currency sink–of maintaining the value of the currency by buying it back and burning it up if necessary. Thus I tend to be a “chartalist”: commodity moneys can maintain their value via their cost of production, but fiat moneys maintain their value when some very large too-big-to-fail entity backs them.
In my view, BitCoin’s chances would be a lot better if there were some large and durable entity that promised to be a BitCoin sink if necessary. If, say, Google Cayman Islands were to start GoogleCoin, and announce that it would always stand ready to buy back GoogleCoins at a fixed real value, it could make a (small) fortune and, I think, eliminate BitCoin’s business in a month…
And John Levine weighs in:
John Levine: An Ubernerd Weighs In: “It occurs to me that part of the disconnect is that Bitcoin solved a major technical problem, one that people had been thinking about for about 20 years, and we nerds just can’t believe that it doesn’t also solve an economic problem. The technical problem is double spending–if I have some digital money, it’s easy enough to verify cryptographically that it’s real, but if I give it to you, how can you tell that I haven’t also given it to someone else?
Until Bitcoin, the answer was to have a bank that knew which coins were valid, so you’d present my coin to the bank, which would check its database and if it’s valid, cancel it and give you a new
one. Bitcoin has its decentralized blockchain which is a very clever recasting of the problem so that the state of the “bank” is whatever the majority of bitcoin miners agree that it is. Getting enough of the miners to agree is known as the Byzantine Generals problem, and has a technical history of its own.So with this breakthrough, we must have an economic breakthrough? We don’t? Well, then you just don’t understand/are in the pocket of the illuminati/whatever. If you belive that Bitcoin is a lot like paying for stuff with little bags of gold dust where every grain of dust has a publicly recorded serial number, well, then, uh.
My current guess is that the Bitcoin bubble will collapse when there is some bad news, e.g., a regulator demands registration of Bitcoin wallets, people try and cash out, and find that that while it’s easy to buy bitcoins, it’s much harder to find people willing to buy back nontrivial amounts, very hard to collect the sales proceeds, and completely impossible without revealing exactly who you are.
And Joe Wesenthal weighs in:
Joe Weisenthal: Why Bitcoin Has Value: “Paul Krugman set off a new firestorm this weekend with a post about Bitcoin that asked a fairly simple question: What gives a bitcoin its worth? The post drew a ton of angry reaction from the internet and tech people for a couple of reasons.
One is that this question — why is a Bitcoin worth anything — is a difficult question to answer. The other is that the post is bizarrely titled “Bticoin Is Evil” even though the post doesn’t say that. But on the internet, people don’t read past the headline and so, outrage!
But back to the question of trying to establish an “intrinsic value” for Bitcoin. It’s not simple. The dollar has intrinsic value because you need dollars to pay taxes in the United States. The government accepts no other currency. So if you’re going to engage in any kind of commerce whatsoever, you need to use dollars. This creates real value for the currency. Gold has real value because it’s shiny and can be used for jewelry. Other commodities get their value from industrial purposes.
But what about Bitcoin? If you ask Bitcoin believers why a Bitcoin is worth anything at all, they will tell you about how amazing the technology is, and how it’s “programmable” and how cryptography and pseudoanonymity are so great. But none of these are very satisfying answers. For one thing, these features mainly explain why Bitcoin as a payment platform are so intriguing. They don’t explain price. And as Krugman even notes in his original post, most of the techie Bitcoin bulls usually talk about Bitcoin as a platform (something that’s easy to defend), rather than Bitcoin as an asset…. Furthermore, if Bitcoin’s value were simply a function of all of the technological aspects, then there’s no reason that Bitcoin wouldn’t easily be supplanted by another crypto-currency that has better features (even the Bitcoin bulls will acknowledge that the technology could be better, particularly on the mining side and the confirmation time). For example Litecoin, the second biggest player in the game advertises that if you transact in Litecoin you can faster confirmation times and that the whole system can handle more volume than Bitcoin. So the usual arguments aren’t that compelling.
Now in the Bitcoin-sphere, there’s a lot of debate about what Bitcoin is. People go round and round in circles about whether Bitcoin is a currency or a commodity or a platform or a protocol or an equity or whatever. These squabbles frequently get semantic (what is a currency? Must it be a stable store of value?) and usually they suffer from an inclination to plug Bitcoin into a category where it never quite fits. I think Bitcoin is a hybrid of three things with which we’re all pretty familiar: A currency, an equity, and a social network.
The currency part is pretty easy to understand. Someone is offering something for sale like a bike or a month’s rent, and they might give you a quote in dollars, yen and Bitcoin. Bitcoin basically acts like a currency then. Bitcoin also has equity-like characteristics in that the value seems to grow as the whole Bitcoin ecosystem grows. The value of a Bitcoin is up about 50x this year, which is an insane swing for a currency, but if you think about it as equity in a hot startup, it’s not that preposterous whhen coming off of a low base. Bitcoins also have market cap (see: CoinMarketCap). And most crucially, there’s a social networking element…. Bitcoin is something that’s valued because lots of people use it…. It got a lot of people using it, and suddenly the platform became tremendously valuable. Strong, robust network effects are crucial for making the whole thing work…. Without the network effects, the technology is nothing. It’s just a theoretical amusement.
The question then becomes: Can the social network last? If it can, then the value can be maintained, or might grow by even a lot. But history is not on Bitcoin’s side on this question. For one thing, no social network seems to have much lasting power… especially not the first in a given category (Napster, MySpace, ICQ, etc)….
Bringing it all back home: A lot of Bitcoin skeptics are willing to accept that there’s something technologically interesting going on here (Paul Krugman even posted a followup to his “evil” post talking about what kinds of problems the Bitcoin technology solves). But the economics of it are more tenuous. But if the network of people remains, Bitcoin may keep solving problems, like the problem of getting money out of a restrictive country.
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