Thursday, 27 October 2016
Ryan Shea Amareos
Money has been around a long time, at least conceptually, with economic historians broadly agreeing that the earliest recognisable form of money was livestock in the period 9,000-6,000BC. This choice made perfect sense considering the six now universally-agreed prerequisites of money.
- Store of value
Commodities have a natural scarcity – their supply is finite – and there is an associated cost of production/extraction. These two characteristics alone make them attractive by satisfying the “store of value” attribute listed above (arguably one of the most important of the six).
However, because commodities are also useful articles of trade, by definition they have uses other than as a medium of exchange. This is a distinctly undesirable feature for any money because it means that monetary shocks can arise from changes in the nonmonetary demand for the commodity. Similarly, commodities are also vulnerable to supply shocks, such as finding new sources of higher-grade metal ores (throughout history gold and silver have been the most popular commodity monies) and/or cheaper extraction methods.
In light of this obvious deficiency, and concomitant with increased financial sophistication, money has evolved into a more abstract form. Today what we all consider to be money is either central-bank issued notes and coins or electronic deposits held at commercial banks (the latter accounting for the overwhelming majority of transactions in modern economies).
That said, the transition from commodity, or commodity-backed, monies to the present fiat money system was neither swift, nor smooth. Indeed, there is a rich history of failing fiat monies dating all the way back to the 17th century.
The key problem with fiat money is that it is not backed by anything other than the credibility of the issuing authority. And, because the marginal cost of production of fiat money is negligible, issuers face strong incentives to increase the supply of money until its market value falls to the (very low) cost of production. This is true even when the issuing authority is the government – or government agent in the case of a central bank.
Indeed, there are numerous examples for government-issued fiat money having failed with fiscal overspend the common root cause of the failure. Simply put, governments faced with escalating expenditures face a stark choice: raise money by increasing taxes (very transparent and politically unpopular) or fire-up the printing press (much more subtle). Debasing one’s currency has disastrous long-run consequences, as the Weimar Republic amply demonstrated in the early 1920s, but numerous precedents suggest it is often the better short-term choice politically.
Hence, while both pure commodity and pure fiat money systems have benefits, they also have significant shortcomings; shortcomings that explain why neither system has proved historically robust. However, this bipolar characterization of money is no longer all-inclusive in light of the innovation of digital currencies, notably Bitcoin.
The underlying rationale for Bitcoin, as outlined in the first few paragraphs of Satoshi Nakamoto’s 2008 seminal white paper, is – like all great ideas – simple. Despite the surge in commerce over the internet, the system still relies almost exclusively on financial institutions acting as “trusted third parties”. The key innovation of Bitcoin is that it does away with the need for a central-issuing body by using complex encryption technology to make transactions “computationally impractical to reverse”. So, rather than relying on a central authority to verify every transaction to ensure there is no double-spending Bitcoin does it via an open network, thereby creating a decentralized money system that allows transacting parties to conduct business bilaterally.
The other design feature of Bitcoin that is ingenious, and which provides the greatest source of intrigue to economists, is that the supply of Bitcoins is predictable and eventually finite. Bitcoins can only be mined at a pre-specified growth rate that will steadily decline until the total supply is capped at 21 million. In order to ensure that the production of Bitcoins is in line with the release schedule, the degree of difficulty in “mining” or verifying existing transactions is variable and a function of the number of “miners” or computer power employed. Hence, even if some individual, or more likely organization, were to employ supercomputers to maximise their mining success, this would simply affect the share of Bitcoins mined not the total amount.
To think about how Bitcoin fits within the spectrum of money classification types consider the following table, which is contained in a working paper on synthetic commodity currencies published by Selgin (2013).
Base Money Types
What is clear from the above table is that Bitcoin manages to combine the pros of a commodity-based system, as its scarcity is – by design – absolute, and a fiat-based system, because just like bank notes or electronic bank deposits Bitcoin has no known (at least as far as we are aware) nonmonetary uses. So, theoretically, it represents significant improvement over the two money-types that have been used during the entirety of human existence.
Before going on to discuss several drawbacks with Bitcoin let us first dismiss one often-stated criticism of the virtual currency, namely that it is nothing more than a sophisticated Ponzi scheme. The analogy stems from the fact that Bitcoin pays no interest rate. Hence, it is argued, making a profit from investing in Bitcoin relies on other investors purchasing it later at a higher price.
Superficially, the analogy seems valid. Yet, it does not require much reflection to realize that it is flawed. Bitcoin is a fully functioning (albeit virtual) money that allows anyone to make transactions – it is no more a Ponzi scheme than any other form of fiat money. Moreover, assuming the supply is eventually capped at 21 million, Bitcoins should – at a minimum – continue to rise in line with inflation, if not nominal GDP growth, as there is no reason to expect its purchasing power to diminish. For both reasons even late adopters (the suckers in a true Ponzi scheme) still benefit.
A more well-founded drawback relates to the credibility of Bitcoin’s founder, the infamous Satoshi Nakamoto. The real identity of Satoshi is unknown and subject to intense scrutiny and speculationin the media. This anonymity naturally raises doubts about Bitcoin’s credibility. However, when considering this question it is worth also reflecting on the following corollary question:
Who would you rather trust? A tech geek who has promised to limit the supply of its virtual money in a highly visible manner, or central banks mandated by their government to issue money in quantities sufficient to ensure its real purchasing power steadily declines.
When considered in this light the answer to the trust question is not so obvious.
Moreover, this was the greatest risk to Bitcoin at its inception. Now the virtual currency has become, in some sense, more established, this concern is somewhat diminished.
Another widely discussed drawback to Bitcoin is that the price is very volatile. Indeed, in 2013 it rallied by nearly a factor of 50. The reason why Bitcoin has such high price volatility compared to other money forms (the volatility of money can be thought of as the inflation rate or the exchange rate versus other currencies) is that the price is purely market driven; there is no market-maker to smooth out short-term imbalances between demand and supply.
Over the very long-term Bitcoin’s price volatility will tend to dampen down as the combination of increased supply (as a result of mining) and – ironically – a higher price means that the Bitcoin market becomes increasingly liquid. That said, until such time, Bitcoin’s price lies hostage to the vagaries of crowd sentiment more than other global currency.
As can be seen in the exhibit below, the crowd-sourced sentiment indicator towards Bitcoin has tracked its price movements reasonably well over the past several years. The first wave of crowd positivity towards Bitcoin began in early 2013 when several factors combined to boost the currency’s legitimacy – even former Fed Chairman Bernanke acknowledged that it “may hold long-term promise” – and, as the price started to rise, public awareness of Bitcoin surged, all of which culminated in a huge price spike.
Exhibit 1: Crowd-Sourced Sentiment and USD Price – Bitcoin
Even though the second wave of optimism that begin in May 2014 preceded a modest rebound in Bitcoin’s USD price, the hangover from the earlier price spike, and the well-publicized bankruptcy of one of Bitcoin’s largest exchanges Mt. Gox in February 2014, proved dominant. As crowd positivity began to wane Bitcoin’s price resumed its downward slide – a trend that persisted until the last summer, when sentiment hit its lowest level since the data have been available. This low point in sentiment marked the completion of a two-year long post-spike consolidation phase in the Bitcoin price and the start of a more measured uptrend (at least in comparison with the 2013’s price spike). Looking at the right hand side of the above exhibit crowd sentiment towards the currency remains constructive suggesting that there remains more upside in Bitcoin’s price.
As to the question of how much upside there is for Bitcoin’s price, this is subject of heated debate. After all, how does one even go about providing a fundamental valuation for a virtual currency that generates no cash flow? Surely it is impossible. Well, it is an intriguing question for economists like us and we are not ones to back down from a challenge. So, consider the following thought experiment
At a global level, the total stock of outstanding fiat money is approximately USD 50tr. Assuming no decline in the stock of money, which would be deflationary and economically toxic given the extremely high levels of debt (public and private) globally, if Bitcoin were to completely replace fiat money then the 21 million Bitcoins that will be produced must equal the global supply of fiat currency. This implies that each Bitcoin would be worth a staggering USD 2mn!
Now we admit that the assumptions we make are brave, but even if we apply very large margins of error around this valuation, it strongly suggests that around the USD 650 mark Bitcoin is significantly undervalued. For those readers who think that such a high valuation makes Bitcoin totally impractical to use, they should note that it has been designed to be divisible to eight decimal places. This degree of divisibility means that even if each coin was valued at USD 2mn payments equivalent to penny transactions could still be made.
At this point we should add a huge caveat to the above analysis; one that highlights another serious risk to Bitcoin. Our USD 2mn valuation for Bitcoin is premised on it replacing all existing fiat currencies. This is never going to happen, although we are still a long way off from this being acted upon.
Governments enjoy monopoly rights to print their own currencies and they can force its usage by requiring taxes be paid it in. This is a huge advantage and they will not give it up. Combined with the ability of Bitcoin transactions to be made anonymously there are extremely strong incentives for lawmakers to try and regulate Bitcoin, or in extremis, try to shut down the entire system.
Moreover, if Bitcoin were to become the predominant money of the global economy, there would be no role for central banks as the need for a single transaction-verifying institution would cease. This, combined with a seeming desire to eradicate cash so as to enable them to remove any lower bound on nominal interest rates, probably explains why central banks are utilizing resources to understand digital currencies better.
Finally, this might seem like an economic anarchist’s utopia but it is worth remembering the words of Milton Friedman, who wrote the following in his 1962 publication In Search of a Monetary Constitution:
“Money is too important to be left to central bankers”.
 We will leave it to the reader to ascertain which of the six prerequisites cows invalidate as we assume it to be self-evident!
 Other commodities include shells, stones, salt and even cigarettes.
 In 1661 Stockholms Banco, a private bank, issued Europe’s first paper money and its failure just three years later was directly a result of printing too many bank notes relative to its collateral. Paving the wave for future trends, the Swedish parliament eventually took over control of bank note issuance after Stockholms Banco lost is charter. After a few name changes Stockholms Banco eventually became the Swedish Riksbank – the world’s oldest central bank.
 The trend over recent decades towards operationally-independent central banks mandated to maintain low-inflation appears to overcome this flaw with fiat money. However, as the nationalization of the BoE in 1946 shows only too starkly this independence is at the gift of the government and hence is hardly worth the paper it is written on. If the economic situation were ever dire enough this independence could easily be revoked. One possible exception is the ECB, not because its legal charter makes its independence more secure, but rather it reflects the region’s sclerotic institutional decision-making processes.
 The ability to use fiat currency to extinguish liabilities, especially tax, is the main reason why paper money is useful given its intrinsic value is effectively zero.
 Hat tip: MG who once informed us that all fiat money systems ever created have ended in failure.
 Bitcoin has not only attracted the attention of the general public but it has also captured the imaginations of commercial and central bankers, as evidenced by Bank of England creating a research team dedicated to digital currencies.
 Once the total supply of Bitcoins reaches the 21 million mark, mining Bitcoins will no longer be rewarded by the addition of new coins. Rather the process of transaction verification will be associated with a fee, one much smaller than that applied by commercial banks at present.
 For the definition of a Coase durable, which is incidental to this research note, please see the research paper by Selgin (2013), “Synthetic Commodity Money”.
 This argument has clearly been severely weakened given the shift towards zero, or in many instances, negative nominal interest rates.
 It may or may not be a pseudonym- see: http://www.coindesk.com/information/who-is-satoshi-nakamoto/
 Recalling that inflation targets are with few exceptions set at 2% per annum.
 Good news if you were long, bad news if you are Laszlo Hanyecz who in 2010 when the virtual currency was in its infancy, purchased a pizza for 10,000 BTC. Back then this was equivalent to just USD 25, but at today’s valuation would be worth more than USD 6 million – surely the world’s most expensive pizza purchase!
 Hat tip (anon). A former boss of mine during a discussion of the gold market made this point about liquidity. His simple point being that the reason the gold market was not viewed by many professional investors as particularly liquid was not that there was insufficient gold, rather it’s price was too low!
 Sentiment data courtesy of our partner www.infotrie.com.
 The online marketplace Silk Road, where many illegal transactions were paid for via Bitcoin tainting its image, was closed; many more mainstream companies started to accept Bitcoin in payment for goods and services (importantly including China), and even the US Senate held hearings on Bitcoin.
 For those interested in trading Bitcoin (and other cryptocurrency and block chain assets) we suggest visiting Gatecoin’s regulated online trading platform www.gatecoin.com. Like Amareos, Gatecoin is an alumni of Hong Kong’s first SuperCharger programme.
 In our view, central bank-issued digital currencies may well come into existence but they are not close substitutes to Bitcoin for the simple reason that they do not offer a decentralized market-based solution.