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2017-10-19Macro `n Cheese

It’s Kryptonite!

In this week’s “Tales from the Cryptocurrencies” Roger latches on to the current Bitcoin-mania and lands in a communist utopia.

I don’t know about you folks, but I am getting swamped with questions on Bitcoin (and other cryptocurrencies). Going with the populist flow, I thought I’d raise a few issues that I have about the current Bitcoin-mania. Just to be brutally truthful, there are tons of (mainly) technical issues that I still do not quite grasp, and which might even invalidate some of the claims I put forward. If you know better, which I’m sure many of you do, please send me an e-mail or something.

With that, let’s start with the obvious.

Macrobond Document

Graph 1: Cryptocurrencies are becoming ever more precious

Yes, cryptocurrencies are all the rage, but other than the simple fact that this is a kind of commodity-currency, the above developments clearly suggest that the base (in this case USD) will be heavily diluted, inflated away, and useless. But is Bitcoin really a superior form of money?

The basics

We all know the premises for being money:

  1. Medium of exchange
  2. Store of value
  3. Unit of account

As for medium of exchange, we need to make a qualification as we rarely directly exchange cash money but rather we issue claims on base money, which is basically also how commercial banks create money, and can be something as mundane as when we use a credit card. If we rarely transact directly and simultaneously with base money, two time-consistency problems arise:

  1. “Settlement risk”
  2. “Valuation risk”

Any money needs to provide an acceptable solution to these risks for parties involved in the transaction.

In my humble opinion, while Bitcoin might do away with any possible lack of trust in the means of payment1, its payments are also irreversible (at least without expensive judicial confrontation). Fiat-money payments, on the other hand, can efficiently be reversed. Some may see this as a flaw, but think of how it helps to build trust on behalf of the buyer. For example, when he/she pays in advance for renting an apartment or buys a product from a far-away internet retailer. Such transactions would probably not occur with irreversible Bitcoin payments. Put another way, fiat currencies build trust and facilitates trade that would not take place under bitcoin-type of money. Admittedly, cryptocurrency also facilitates some types of transactions where there’s a risk of … “governmental interference” (hmm). Of course, the feature of reversibility also opens up for a certain degree of discretion (often of the intermediator, typically a bank). That said, those costs should be rather small in comparison to the productive relations that can be built on “reversibility”.

1The celebrated feature of anonymity is only there as long as no transaction is traced back to you. If and when that happens (there has already been multiple incidents), all your previous transactions become exposed. Likewise, the increased complexity of the cryptopuzzles make storage impractical why most users tend to store their coins in exchanges. And we know from the Mt Gox experience (there have been others) that such exchanges can be compromised, and lose the coins.

Monies’ function as store of value and unit of account are, of course, closely related. Without store of value it will be hard for us to make economic calculations and to balance future incomes and outlays, hampering the formation of more complex economic (and thus physical) constructs. If the value of our assets (incl. human capital, n.b.) and, debts (almost always obligations nominally fixed in the unit of account) are volatile, we will probably refrain from taking on debt, or at least considerably less of it (with less investments and welfare as a consequence).

Potential stabilisation policy effects

Cryptocurrencies in general, and Bitcoin in particular, are the modern equivalent of a “gold standard” with fixed or near-fixed supply of money. Put another way, such monies are unavailable for stabilization policy purposes, should they ever replace current fiat-money as unit of account. Any cyclical deviations will therefore be magnified as wages and prices are “nominally rigid to the downside”. In essence, this means that when we enter a recession, unemployment rates will need to rise further to bring about the necessary relative-price adjustments. Under a fiat-money regime, this adjustment would be facilitated by changes to interest rates or QE or of the currency. In fact, fiat-money were designed to bring price stability and, hence, to minimize cyclical swings.

A glaring example (and a blatant rip-off from David Andolfatto of St Louis Fed) of life under a Bitcoin-money regime is to see how the use of Bitcoin would spell out in terms of the US deflator for personal consumption expenditures (PCE).

Macrobond Document

Graph 2: Now that’s what I call uncertainty

Bear with me for a moment: If the US would have started to use Bitcoin in January 2014, the ensuing year would have implied more than a doubling of prices and a purchasing power cut in half. Ouch. Thereafter, however, the US would have experienced a deflation of around 900%; a nine-fold increase in purchasing power. In USD-terms, prices would have been almost completely stable. Fact is, it would even have been better for the US to switch to Euros instead of Bitcoin, as it would have implied at least a relatively stable price level.

Admittedly, since USD has been the actual unit of account for all US domestic contracts, the comparison is not completely fair, but that would probably only imply a minute improvement in the performance of Bitcoin as a store of value (and unit of account).

No-Lo transaction costs

By now, you have probably guessed that I am a bit hesitant to a more wide-ranging use of Bitcoin in the economy. Unfortunately, there are other issues with Bitcoin and many other cryptocurrencies that I fail to wrap my head around. For instance, one of the stated objectives with Bitcoin was to bring down transaction costs (for doing small transfers). The way I see Bitcoin, this seems completely topsy-turvy. Transaction costs will probably rise as maintaining the ledgers and mining new Bitcoins requires ever more computer capacity and energy2.

2 Business Insider have a fun article on how the amount of electricity to process one single bitcoin trade would actually power a house for a whole month. This cost will only rise as the cryptopuzzles that needs to be solved will become ever more complicated. In addition, it puts a severe limit on the number of transactions per time unit.


Note: This is not (yet) in the Macrobond database, but as I know all of you will send support-tickets asking for this to be added, it is just a matter of time. ?
Diagram 3: Bitcoin transaction costs are on the rise

One of the reasons for these developments is of course the rising value of Bitcoins. As of now, at least, bitcoins need to be transferred into a working fiat-currency, making this transaction cost very real. Even in Bitcoin-terms the transaction cost has nonetheless risen and is currently between one to two per cent, which puts it on par with any old credit card. Transaction costs are, admittedly, not fixed on Bitcoin markets but depend on, among other things, how you prioritize your transaction. Given the extreme volatility of the currency, it is nonetheless plausible that most participants prefer rapid settlements. The transaction cost, together with the “coinbase block rewards” constitute seigniorage for the “miners” (ledger keepers) and recently reached an incredulous USD 14 million per day (!).

Many of the alternative cryptocurrencies out there were created to address some of the weaknesses discussed above, but any clear alternative has yet to materialize. On that note, and remaining vigilant on the ongoing hype of ICO:s (initial coin offerings), it is not hard to conjure up a scenario where a big respectable company such as Amazon or Google will soon be funding themselves issuing their own private money. And that will probably pose a more acute threat to the current fiat-money system than what Bitcoin and its siblings can ever muster.

Fiat-currencies rule, then die

For now, and as I have tried to argue above, current fiat-monies perform the three basic functions of money much more efficiently then cryptocurrencies. In addition, they provide a means to stabilize economies and the transaction costs are not dauntingly high for most transfers. However, the fiat-system requires a certain amount of trust and the flexibility of the arrangement also invites discretion which might provoke some.

Let us put it bluntly, every fiat-system has failed and all current and future fiat-systems will probably also fail. No state has ever lived indefinitely and I believe this conjecture to hold true for modern nation states as well. And this probably goes to the core of both “gold- and crypto-bugs”. A fiat-system is an agreement. We agree to live in and use the money of a nation and let the government collect taxes and seigniorage to all our benefit. In return, the government will not go all haywire and squander all our money effectively refusing us the possibility to exchange our amassed assets for a decent standard of living in a not too distant future.

In economies where trust in the government is low, I can more easily understand the presence of such fears. That Cypriots popularized Bitcoin during the enforcing of capital controls and that Chinese people similarly saw Bitcoin as a way to sneak past currency and capital controls3 is even somewhat understandable. For most other countries; developed economies and democracies, the current interest in cryptocurrencies is simply … baffling.

3Clearly put in place to support a depreciating currency.

A world marred by mediocre weak income growth, low or negative interest rates, rising debts and brazen political clientelism is fertile ground for conspiracy theories: Central banks are only an extension of the state. If they could, they would inflate away all debts, confiscate massive assets, and destroy our future welfare in the blink of an eye. If holding such thoughts, Bitcoin should perhaps not be argued for in terms of efficiency, but more in terms of political ethics, or the lack of it. From that perspective, Bitcoin is the digital equivalent of gold.

Macrobond Document

Graph 4: Is Bitcoin digital gold?

Why are central bankers so positive?

Given the massive drawbacks of current cryptocurrencies it is perhaps even more surprising that almost all major central banks (CBs) and attached institutions (BIS, IMF) have articulated such an overwhelmingly positive view of central bank crypto currencies (and other forms of e-money). Then again, considering even the slimmest chance of a loss of seigniorage, that position is perhaps understandable after all.

It’s just that I don’t get4 how such an arrangement will play out? As indicated above, we can rule out arguing for “CB-cryptonite” in terms of increased efficiency of money. And to fully utilize the digitalization of money, the CB will want to (and needs to) become the depository institution (ledger keeper) of both households and companies (incl. banks). This will, e.g., enable them to attach negative interest rates on deposits and escape the Zero Lower Bound of pesky physical fiat-monies.

4A view I seem to share with former BoE-economist Tony Yates.

Actually, this will probably happen anyway, as depositors will eventually all run to the (public debt financed) central bank with deposits when they fear their current (private debt financed) bank is insolvent. Thus, in extension, the central bank could very well become the sole lender in the economy. I don’t know about you, but to me, that sounds like credit control, plan economy and communism. And here I thought cryptocurrencies were some kind of gigantic libertarian project. Turns out it’s not. Turns out it’s red Kryptonite5! (I apologize for an unnecessarily melodramatic final passage.)

5 Wikipedia on Red Kryptonite: “Originally, Red Kryptonite simply weakened Superman, but to a greater degree. Red Kryptonite was later described as causing odd behavior or bizarre transformations, albeit temporary and non-fatal. TV adaptations typically show Red Kryptonite making Kryptonians dangerously uninhibited and narcissistic.”

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