Bumps in the Bitcoin Road

April 17th, 2013   Submitted by Jeffrey A. Tucker

BitVolatileNow that Bitcoin seems to be on the way toward monetization, or at least the long process is noticeably underway, there are a number of issues that are troubling people. I will deal with a few here. Note this crucial distinction which is somehow lost on many commentators on the Bitcoin issue. The flaws are not with the technological unit itself but with its mode of delivery in real market conditions.

When do we know it is money?

As I was preparing a report for subscribers of the Laissez Faire Club, I was going through the list of goods and services currently priced at and available on the web. It is mind boggling how many there are. I’m not sure I knew just how much you can get right now. The conspicuous hole in this panoply are local merchants — the pizza joint down the street, the rent, the cab fare. Otherwise, anything you can buy on the web, you can buy with Bitcoin.

Then it suddenly occurred to me.

If you put this list together and look at the total, what you find are more goods and services available right now using Bitcoin than have been available to most everyone in all times and places in all of human history except for the past few years using any money that has ever existed.

True, you can buy more with dollars now, but you can get more stuff with BTC now than you could get with dollars in the 1980s or any other time in history. You can buy more varieties of grain, cereal, and spices now than you could get with government money at the local grocery back then. You can buy smartphones, tablets, scanners, and cameras that didn’t even exist back then. You can get clothing at prices that were unthinkable back then.

In other words, from a broad historical perspective, Bitcoin is already one of the most functional currencies in the history of humanity. What’s more, some estimates put the population of current Bitcoin users at approximately 500,000.

Why isn’t Bitcoin money?

What keeps it from being money — Bitcoin’s value is constantly assessed in terms of its exchange ratios with government currency — is not its usability but its stage of development. Its volatility is a problem that raises other problems. The other problem has to do with current infrastructure of Bitcoin that is not sufficiently mature to justify calling it a full-blown money at this stage. All the signs look great but we are not there yet.

For example, many in the Bitcoin world today are enormously frustrated with Mt. Gox, the Bitcoin exchange in Japan that processes some 67% of the Bitcoin business on the web. That’s down from its near-monopoly status just two years ago, and its percentage of overall business will continue to decline.

One factor that troubles many is that Mt. Gox is highly conventional in its political relationships with the state. Just getting an account there requires a great deal of information, more than most people would give even to open up a local bank account. There is no anonymity; not even close. However, this situation is surely short lived. The more government money moves to digital currency, the more exchanges can rely on a self sustaining Bitcoin economy. The problem of state-connected, privacy violating corporations are a feature of the transition but not of the long-term operation of the system.

The process toward this self-sustainability will follow no predictable course. In the digital age, conditions can change extremely rapidly. As we saw with Cyprus, if people believe that government can rob them of their money, they will do what they can to move it, regardless of ideology. No one likes to be robbed. A technology that can prevent that can go from obscurity to ubiquity in days.

But there are other problems with Mt. Gox. It has borne the brunt of anger for several instances of technical failure since 2009. Most recently, the runup of the BTC to dollar exchange ratio from $30 to $266 in a matter of days overwhelmed MT. Gox’s servers. At the same time, the service was hit by DDoS attacks. After the onslaught and constant crashes that drove a selling panic, the company finally declared a cooling off period of 12 hours while it upgraded its servers.

Mt. Gox needs more competitors

Right now, we are watching a mad scramble for other services that can provide more reliable service and thereby diversity the Bitcoin trade. Many people sense that the market function of price discovery is being inhibited by industrial concentration with the world of Bitcoin. It seems unsustainable for there to exist tens of thousands of Bitcoin retailers and services but for one company to so thoroughly dominate the producer end.

But there’s a beautiful thing going on here. There are no restrictions on establishing a Bitcoin exchange. The barriers to entry are extremely low, and there are not yet any prohibitive legal barriers. This means the competition for handling coins is already very intense. For Mt. Gox to survive in this environment will require it to be unrelentingly innovative.

Is it? With all services like this, they wear their flaws on their sleeves because they are seen by 100% of users. When things go wrong, we lunge for our rotten tomatoes and start hurling them. Having been on the other side of this for many years, my sympathies go out to any company faced with these sorts of problems.

In the world of server administration and website management, problems are preludes to solutions. The failures serve a profoundly important purpose: they draw attention to the weak points of the current server and database configuration. Things have to break in order for them to be fixed properly and with precision. One hates for this to happen in real time, but such is the way with markets. This is no perfection out of the box, and this is the way it must be. The upheavals are more productive in a market economy than the stability. And, again, these problems have nothing to do with Bitcoin but rather the infrastructure in which it is being introduced to the market.

Bitcoin is deflationary

A larger problem with Bitcoin concerns its essential structure that lends itself to growing value in terms of goods and services over time. This is also known as deflation. With a supply that grows on a predictable basis leading to a final fixed supply, it will always buy more and more. Why would that be a problem? Deflation poses special problems for merchants.

Let’s say you buy 5 tablets for 100 Bitcoin that you intend to resell at a profit. But by the time they enter on the market, the value of Bitcoin has risen and you can’t resell them at a reasonable markup. This is a similar situation many merchants found themselves in with regard to memory sticks and thumb drives over the last 10 years. They buy them and end up eating them given the falling price of the goods on the retail market.

How can merchants deal with this? Well, we can be inspired by the software and computer markets over the last 20 years. Deflation has been the rule. The retailers who have made it through have proven themselves to be radically “antifragile” in the neologism of Nassim Nicholas Taleb. They have adapted through limited inventory, providing top service, excellent marketing and a general reliance on relentless improvements in product quality to carry the day. These have been gigantically profitable industries in spite of the constant fall in price of their goods relative to money.

If Bitcoin does indeed grow in value over time, savers will be rewarded. But never forget this fundamental truth: the only point of saving is eventual spending. Those who are hoarding Bitcoins today will be on the market for Bitcoin products and services tomorrow. This is a truth that Keynesians of all sorts turn away from but it highlights the reality that hoarding is actually a productive force in the market economy.

Still, replicating that model with today’s wild volatility of Bitcoin seems implausible. But this raises another issue.

Bitcoin is volatile

Why should this volatility matter in our minds at all? Because the market is still in its infancy. We are accustomed to constantly checking the price of Bitcoin in terms of other currencies. It does not always have to be this way. For example, most people today couldn’t tell you anything about the Dollar-Euro exchange rate because it just doesn’t matter. The more you deal in one currency, the more we think in terms of that currency and not its exchange rate.

Bitcoin will have matured as a currency when people stop concerning themselves with the exchange rate in terms of other monies but mostly in terms of its value against the goods and services it buys. At that point, it will not be necessary for merchants to constantly adjust prices. The prices in Bitcoin will have meaning on their own. Even now, Bitcoin users grow tired and frustrated with the relentless focus on its dollar price. This focus tempts people to think of Bitcoin as a speculative product or investment rather than what it seeks to be, which is an emerging unit of account.

Part of the irony of Bitcoin’s volatility is that it is a sign of its success. The markets are testing it, flitting between belief and doubt based on events such as bank runs and currency upheavals. It is a viable option today to government currencies, which is why we are seeing panic rushes to buy followed by panic rushes to sell. Once the futures markets of Bitcoin have matured, we will start seeing those ups and downs smoothed over in a way that at least incorporates the speculative judgements of the players with skin in the game.

So, yes, there are myriad problems between where we are today and where I think we will eventually be, with money finally leaving the analog age and entering the digital age. But the trajectory is clear and those who see this and act on it will be ahead of the historical curve.

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17 Responses to “Bumps in the Bitcoin Road”

  1. HReardenNo Gravatar says:

    Good article. Like all alternative currencies in the USA it’s value is measured in FRN dollars. People want to know what the value of something is in FRN dollars. Bitcoin is exchanged for FRN dollars. It’s value is thus tied to FRN dollars or at least is measured in FRN dollars. In Canada the value of goods is measured in BOC dollars. As long as there are central banks the value of goods and services will be determined and measured by the currency issued by the central bank. Ironicly in colonial America although it was “illegal” to bring foreign coin into America many people did and the most popular coin that used as money was not English coins but the Spanish milled dollar. Thus the dollar became the unit currency. Alexander Hamilton as Treasury Secretary had a Spanish muilled dollar weighed and disected and determined the number of grains of silver in one was 371 4/16 grains of pure silver or 416 grains of standard silver and that became the definition of a dollar wich held until at least 1837. Today there is no legal definition of a dollar in US statute.

    $

  2. AnonymousNo Gravatar says:

    The merchant doesn’t need to set prices in bitcoins, I’m simply paying with bitcoins at checkout. The price can still be shown in whatever fiat currency is local for me, or just USD prices as so many e-Commerce sites use now regardless of where the buyer is from.

    So at checkout is when the total payment amount in BTCs would first be shown.

    • AnonymousNo Gravatar says:

      And at some point the prices will be more stable when priced in an energy unit than when compared to any fiat unit.

    • Martin BrockNo Gravatar says:

      That’s basically how merchants “price” goods in Bitcoin now. In other words, they don’t price goods in Bitcoin. They price goods in dollars or another currency and calculate a Bitcoin price that can change from minute to minute. If dollar prices changed this way, we’d say that the dollar is on its way out as a currency, not on its way in.

      Merchants that don’t use bitcoins to buy the goods that they sell for bitcoins while paying wages and other expenses in bitcoins and reinvesting their profits by spending bitcoins are not using bitcoins as money. They’re using bitcoin exchanges for transaction processing. That’s fine, but is it really more cost effective than other transaction processing services? If it’s not, it won’t become more widely accepted. Most people won’t use bitcoin because using it excites them. The excitement value for most people is less than zero.

      Even with coinbase, I pay 1% to convert dollars in my bank account to bitcoin, and the merchant from which I purchase goods presumably pays another 1% to convert the bitcoins back into dollars in his bank account. I can spend dollars from my bank account directly without any direct cost, and indirect costs don’t seem higher. Dollar prices at bitcoinstore are not lower than dollar prices at amazon.com.

      • Seth KingNo Gravatar says:

        Are you at all familiar with the network effect?

        https://en.wikipedia.org/wiki/Network_effect

        In the Wikipedia article they use the telephone as an example. Clearly the first people who bought telephones paid an exorbitant price with very little utility. But thank God they did because had it not been for the first users, we wouldn’t have them today.

        The same goes with Bitcoin. Clearly the first users have limited utility compared to an entire planet of Bitcoin users. I just don’t understand how you could criticize Bitcoin so much when it’s a brand freaking new currency.

        Expecting perfection out of the gate is not how any new technology works, at all. I mean, the first people who bought CD players paid thousands, THOUSANDS of Dollars 30 years ago, when the Dollar had a lot more purchasing power than it does today. And for what? The sound quality is arguably little better than a vinyl record.

        I think your hyper-criticism of Bitcoin is extremely short-sided, with all due respect.

        • Martin BrockNo Gravatar says:

          I don’t expect perfection out of the gate, and I’m not hypercritical. The first users of telephones had no option. If they wanted to talk to someone a mile away, they had to pay for the mile long wire. They paid far more than anyone pays for far superior telephone service today, but for a few people, this price was worth paying.

          The alternative was not talking to someone a mile away. If you’re at a commodities exchange a mile from the coast when a ship makes it to port carrying a valuable cargo following a very hazardous voyage, that instantaneous communication can be worth a lot compared to the alternative.

          For a few people, using Bitcoin is similarly valuable today, because using conventional payment systems is impractical for them. These people are largely in the black market, at Silk Road for example. For other people, no situation comparable to early adopters of telephones exists. These people have serviceable currencies and electronic payment systems already. Bitcoin must compete with these alternatives. That’s just a fact.

          Competing peer-to-peer currencies also exist, and more are on the way, and Bitcoin must compete with these alternatives too. Expecting Bitcoin to become a worldwide currency on the scale of the dollar is extremely pollyannish. I’m not saying it’s impossible, but Bitcoin is not only a new digital, peer-to-peer currency. The whole idea of a digital, peer-to-peer currency is new, and Bitcoin is blazing the trail. It won’t be the last, because it isn’t the best model conceivable. That’s not hypercritical. It’s just a fair warning.

          Suppose many bitcoin nodes started adopting an altered algorithm permitting the production of more than 22 million bitcoins? Some nodes might never recognize the new bitcoins as legitimate, but most do. Say the new mining algorithm is sensitive to the current bitcoin price of silver. When enough nodes agree that this price exceeds some threshold, miners find new bitcoins more frequently. How would you react to that?

          This sort of variation on the Bitcoin theme could be an improvement. It could result in a more stable, reliable payment processing system. Other variations are also possible, and we should discuss these variations rather than insisting that Bitcoin skepticism is somehow ill-intentioned or illegitimate.

  3. Saras DewiNo Gravatar says:

    Not just pizza and electronics. You can now buy a long-term vacation home on the paradise island of Bali with you hard mined BTC :-)

  4. “Even now, Bitcoin users grow tired and frustrated with the relentless focus on its dollar price. This focus tempts people to think of Bitcoin as a speculative product or investment rather than what it seeks to be, which is an emerging unit of account.”

    Someone please correct me if I’m mistaken, but Bitcoin as a speculative product or investment is a good thing. Speculation and investment is the very essence of the futures market which article later correctly recognizes as having a moderating effect on price, making it a better money (because economic calculation is easier):

    “. . . . Once the futures markets of Bitcoin have matured, we will start seeing those ups and downs smoothed over in a way that at least incorporates the speculative judgements of the players with skin in the game.”

    Perhaps the criticism is the recent spike has been a distraction from Bitcoin’s more important purpose, namely a medium of exchange.

    • It’s good but frustrating. I grow weary of people who only analyze this as a stock. It becomes tedious. But yes, speculation can only help BTC really. It doesn’t help the punditry class see what’s going on here.

      • Martin BrockNo Gravatar says:

        I expect the speculation to help Bitcoin’s competitors, unless Bitcoin itself changes to dampen the speculation, and only a change in the production algorithm seems to have this effect. People should speculate on Bitcoin if this speculation is their preference, but people speculating on Bitcoin are using a competing currency as money, and that’s the problem.

    • Martin BrockNo Gravatar says:

      If I expect Bitcoin’s value to fall in the future, I don’t need a future’s contract. I can sell now. A futures market might dampen bubbles, but the fundamental problem still exists.

      A futures market can dampen price swings for goods with different values at different times, like agricultural commodities during different growing seasons subject to uncertain weather.

      A futures market in which people bet on when a speculative bubble bursts doesn’t follow this pattern, and I’m not sure it changes the bubble dynamic fundamentally at all.

      • Seth KingNo Gravatar says:

        Yes, if you expect Bitcoin’s value to fall in the future you can act like a day trader and sell. But history shows that the vast majority of day traders don’t have a clue what they’re doing and lose their shirts over the long run.

        I think every die-hard Bitcoin user, like myself, knows Bitcoin will have several more bubbles between now and ubiquity. And if we were all completely omniscient we would always sell at the peek and buy and the bottom. But we’re not omniscient, and instead of playing the day-trading game we’ll just stick to going long on Bitcoin and reaping the rewards of patience.

        • Martin BrockNo Gravatar says:

          People investing in futures markets also lose their shirts. My point is not that day trading is a good idea. My point is that a futures market need not address the problems I’ve discussed, related to Bitcoin’s inelastic supply and its lack of another valuable use. You’re ignoring these points rather than countering them.

          Most economists agree with me. If you want to claim that most economists believe some bogus theory, that’s fine. I can believe that most economists are mistaken, but I need more than “it’s bogus”. If you’ll tell me what’s wrong with the logic, I can be persuaded.

          I’m happy for you to be long on Bitcoins, but if the diehard Bitcoiners are all long, if they’re all accumulating Bitcoins expecting Bitcoin to become ubiquitous, that’s exactly what I say is wrong with the system. If most people buy and sell bitcoins for this reason, then Bitcoin is not becoming ubiquitous as money. Bitcoin will only be ubiquitous as money when most people hold bitcoins only for short periods, only long enough to mediate indirect exchange.

  5. Martin BrockNo Gravatar says:

    Re: FreeRadical @ April 14, 2013 at 3:02 am under Bitcoin Skepticism and Bitcoin Fever

    Demand for a decentralized, digital, peer-to-peer currency, that states can’t easily commandeer or create, is real, and this demand is part of the demand for Bitcoin. I want this currency myself, despite my skepticism of Bitcoin specifically, so I am part of this demand.

    Speculation is also part of the demand, and I’m also very tempted to join the speculators, and that’s the problem with Bitcoin.

    Price stability is one of the most valuable charactistics of a medium of exchange. If Bitcoin were a currency likely to succeed on a large scale, I would not be so tempted to speculate on its future value, because I would not expect its future value to differ radically or unexpectedly from its current value. If accumulating Bitcoin is a good invesment, then Bitcoin is not a good medium of exchange.

    Hedging against inflation of other currencies is still speculation. Hedging with gold is also speculative, but hedging with Bitcoin is even more speculative, because Bitcoin has no use other than its monetary/speculative use. A pure “Ponzi scheme” type of “investment” has no use other than its speculative use, so Bitcoin is not a Ponzi scheme, but it becomes a Ponzi scheme without its monetary use. If you accumulate Bitcoin, you’re betting that its monetary use dominates, and if you’re wrong about that, you’re betting on a Ponzi scheme.

    Bitcoin’s value relative to the dollar is volatile for this reason, not because people fear rapid dollar inflation at the moment. I use dollars every day, and there clearly is no rapid dollar inflation at the moment. Gradual inflation doesn’t concern me, because I don’t hold dollars for very long anyway, because dollars are my medium of exchange.

    I don’t save dollars. I save stocks, bonds, real estate, commodities and other investment goods. The idea that people get rich by saving money is a fundamental error that classical liberals like Smith and Bastiat debunked centuries ago. Saving is not a bad idea, but saving money is, and the idea that “saving money” is misconstructed is a classically liberal idea, not a Keynesian idea.

    “As long as there is an increase in trade via Bitcoin the value of Bitcoin will rise.”

    That’s right, but a problematic feedback exists for this reason. If the value of Bitcoins rise more than the value of competing currencies, people will hold Bitcoins rather than spend them, but if people hold Bitcoins rather than spend them, then trade via Bitcoin does not increase.

    Using Bitcoin as a medium of exchange and speculating on rising Bitcoin value are competing uses of Bitcoin, and the competition is effectively zero-sum. A Bitcoin held speculatively cannot be used to mediate exchange, and new Bitcoins do not appear to replace Bitcoins held speculatively.

    The bubble scenario is more than a theoretical possibility at this point. It’s an empirical observation. I’m not predicting the imminent collapse of Bitcoin, but the latest bubble won’t be the last. You can speculate on the next one if you want, but insofar as you speculate on it, you aren’t actually using Bitcoin as a medium of exchange. You’re destablizing Bitcoin prices, and other exchange media with more stable prices compete with Bitcoin.

    I’m not preaching a “don’t speculate on Bitcoin” sermon here. Any sermonizing is irrelevant. If holding Bitcoins is attractive compared with spending Bitcoins, people will hold Bitcoins and spend something else. That’s my only point. Money is what people spend, not what people hold. People hold reams of Microsoft shares worth far more than Bitcoins, but no one says that Microsoft shares are money.

    “The other possibility is that the demand for Bitcoin as money grows at a sufficient rate to absorb any speculator sell-offs, or at least mitigate their effects to the degree that the market doesn’t spiral out of control.”

    I doubt that Bitcoin’s use as money is absorbing the latest sell off. Speculators are now betting on the bottom. If this bubble is not the last (and I don’t believe it is), then a new equilibrium may occur and gradual deflation reflecting growing use of Bitcoin as an exchange media may resume, but the fundamental problem still exists.

    I don’t expect speculation fueled crises to become less frequent as Bitcoin becomes more widely used as an exchange medium, because speculation fueled crises impede the wider use. That’s the problem. The speculative bubbles could continue forever, but I don’t expect this outcome, because less bubbly alternatives to Bitcoin will appear, possibly a Bitcoin 2.0.

    Deflation does not encourage savings, capital investment and wealth creation. The prospect of wealth creation encourages investment. Saving money is not necessary for investment at all. Spending money is necessary for investment, but I’m not discussing state spending here. If I hold cash, I’m !not! investing. I’m refraining from investment. If I want to invest in Bitcoin, I do what Jeffrey Tucker suggests. I create a new Bitcoin exchange or something.

    What I write above is not Keynesianism. It’s classical liberalism. Read Bastiat.

    The divisibility of Bitcoin doesn’t solve the problem. The problem involves Bitcoin’s value relative to other goods, not the number of separate units. If people think of Bitcoin prices in billions of Satoshi’s, the problem doesn’t change at all.

    The problem with Bitcoin is fundamental to the structure of Bitcoin, but a different sort of digitial money could solve this problem. Bitcoin technicians are already thinking in this direction, because they’re tracking Bitcoin Days Destroyed, but a solution must fundamentally change the way that Bitcoins are produced. The production scheme must replace hoarded Bitcoins to stabilize the volume of Bitcoins circulating as money (to make this volume grow with demand for Bitcoins as money). This replacement makes hoarding pointless.

    This solution does !not! discourage saving. If you want to !save! something, spend your Bitcoins on silver. Better yet, buy shares of a Bitcoin exchange employing my son more productively than his current employer.

    • FreeRadicalNo Gravatar says:

      “Price stability is one of the most valuable charactistics of a medium of exchange. If Bitcoin were a currency likely to succeed on a large scale, I would not be so tempted to speculate on its future value, because I would not expect its future value to differ radically or unexpectedly from its current value.”

      If Bitcoin is likely to be accepted as currency on a large scale, then you’d better believe I’m tempted to speculate on its future value, because I do expect its future value to differ radically from its current value. The value of the currency will be proportional to the size of the network using it for currency (i.e. the demand). A given number of Bitcoin will be worth far more if there are a million people competing for its use then if there are only 100 (or six billion versus five hundred thousand).

      The fact that Bitcoin is not a (relatively) widespread currency does not a priori preclude such a development but the limited supply of Bitcoin does mean that its value will necessarily rise as demand for its use as a means of exchange grows. So if it is likely to be accepted as a currency on a large scale at some point in the future then I want to buy now and hold.

      On the other hand, so long as there is continued price instability we will know that Bitcoin is not yet money (which is something that Tucker covered in the article above).

      “If accumulating Bitcoin is a good investment, then Bitcoin is not a good medium of exchange.”

      For some transactions Bitcoin may be a preferable means of exchange (as judged by market actors), regardless of its value as an investment vehicle. Exchanges are taking place today in Bitcoin, and people are making money off of it as an investment.

      I do concede that it realistically will never be money – “the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market”(Rothbard) – unless it becomes less volatile.

      “Hedging against inflation of other currencies is still speculation. Hedging with gold is also speculative, but hedging with Bitcoin is even more speculative, because Bitcoin has no use other than its monetary/speculative use.”

      I’d say Bitcoin is more speculative because the network of users is underdeveloped (and may never develop). If Bitcoin were accepted as money worldwide it would be less speculative than gold even though it has no use other than as money.

      (Fiat money has no use other than as currency, but I doubt that you’d say that it’s more speculative than gold for that reason.)

      “A pure “Ponzi scheme” type of “investment” has no use other than its speculative use, so Bitcoin is not a Ponzi scheme…”

      True.

      “…but it becomes a Ponzi scheme without its monetary use.”

      Which it has, so it’s not.

      “If you accumulate Bitcoin, you’re betting that its monetary use dominates, and if you’re wrong about that, you’re betting on a Ponzi scheme.”

      If you invest in a company that fails despite offering a service to the market did you bet on a Ponzi scheme? Of course not, irrespective of any speculative bubbles in the stock price or the ultimate failure of the company. The same is true for Bitcoin.

      (The end result – loss of your invested capital if you’re left holding the bag – might be the same in either case, but it’s disingenuous to liken Bitcoin to a Ponzi scheme.)

      “Bitcoin’s value relative to the dollar is volatile for this reason, not because people fear rapid dollar inflation at the moment.”

      I agree – Bitcoin’s value relative to the dollar is volatile because no one is sure whether or not it will end up being money and people are betting for or against the possibility.

      “I use dollars every day, and there clearly is no rapid dollar inflation at the moment. Gradual inflation doesn’t concern me, because I don’t hold dollars for very long anyway, because dollars are my medium of exchange.

      I don’t save dollars. I save stocks, bonds, real estate, commodities and other investment goods.”

      And if Bitcoin were money you’d go on looking for higher return investment vehicles along with every other investor. The only difference is that people might hold relatively more of their wealth in money that isn’t continually losing its value.

      Added bonus – the wealth that investors work to build would be what people actually prefer, instead of the military-industrial complex that the gradual inflation you’re not worried about makes possible.

      “The idea that people get rich by saving money is a fundamental error that classical liberals like Smith and Bastiat debunked centuries ago.”

      I wouldn’t argue that individuals get rich by saving money, and never intended to imply as much. (Although this does depend on your definition of rich – there are examples of people who lived industrious but Spartan lives and ended up with a fortune on their death beds. Not what I would want for myself, but…)

      “Saving is not a bad idea, but saving money is, and the idea that “saving money” is misconstructed is a classically liberal idea, not a Keynesian idea.”

      I think it’s an overgeneralization to say that saving money is a bad idea, although it often is. (How much is being saved? For how long and for what purpose? What is the opportunity cost of saving for the individual?)

      Saving inflationary money is certainly a much worse idea than saving deflationary money.

      “If the value of Bitcoins rise more than the value of competing currencies, people will hold Bitcoins rather than spend them, but if people hold Bitcoins rather than spend them, then trade via Bitcoin does not increase.

      Using Bitcoin as a medium of exchange and speculating on rising Bitcoin value are competing uses of Bitcoin, and the competition is effectively zero-sum. A Bitcoin held speculatively cannot be used to mediate exchange, and new Bitcoins do not appear to replace Bitcoins held speculatively.”

      Some of what you say is true. If I hold a Bitcoin speculatively then it cannot be used to mediate exchange, and no new Bitcoins appear to replace the ones I hold. There are other potential Bitcoin sinks as well – if I lose the private key to a Bitcoin address then I’ve effectively destroyed the Bitcoin at that address.

      Where you go wrong is in thinking that “…if people hold Bitcoins rather than spend them, then trade via Bitcoin does not increase.” This does not follow for two reasons.

      First of all, if people would rather hold Bitcoins than spend them that also implies a market for Bitcoins and that some people will want to accept Bitcoins as payment. Gresham’s Law only applies when people are obliged to exchange at set rates – otherwise market prices will emerge and trade will continue commensurate with supply and demand.

      Also, the competing uses of Bitcoin for speculation and as currency is not “zero-sum” in the sense that you mean because Bitcoin is infinitely divisible. The people holding Bitcoin certainly do drive the price of Bitcoin up, but without controlling every single Bitcoin they can’t stop the trade function of Bitcoin. One Bitcoin is enough to run an entire world economy – everyone could just trade in fractions of a Bitcoin in such a scenario. There is no minimum number of Bitcoins needed in order to make a particular number of transactions, despite the scarcity of Bitcoins.

      “I doubt that Bitcoin’s use as money is absorbing the latest sell off. Speculators are now betting on the bottom. If this bubble is not the last (and I don’t believe it is), then a new equilibrium may occur and gradual deflation reflecting growing use of Bitcoin as an exchange media may resume, but the fundamental problem still exists.

      I don’t expect speculation fueled crises to become less frequent as Bitcoin becomes more widely used as an exchange medium, because speculation fueled crises impede the wider use. That’s the problem. The speculative bubbles could continue forever, but I don’t expect this outcome, because less bubbly alternatives to Bitcoin will appear, possibly a Bitcoin 2.0.”

      I don’t believe that this is the last speculative bubble either – I believe that there is a long way to go before Bitcoin’s value stabilizes based on its use as currency (if it ever does). Bitcoin represents a tiny fraction of the world economy, and its widening adoption would continue to drive up its price and invite speculation. That was my point in my previous post – if Bitcoin were widely adopted on a world scale then a single Bitcoin could be worth the equivalent of a million dollars or more. There’s still a long way to go before we hit that point, and depending on the speed of adoption that leaves Bitcoin open to a large number of speculative bubbles before the price reaches a relative stability that would minimize the impact of speculation. Even if Bitcoin use continues indefinitely as an ‘underground’ economy there’s still no saying how large that economy will end up being.

      And once again I agree with you that this could be the Achilles’ heel of Bitcoin – people might abandon it if the volatility persists. I just don’t take that as a given.

      “Deflation does not encourage savings, capital investment and wealth creation. The prospect of wealth creation encourages investment. Saving money is not necessary for investment at all. Spending money is necessary for investment, but I’m not discussing state spending here. If I hold cash, I’m !not! investing. I’m refraining from investment.”

      My fault – poor wording on my part. Let me try again, more carefully.

      I’m in full agreement that saving money, as such, does not create wealth any more than printing money or stuffing it in your mattress does. You’re absolutely right that the prospect of wealth creation encourages investment and it is those people who are spending money that create real wealth.

      What savings does is alter the price of money, changing the incentives towards various types of investments and creating price signals for entrepreneurs. (Austrian business cycle theory.)

      An inelastic money supply would encourage wealth creation in the sense that it would avoid the malinvestment trap of Keynesian economic policy (since no one could artificially control the price of money). This would ultimately lead to more net creation of wealth.

      It would also prevent government from using inflation to fund projects that impede wealth creation (by taking resources away from productive decision makers and putting them into the hands of unproductive individuals or institutions) or outright destroy wealth (war).

      How this would play out in a Bitcoin economy is uncertain. There are many questions that are up in the air. (Like what kinds of markets would develop for Bitcoin loans, and how they would work.) *But* the value of money would be tied to market forces instead of bureaucratic decision making and this would lead to more wealth for society as a whole.

      “…a solution must fundamentally change the way that Bitcoins are produced. The production scheme must replace hoarded Bitcoins to stabilize the volume of Bitcoins circulating as money (to make this volume grow with demand for Bitcoins as money). This replacement makes hoarding pointless.”

      Let me throw this back at you. Bitcoin is open source, which means that you’re free to go ahead and create a “Bitcoin 2.0″ that has some mechanism that ties the creation of units of currency to the demand for transactions and devalues hoarded currency. If you really think that will “fix” Bitcoin than do it, bring it to market and see what happens.

      I’m skeptical. How would you initially value this currency? And how would you convince anyone to accept it short of force or fraud?

      What mechanism could possibly be implemented to fairly devalue the currency of hoarders?

      I’ll tell you this much – there’s no way that I’d take a new and untested depreciating asset (Bitcoin 2) over a new and untested appreciating asset (Bitcoin). In fact, all other things being equal, there’s no way that I’d take payment in something that’s depreciating over payment in something that’s appreciating.

      • Martin BrockNo Gravatar says:

        Thanks for a thoughtful reply.

        “If Bitcoin is likely to be accepted as currency on a large scale, then you’d better believe I’m tempted to speculate on its future value, because I do expect its future value to differ radically from its current value.”

        Exactly. This expectation has a feedback effect. Because you expect Bitcoin to become a currency on a large scale, you expect its value relative to other goods to rise, and because you expect its value to rise, you accumulate it rather than spend it on other goods.

        Your expectation is not unique. If you’re right about Bitcoin, other people also accumulate it rather than spending it, but if too many people accumulate Bitcoin rather than spending it, or only trade it speculatively for other currencies, then it doesn’t become a currency on a large scale. That’s the problem.

        If you’re right about the increasing value of Bitcoin, then you seem to be wrong about it becoming more widely used as a currency. The assumption that Bitcoin becomes a widely used currency seems logically to imply that the assumption is false. This reasoning looks like a proof by contradiction that the assumption is false.

        For this feedback effect not to occur, many people, more and more all the time, must forego the profit that you expect in order to use Bitcoin as money rather than using some other currency. These people must have more to gain by using Bitcoin as money, rather than using the dollar say, than they have to gain by holding Bitcoin for the profits you expect.

        Who are these people? If you can’t identify them, then the market you imagine for Bitcoin as money is illusory, and your assumption of growing bitcoin value depends upon an ever growing group of them, so the assumption is wishful thinking.

        “So if it is likely to be accepted as a currency on a large scale at some point in the future then I want to buy now and hold.”

        Think about what you’ve written here. Bitcoin is a currency only if people primarily buy it or accept it in trade to spend it for something other than another currency. Something that you buy to hold is not money by definition. It’s an investment.

        You’re saying that if Bitcoin is likely to be widely used as a currency, then you won’t be using it as a currency. So who will be using it as a currency as it becomes widely used? If people accepting your logic are not using Bitcoin as a currency, who is?

        “Exchanges are taking place today in Bitcoin, and people are making money off of it as an investment.”

        The currency exchange trade swamps all other trade in Bitcoin. At MtGox, the dollar volume of Bitcoin trade has been above $10 million a day for most of April, and some days have seen volume over $40 million.

        During the same period, bitcoinstore.com is struggling to make $10,000 a day in sales, and if it doesn’t average this volume between now and June, it’ll lose the financing it needs to continue selling goods for Bitcoin at competitive, dollar prices.

        Furthermore, bitcoinstore is not using Bitcoin as money itself, because it is accumulating the Bitcoins paid for its goods rather than spending them for new inventory. When you buy something at bitcoinstore.com, your Bitcoins leave circulation, so even if you want Bitcoin to succeed for ideological reasons, why would you spend them at bitcoinstore.com? You might as well withhold the Bitcoins from circulation yourself and spend dollars at amazon.com. If you’re right about the appreciation, many bitcoinstore customers eventually reach this conclusion.

        “If Bitcoin were accepted as money worldwide it would be less speculative than gold even though it has no use other than as money.”

        I’m not sure why this statement is true, but the hypothesis is the controversy here. Will Bitcoin ever be accepted as money worldwide in more than a tiny proportion of transactions?

        “(Fiat money has no use other than as currency, but I doubt that you’d say that it’s more speculative than gold for that reason.)”

        I would say so. Competing uses of a good with different marginal values in different economic processes stabilize price. The price of a good is an equilibrium between its supply and demand for it in diverse uses.

        If demand for gold as money rises, then its rising price can reduce demand for its other uses as people adopt less costly substitutes, so the falling demand for other uses can offset the rising demand for gold as money, thus stabilizing the price. If gold has no other use, this stabilizing feedback doesn’t occur.
        “Which it has, so it’s not.”

        It’s not an all or nothing thing. If you think that, Bitcoin is either a Ponzi scheme or not a Ponzi scheme, you can’t see it behaving like a Ponzi scheme. It’s a matter of degree. Bitcoin is more or less a Ponzi scheme, and the more it behaves like a Ponzi scheme, the less stable its value becomes and the less it behaves like money.

        But there is no Ponzi. No one is deliberately peddling Bitcoin as a Ponzi scheme. That’s not my point.

        “If you invest in a company that fails despite offering a service to the market did you bet on a Ponzi scheme?”

        Is the company AmWay?

        “… it’s disingenuous to liken Bitcoin to a Ponzi scheme.”

        It’s denial to ignore the possibly of similar economic dynamics.

        “And if Bitcoin were money you’d go on looking for higher return investment vehicles along with every other investor. The only difference is that people might hold relatively more of their wealth in money that isn’t continually losing its value.”

        That’s true, but I don’t worry about holding my wealth in dollars, because it’s always a losing proposition. It’s a losing proposition by design. I don’t think about “investing” in money at all. I think about spending money. I might spend money on an investment, but money itself is not an investment.

        Even if my only options are different appreciating, durable goods, I use the good that appreciates least rapidly as money. Don’t I?

        Suppose I have both X and Y. I can buy one X with one Y today but I expect to buy 1.5 X with one Y a year from now, and I have no other use for either X or Y. Today, I need one Z, and you’ll sell me one Z for either one X or one Y? What do I trade for your Z today?

        “Added bonus – the wealth that investors work to build would be what people actually prefer, instead of the military-industrial complex that the gradual inflation you’re not worried about makes possible.”

        No one is advocating fiat money here. The choice between fiat money and deflationary money is a false choice. A stateless currency need not be deflationary by design, and a deflationary currency can feed a military-industrial complex as surely as an inflationary currency. A state that can impose an inflation tax can also impose a conventional tax. The inflation tax might be easier to impose in some scenarios, but imposing either tax requires a powerful state.

        “… there are examples of people who lived industrious but Spartan lives and ended up with a fortune on their death beds.”

        This life does not involve saving money. It involves trading fruits of an industrious life for money and then trading the money for other goods like real estate, stocks and bonds. Rich people do not save money. They accumulate property in productive capital. Money is a means to an end, not an end in itself. Again, read Bastiat.

        “I think it’s an overgeneralization to say that saving money is a bad idea, although it often is.”

        If I receive money in a transaction today and spend it tomorrow, I have “saved” the money for a day, so “saving” is also a matter of degree, but a good is money more than other goods when people save it less than other goods.

        In the free market that we both want, no one good is money. You think of money as a monolith, because you live in a world dominated by a state monopolizing money. If you think of Bitcoin similarly, you miss the point. Bitcoin must compete with alternatives and not only the fiat alternatives.

        “First of all, if people would rather hold Bitcoins than spend them that also implies a market for Bitcoins and that some people will want to accept Bitcoins as payment.”

        Speculation can dominate the trade in Bitcoins. People can buy Bitcoins with dollars only to hold the Bitcoins expecting a higher dollar price later, and people can sell Bitcoins only to take a profit in dollars. As long as the volume of dollars chasing Bitcoins in this game is rising, the game can continue.

        “Gresham’s Law only applies when people are obliged to exchange at set rates – otherwise market prices will emerge and trade will continue commensurate with supply and demand.”

        The demand for Ponzi schemes is real and persistent, even though the schemes always implode ultimately. Few people in a Ponzi scheme believe themselves in a Ponzi scheme. That’s true of every Ponzi scheme.

        Your description of Gresham’s Law misses the bigger picture. Yes, Gresham was discussing fiat exchange rates, but neither of us is discussing fiat money.

        I will hold a more rapidly appreciating, durable good and trade a less rapidly appreciating good, all else being equal. So would you. The question is: who are you expecting not to behave this way?

        My point concerns Bitcoin’s competition with all other goods potentially useful as money, including other stateless, peer-to-peer currencies, not only its competition with fiat money.

        “Also, the competing uses of Bitcoin for speculation and as currency is not “zero-sum” in the sense that you mean because Bitcoin is infinitely divisible.”

        Divisibility is irrelevant in this context. Dividing a Bitcoin does not create two Bitcoins. It creates two half-Bitcoins, and two half-Bitcoins are no more valuable than one Bitcoin. This accounting is even truer of Bitcoins than of conventional currency. Carrying a dollar’s worth of pennies in my pocket is actually costlier than carrying a dollar bill, but a hundred million Satoshis in my Bitcoin wallet feels just like one Bitcoin to me.

        “There is no minimum number of Bitcoins needed in order to make a particular number of transactions, despite the scarcity of Bitcoins.”

        This fact is irrelevant. The point involves Bitcoin prices, not the form of these prices. If every price is given in Satoshis rather than Bitcons, the difference is entirely superficial. People still prefer spending another currency while Bitcoins are becoming more valuable, and that’s the problem.

        “… if Bitcoin were widely adopted on a world scale then a single Bitcoin could be worth the equivalent of a million dollars or more.”

        People expecting this outcome any time soon do not exchange a Bitcoin for an iPod or even for an ounce of pot, so if you expect the outcome yourself, you must expect many other people not to expect it. Who are the other people, and why do their expectations differ from yours?

        “Even if Bitcoin use continues indefinitely as an ‘underground’ economy there’s still no saying how large that economy will end up being.”

        That’s true, and a black market demand for Bitcoin, as a currency, does exist, but Bitcoin is not the only possible medium of exchange for the black market.

        The last Bitcoin bubble could burst when another currency overtakes Bitcoin as the most popular currency on TOR network markets (like Silk Road), or Bitcoin itself could morph into a more stable currency with a more elastic supply discouraging speculation. In the latter scenario, Bitcoin 2.0 could break out of the black market more easily, but in white markets, states will likely commandeer it.

        “What savings does is alter the price of money, changing the incentives towards various types of investments and creating price signals for entrepreneurs. (Austrian business cycle theory.)”

        “The price of money” in this theory refers to interest rates, not to an expectation of inflation (or deflation). A “real interest rate” combines the two, but people prefer price stability for this reason. People making long term credit agreements want to believe that a specified interest rate is meaningful, not to speculate on the currency.

        “An inelastic money supply would encourage wealth creation in the sense that it would avoid the malinvestment trap of Keynesian economic policy (since no one could artificially control the price of money).”

        The false choice appears here again. The Keynesian malinvestment trap is a consequence of inflation fueling state spending as well as artificially low interest rates. A currency with a more elastic supply need not be inflationary or fuel state spending or artificially lower interest rates.

        The supply of Bitcoin is both completely artificial can centrally planned. It’s a direct consequence of choices made one man at one point in time. If this man were Ben Bernanke, the supply of Bitcoin would be the central plan of a state agent. Since Satoshi Nakamoto presumably is not a state agent, the supply is an entrepreneurial experiment that can succeed or fail.

        “It would also prevent government from using inflation to fund projects that impede wealth creation …”

        A stateless currency with a more elastic supply can also have this effect. An inflation tax and a deflationary currency are not mutually exclusive alternatives.

        “… the value of money would be tied to market forces …”

        What if market forces favor a less deflationary currency? Bitcoin (1.0) is highly deflationary by design. It tolerates no market preference for a less deflationary currency.

        “If you really think [a more elastic supply] will ‘fix’ Bitcoin then do it, bring it to market and see what happens.”

        I favor a different model and have implemented one in fact, but I haven’t brought it to market. I’m more of a tinkerer really, but I still hope to bring something to market someday.

        I don’t need to implement Bitcoin 2.0, because others will, but the time is not ripe for an exodus from Bitcoin 1.0. Alternatives like Litecoin (and Ripple and Ithaca Hours and Equal Dollars) already exist, and others are coming, but Bitcoin has the mindshare at this point.

        E-Gold might have grown in popularity had the United State not crushed it, and this precedent doesn’t bode well for any free currency or for TOR and similar technologies ultimately, but I want a stateless currency as much as you do.

        “I’m skeptical. How would you initially value this currency? And how would you convince anyone to accept it short of force or fraud?”

        I would value the currency relative to a standard commodity, as in a gold standard though gold is not my preference. My preference for the standard of value is some sort of standardized labor, what early libertarians called “common labor”.

        State socialists also used this pair of words (“common labor”), but this fact should not prejudice you against the idea. Classical liberals generally (including Mises) thought labor the most valuable resource, not the only valuable resource only the most valuable. I’m not promoting a labor theory of value here. Gold is a standard of value under a gold standard, and it’s obviously not the only source of value either.

        Why did people accept E-Gold and Liberty Dollars before the state accused proprietors of fraud?

        “What mechanism could possibly be implemented to fairly devalue the currency of hoarders?”

        Devaluing the currency of hoarders is not necessary, only stabilizing the value. If the currency’s value does not rise, people will not hoard it. Bitcoin 2.0 might only stabilize the value of Bitcoins, and current Bitcoin holders might welcome this change. As you say, the software is open source, so the developers and users of this software decide what constitutes a Bitcoin ultimately.

        Units of a currency can even expire as some banknotes have in the past. If you know that units of a currency in your possession expire, you don’t hoard them. You exchange them for a valuable good instead. No one steals from you in this scenario, any more than someone steals from you when an options contract expires worthless.

        “I’ll tell you this much – there’s no way that I’d take a new and untested depreciating asset (Bitcoin 2) over a new and untested appreciating asset (Bitcoin).”

        How tested is Bitcoin?

        If you could buy Bitcoin 2 for dollars (or for hours of your labor) and immediately sell Bitcoin 2 for an iPod at bitcoinstore.com, why wouldn’t you do it? You don’t hold the Bitcoin 2 in this scenario, so why do you care about its appreciation?

        Suppose you can buy both Bitcoin 1 and Bitcoin 2 for dollars, and suppose you can buy an iPod at bitcoinstore for either one Bitcoin 1 or one Bitcoin 2, and suppose you expect Bitcoin 1 to buy 2 iPods next year while Bitcoin 2 stilly buys only one. Would you buy the iPod today with Bitcoin 1 or Bitcoin 2? That’s the question.

        Bitcoin 2 can exist, so Bitcoin 1 must compete with it. That’s the free market assumption.

        “… there’s no way that I’d take payment in something that’s depreciating over payment in something that’s appreciating.”

        A carton of milk depreciates faster than a dollar bill. You don’t buy milk with dollars?

        Your customers also prefer to keep the appreciating thing. If you’re a merchant, you take what your customers are willing to pay, or you don’t trade with them.

        As a competing merchant, I want your customers, so I’ll take their depreciating thing in trade, because I don’t intend to hold it. I intend very soon to exchange it for new inventory or durable investment goods. How are you competing with me for customers who prefer to hold the appreciating thing as much as you do?

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