Selling coins

Money to economic man is like water to fish. This analogy suggests that fish are oblivious to water, and man is likewise often unaware of what money does or is. Fish seem happy, at least, swimming along the sea or the river. Homo sapiens are very different. We are rarely at ease with this thing called money.

I stumbled on the fish-in-water idea in a 1974 book on money by Michael Phillips and Salli Rasberry, The Seven Laws of Money. Among the seven laws, one said, “You can never give money away.” Another said, “You can never really receive money as a gift.”

Phillips and Rasberry thought gifting money was a two-way street because the giver sooner or later gets repaid. It was, nonetheless, the first law that intrigued me most because it said, “Money will come when you are doing the right thing.”

Their book suggests that money moves in mysterious ways, even if mainstream economics sees it mainly as a “veil” that facilitates trade and exchange. For decades I struggled to reconcile the veil metaphor with a zen-like way of looking at money.

The struggle is enhanced and made more poignant when considering a more recent innovation about money. I am talking about digital money, also known as cryptocurrency, of which Bitcoin is the most prominent.

To those who have dabbled in them, cryptocurrencies are speculative toys. They start life as play money and later become an ‘investment.’

Initially, you could “buy” one Bitcoin for $0.25 (twenty-five cents), but today it is something like $28,000. This would represent a mind-blowing return if you had ‘invested’ in Bitcoin in its early days (circa 2009) when you needed 10,000 coins to buy a pizza. If you ate that particular pie, you would have parted with something worth $280 million today.

To others who seek a ‘cypherpunk’ monetary universe, Bitcoin is akin to the Holy Grail. It would solve a host of problems confronting humanity.

This is the theme of a recent book by Florin Hilbay. The book is Bitcoin, an introduction to the peer-to-peer, open source, censorship-resistant, immutable, permission-less, decentralized, global, digital monetary network of the 21st century.

Hilbay is currently the dean of the College of Law at Silliman University. He autographed my copy of his book: “.. fix the money, fix the world.”

Bitcoin is theoretically money because it can perform the three functions of money – as a medium of exchange, store of value, and unit of account. Bitcoin has a tenuous role as a unit of account; I have yet to meet anyone who measures his income or wealth in Bitcoin.

Bitcoin has not lived up to its promise as a medium of exchange. What’s prominent is the store-of-value aspect when people hold Bitcoin for future resale.

The goal of his book, according to Hilbay, is “to help the reader understand what [Bitcoin is] … and why it matters to every human being today and in the future.” In the book’s title are eight features of Bitcoin.

Let me dispose of seven of the features of Bitcoin (other than being a “digital money and payments system”). The claim is that Bitcoin is open, permission-less, peer-to-peer, immutable, censorship-resistant, decentralized, and global. The claim is obviously valid, in keeping with Bitcoin’s anti-establishment or anti-centralization features.

But the characterization also applies to gold! Gold is open, permission-less, peer-to-peer, immutable, censorship-resistant, decentralized, and global. Fiat currency held as cash (in bank notes) is not much different from gold (except that it is printed by central banks and can fuel inflation). Hilbay would agree with these distinctions.

Bitcoin then matters primarily because we do not like inflation. As inflation eats away at the savings of ordinary people, an alternative to fiat money becomes attractive. Bitcoin will then “save” humanity because it will also solve related problems, such as the “unfair” monopoly on seignorage accorded the US dollar and major currencies, the high fees of today’s banking transactions, the lack of banking for the poor, the recurrence of financial crises, the “forever” wars among countries, and “monetary colonialism and imperialism.”

Utopia comes to mind when thinking about Bitcoin. Hilbay waxes poetic regarding this end-state of affairs. He writes (on p. 203):

“Once you get a feel of your surroundings and understand however gradually, what’s going on, the unarticulated intuitions will soon turn into clear premises that will be the solid foundations for grounding your rationality. … the heart and mind will inevitably unite: the eyes will discover vision, the lungs will clear … The path of Bitcoin will become visible, and you will finally understand that yes, this is the way.”

We can analyze the argument relating to inflation, but I don’t know how a particular form of money will eliminate wars or prevent financial crises.

So let us discuss the matter of inflation. An important characteristic that distinguishes cash, gold, and Bitcoin is their aggregate ‘supply’ or quantity. The total of cash is determined by the central bank. The supplies of gold and Bitcoin share similar features. Both come into being through mining – physical for gold, electronically through some form of mathematical confirmation for Bitcoin. The supply of gold is limited by its natural scarcity; Bitcoin is capped at 21 million coins by tacit agreement among its holders and users. (It is somewhat strange to talk about ‘agreement’ within a community that values decentralization, but never mind this for now.)

Mainstream economics considers inflation (measured in terms of a given monetary unit) subject to the ‘quantity theory of money.’ Prices are stable if the quantity or supply of money is fixed (and when we also assume constancy in the volume and velocity of transactions). Prices rise in a fiat world when central banks print too much money. Prices fall when there is too little money relative to goods.

The theory of the proponents of Bitcoin is that inflation would disappear in a world where the money is Bitcoin. Supposedly this is because of the cap on the amount of Bitcoin that can be created. But is this theory correct?

In reality, inflation was a problem during unexpectedly large discoveries of gold. Inflation is a potential problem when central authorities can create or debase the (fiat or metallic) money they espouse. It is a tax that falls hardest on those who hold assets, such as cash or bonds, denominated in fiat currency.

A libertarian view is that the inflation tax is also state-sanctioned theft. A pro-government view is that the inflation tax is just another (fiscal) instrument that may help to reduce unemployment.

The questions that matter are: Will inflation in fiat currencies be solved by adopting Bitcoin as the only alternative? Will the emergence of other cryptocurrencies solve the problem of inflation? Will doing away with fiat currencies result in a deflationist tendency in the economy? I submit that there are no easy answers.

If the supply of Bitcoin were fixed and the world’s production of goods and services were to continue to grow, Bitcoin would be a prototype of a deflationary currency.

In other words, the Bitcoin price of goods and services would fall. Indeed, since 2012 (when Bitcoin prices took off materially), the annual inflation numbers in the United States – the change in consumer prices when measured in Bitcoin – show an average of minus 30 percent, which contrasts with the official (dollar) inflation average of 2.5 percent. Will the Bitcoin deflation continue?

In the transition from fiat currencies to Bitcoin, the issue of inflation vs. deflation is the same as how Bitcoin is priced. Against fiat, Bitcoin will rise and fall according to market expectations. The original hodlers will likely hang on to their Bitcoin if they expect its value or price to continue upward. The late-comers to this ‘investment game’ would feed the speculative beast. Will this speculation ever end?

Perhaps not, so long as newcomers’ intended purchases exceed the amounts that existing hodlers would sell. I note that the ownership and mining of Bitcoin have been highly concentrated. In effect, the Bitcoin ‘ecosystem’ is dominated by a very small number of players.

There is a likely explanation for the concentration in the ownership of Bitcoin. In its early days, with Bitcoin priced at about $500, early investors could stake out significant positions with little capital. The market valued the then-existing total of Bitcoins in 2013 (12 million) at $6 billion. (Such an amount would be peanuts compared with the $13 trillion net worth of today’s roughly 3,000 billionaires.)

If something like 400 billionaires were among the early investors, each one could have bought on average less than $10 million of Bitcoin. $10 million is close to the price of a high-end super yacht or an executive jet plane.

One commentator has remarked on his personal investment in high-risk, high-upside assets, “[I]f it goes up a lot, you don’t need much, and if it goes to zero, you don’t want much.”

I cannot help but repeat the quip from F. Scott Fitzgerald and Ernest Hemingway: “The rich are different from you and me; they have more money.” And they probably have Bitcoin in their portfolios. If they can get others to join the speculative frenzy, the more, the merrier.

Because of their concentrated ownership and relatively small initial investments, high net-worth owners of Bitcoin are likely to simply “stay the course.” I can imagine a horizon of at least ten years for the persistence of the expectation that the price of Bitcoin against fiat will continue to rise.

For cynics who think of Bitcoin as a scam, ten more years is short. Bernie Madoff got away with his Ponzi for at least twenty years.

The idea of 10 more years is suggested by Hilbay for judging whether Bitcoin will become a legitimate form of money. He writes: “[L] et’s wait a decade and see how things turn out” (p. 202). He even mentioned Paul Krugman, who had famously suggested that the internet would be a fad (“… go and have a drink with Mr. Krugman”).

Hilbay also believes that there will be a “paradigm shift” whereby Bitcoin becomes the dominant form of money. That shift might come about through competition. He says, “… money is a commodity that is selected by the market itself from among different types of money available. From this monetary competition …, the best form of money is selected and dominates the rest. The game is winner-takes-all” (p. 194).

This approach of subjecting innovations to the vagaries of consumer preference seems reasonable. Even today, fiat currencies compete against each other within and across the borders of countries.

Whether cryptocurrencies can displace fiat currencies and related payment systems (credit cards, etc.) is perhaps an open question, at least for the next 10 years.

Alternatively, the speculative fever will end if the demand for Bitcoin collapses. This can happen if Bitcoin enthusiasts lose interest (they lose faith in the “forever upward” theory) or if Bitcoin is surpassed by other digital currencies that better hedge against inflation or can process transactions at a lower cost.

Demand for money, in general, can also decline through a nuclear winter or an incurable plague that causes the global population and economic production to fall. The quantity theory then says that the fixed supply of Bitcoin will translate into a rise in the prices of ordinary goods, and Bitcoins will become (amazingly) inflationary and antithetical to the goal of its proponents. Far-fetched?

The point of the preceding discussion follows from a seminal article by Kareken and Wallace (1981) on the fundamental indeterminacy of floating exchange rates. The equilibrium exchange rate (between US dollars and euros, or US dollars and Bitcoin) is rooted in market expectations – today’s price is the price tomorrow, adjusted for interest differentials. This is the ‘backbone’ exchange rate equation in the textbook treatment of an open macroeconomy.

If hodlers continue to hoard Bitcoin while using fiat, Bitcoin can never become a medium of exchange. This result is from a crude version of Gresham’s Law – the “bad money” (fiat) would drive out the “better money” (cryptocurrency) that is prized but not spent.

In other words, “success” in Bitcoin’s price action or that of any other cryptocurrency would keep them from becoming viable as money. It is as though Bitcoin were to remain a fetus that is never born!

An even weightier consideration is an incompleteness in the economic theory behind the promised widespread adoption of Bitcoin. Inflation could give way to deflation, which some Bitcoin proponents view as good. They forget that deflation has been associated with economic recessions and depressions. Will the Bitcoin proponents who enjoy tremendous capital gains as hodlers feel responsible for that other scourge of the modern economy – unemployment?

I do not jest. Deflation is no laughing matter. If we can, we must find out how deflation comes about.

We have evidence from countries that have suffered deflation. Japan is a recent case of the dangers of deflation. In the early 1990s, the Japanese economy went into deflation after a crash in land and stock prices. The deflation apparently did not reflect such possible factors as unusual productivity growth or shifts in the country’s terms of trade. The deflation also cannot be attributed to Japan adopting a hard currency like gold because it remained on a fiat currency.

The official story is that the deflation resulted from a long-running economic malaise and stagnant aggregate demand. This is the mainstream analysis. Changes in aggregate demand result in price inflation or deflation (likely with a recession).

The theory is traceable to John Maynard Keynes who explained that recessions result from the inadequacy of aggregate demand in the short-run period when wages are ‘sticky.’ Keynes is quoted in an IMF report as having said (in 1923): “Inflation is unjust and deflation is inexpedient. Of the two perhaps deflation is … the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier.”

But there may be a way out of the predicament. Every time the world economy veers toward recession, the army of the unemployed should become Bitcoin miners or promoters. The unemployment problem is solved. I recall a take on Keynesian economics when I was a babe in the macroeconomics woods. Fiscal authorities, on the advice of Keynes, would have the unemployed dig ditches one day and cover them up the next, and so on, so that unemployment would disappear. Did it work?

Another way out of deflation is the emergence of alternative cryptocurrencies. Inflation measured in terms of these currencies can be positive because the so-called hard cap on Bitcoin supply will no longer operate.

Other forms of cryptocurrency will add to the moneys chasing a fixed or slowly growing amount of goods. But then we would be back to the current world of competing fiat currencies, where the issuing central banks commit themselves to inflation targets.

The last of the Seven Laws of Money is an observation: There are worlds without money. These worlds involve “the essentials of human life” – music, art, poetry, love, sex, friendship, dreams, etc. (p. 112 of Phillips & Rasberry). We think and live in worlds without money while recognizing that we also have a day-to-day world with money surrounding us, like water enveloping fish.

The economist Alfred Marshall called this world “the ordinary business of life.” We take the infrastructure of money for granted except when we face disturbances such as inflation, financial crises, bubbles, or life-changing innovations like credit cards or online payments.

Hilbay suggests that we view Bitcoin as an apocalyptic but benevolent paradigm shift in our monetary system, not as a bubble on a bauble.

Which book should I recommend you read? As the song goes, the answer is blowing in the wind.

I put myself in the shoes of Nakamoto, the inventor of Bitcoin, who is said to have hodled one million Bitcoins. Did I indirectly monetize the software underlying Bitcoin?

I think of what I had done as a Faustian bargain. I have caused Bitcoin to sprout into a cult. I have also absented myself from the scene, and ascended to Bitcoin heaven, leaving mortals to carry on. Or stand aside.

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Author’s email: ORoncesval4@gmail.com; Twitter: @ORoncesvalles