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Kevin Drum, riffing off yesterday’s epic Mt. Gox and BTC implosion:

Bitcoin, after all, is the ultimate fiat currency: just a bunch of ones and zeroes on a computer with no intrinsic value. But so are all currencies. The difference is that it’s more obvious with Bitcoin because the entire enterprise is actively marketed as nothing more than algorithmically-created data. It’s one of their big selling points.

So that forces you to think about what the ultimate value of a Bitcoin can be. And if there isn’t any, then why do dollars and yen have value? Why do IOUs passed around in prison camps have value? Or babysitting chits? Once you figure out what ultimately underlies the value of these various fiat currencies, you’ve taken a big step toward understanding why some currencies are better than others and why playing games with the debt ceiling is so stupid.

Which reminds me that I wanted to knock down this whole notion of “fiat currencies” in the first place.

Money is a technology devised as a solution to a bundle of collective action problems centered around network effects and the transaction costs of exchange above a certain threshold of scope and scale. It works really, really well, but it has a few problems. A key problem (though not the only or, perhaps, even the most important of which) is the one of storing value – money is only useful if its value doesn’t fluctuate too much, too unpredictably, too soon. However, there are incentives for whomever issues the money (as well as counterfeiters) to take actions that result in just those kinds of fluctuations, as well as outside pressures that make such fluctuations more likely. Therefore, almost every money issuer ever has taken some sort of steps to regulate the value of its currency and the rate at which that value changes.

One solution to this was to make the money out of rare, durable, verifiable elements. One solution was to have private actors issue money and caveat emptor. One solution was to have a bunch of state technocrats issue paper redeemable for said elements. One solution was to have a bunch of state technocrats issue paper redeemable in more paper and pinky-swear not to allow the value of the currency to fluctuate. One solution was to create a self-perpetuating algorithm that fixed the supply of currency units. There were also other solutions.

I think trying to sort those and the myriad other solutions to the money problem into “fiat” and “backed” is as irrelevant as it is obscurant. In each of those schemes there are two identifiable foci from which value regulation derive and distinguish various schemes from each other:

-The algorithm – the rule governing the value path of the currency.

-The credibility – the likelihood of the currency following the value path promised by the algorithm, and the accountable party for those outcomes.

This makes actual, categorizable sense of the differences between various monetary regimes. The algorithm of a gold-standard is “the value of this currency will always be equal to a certain quantity of gold, and you can always exchange your paper for that quantity” and the credibility is in the issuer, whether it’s a private bank or the central bank. Nothing stops me from issuing a gold-backed currency tomorrow, but nobody would use it because my promise to redeem all the SquarelyBucks I’m issuing for shiny gold coins is, sadly, totally lacking credibility. The algorithm of a “fiat” currency is “the value of this currency will never decline by more than ~2% annually” and the credibility is in the issuer, in this case Janet Yellen, the FOMC, and the institutional apparatus in which they operate. The algorithm of Bitcoin is “the money stock will never exceed 21mm BTC” and the credibility is in the nature of the currency’s code which until recently seemed very well-designed to prevent counterfeiting.

The genius of Bitcoin is that it takes the algorithm out of human hands; the tragedy of Bitcoin is that its algorithm is stupid, for two reasons. The first was that Bitcoin’s algorithm was borne out of an ideology which believed that central banks inherently lacked credibility and that therefore central bank currency inflation, even hyperinflation, was not just possible but inevitable, especially in light of the various Federal Reserve responses to recent economic shocks. This ideology is wrong:


TIPS Spread

The second reason is that there are better algorithms even if you believe in that (wrong) ideology. A good example would be “one BTC will always equal one 2009 USD no matter what happens to the value of USD over time.” This, of course, is way more complicated than the BTC algorithm as a coding matter, because it would have to either trust CPI or another inflation measure or somehow routinely update an internal proprietary index based on accessible price data, a tricky thing to do into perpetuity. If someone wanted to program and release that cryptocurrency, BTW, it would be a fantastic economic experiment. But that’s not BTC, which instead fixed its money supply, and lacking any private or public chartalistic price anchor allowing for large, unpredictable, rapid fluctuation in its value, thus defeating the purpose of money itself.

I hereby therefore petition that we suspend all discussion of “fiat” currencies and “backed” currencies and instead discuss rules and credibility.

(Thanks to Mike Sproul and Nick Rowe for kicking this around with me in the comments of this post)


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Ryan Cooper says this about Bitcoin:

…there is no human judgment whatsoever on the size of the bitcoin money supply, because it is all determined by prearranged mathematical formulas. This solves the problem of the currency being destroyed by the government, but at the cost of an inherent vulnerability to deflation and boom-and-bust panics, as we’re seeing today. (I strongly suspect some Wall Street types are making out like bandits at this very moment.) The only way to solve the panic problem is with a trusted central bank that credibly promises to intervene to prevent excessive inflation or deflation, thereby short-circuiting the self-fulfilling cycle. Again, this is impossible with Bitcoin.

Which is correct! But asks the question – what is the point of Bitcoin?

Money is three things – a medium of account, a medium of exchange, and a store of value. Let’s say USD:BTC is a random walk with unknown parameters. Is Bitcoin money?

The fact that, at any given moment, the USD:BTC has deviated stochastically from its prior value should not impact Bitcoin’s usefulness as a medium of exchange. Much has been written about the cleverness of Bitcoin’s code and structure; this makes it a very useful way to make secure exchanges.

But what about a medium of account? If Bitcoin’s value is random (and, presumably, fluctuating quite wildly), that doesn’t mean it can’t be a medium of account; it just won’t be a very useful one. Something that was 3BTC today will be 30BTC tomorrow and 0.000003 BTC next week. You could certainly keep track of USD:BTC and "translate" a Bitcoin ledger into dollars, but that only goes to prove that usefulness as a long-term medium of account has something to do with…

"Store of value." The thing about Bitcoin is that it is not solely a platform for secure exchange; once an exchange is made, one party or another is holding some number of Bitcoins. In fact, since there is no Bitcoin finance, at any given point individuals are holding all the Bitcoins in the world. And, if the price can fluctuate wildly between exchanges, it is a terrible store of value. Something you sold for 5 BTC yesterday could be worth 50 or 0.5 BTC today, and you haven’t had a chance to change your BTC for something more stable – or, if you have, the next guy got screwed.

So, to be money-er, Bitcoin really could use some sort of exchange rage regulation. The problem is…who? Even in the Cryptonomicon scenario, you’d have to trust the authority regulating the currency. And why would you? They may not have any power to buy back the currency if inflation is overheating, and no power to inject new money unless there is demand for it. The central bank of a country, back by laws and institutions and police and armies, have the power to compel money demand chartally; they have regulated banks that must maintain reserves at the central bank; they have deposit insurance; they have foreign reserves; they have gold; they have all kinds of things that allow them to back currency with trust, because they back trust with the state.

Point being, that in this modern age non-state currencies without intrinsic value are destined to either fail or be severly limited in their broader utility, especially to folks who want to engage in legal transcations.

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