Bitcoin as a Monetary Issue
Filippo Balestrieri and Bernardo A. Huberman
The intense controversy about the virtues and flaws of Bitcoin has obscured an important point central to its use as a currency. While the technology in itself is quite brilliant and suggests a number of interesting applications, its monetary aspect has received little attention. Ironically, it is in this domain that the success of Bitcoin as currency is in doubt.
The Bitcoin system relies on a novel and sophisticated solution to an important problem within the field of distributed systems, the Byzantine Generals problem, The solution consists of an algorithm that guarantees the reliable distribution of messages across all the separate units of a network regardless of the trustworthiness of the network communication lines. In principle, this breakthrough should make it easier to implement a wide array of peer-to-peer exchanges that in the past required the presence of reliable mediators.
Bitcoin is an application of this algorithm to money transfers. In a recent article Marc Andreessen provided a compelling list of use-cases for this new technology: cheaper international remittances, financial services for the “unbanked” world, digital micropayments, anti-spam policies and easier fund raising.
These claims rely on the fact that with Bitcoin it is possible to avoid the fees that banks collect as part of their intermediation services. However, even assuming that the Bitcoin ecosystem is indeed a cheaper environment for the transfer of “money” from one person to another, there is yet another issue in the analysis of the Bitcoin phenomenon that puts a damper on these claims.
First of all, it is important to stress that all the new benefits from the technology could be reaped with a Bitcoin pegged to the dollar. Since the total supply of Bitcoins and their conversion into dollars are not constrained in a specific way by the algorithm that solves the Byzantine Generals problem, a fixed 1 Bitcoin=1 Dollar exchange rate, for example, would allow people in the US to use Bitcoins only in order to take advantage of the new underlying technology.
Second, the decisions to set a floating exchange rate with other currencies, and establish a controlled supply of new Bitcoins (gradually decreasing until year 2024) make Bitcoin into an independent, alternative currency in competition with the existing ones. Thus, the technological advantage of reliably transmitting money in an unmediated network is now bundled with the risks and properties of the new currency.
Bitcoin is a peculiar currency. As other currencies, it offers a way to store value and is thus an investment asset. Differently from the Dollar, Euro, and Yuan, however, there is no geography where it is recognized as the legal tender. This implies that a debt that is paid in Bitcoin is not legally considered as eliminated. The acceptance of Bitcoins to settle a debt is up to the lender’s will, which implies that the fate of Bitcoin relies critically on its voluntary adoption by others. Thus, in the US, this adoption is crucially dependent on the the Bitcoin-Dollar spot exchange rate, whose value makes it more or less convenient for a lender to accept Bitcoins as repayment for a loan originated in Dollars.
Additionally, Bitcoin requires permissive policies by the political authorities of the countries where it gets adopted. If people were to massively adopt Bitcoins in place of the local currency, a country would end up with no effective monetary policy tools available. Moreover, given the lack of a clear tax treatment of Bitcoin-related returns (it is not obvious if Bitcoins should be treated as commodities, assets or currency), fiscal policies could become difficult to administer. Even the most optimistic scenario of a universal adoption of a hetero-defined currency implies the surrender by all countries of a big share of the power to self-determine their economic policies. While perhaps similar to the situation in Europe when the Euro was adopted, the global reach of Bitcoin will make most countries extremely reluctant to give up their sovereignty in monetary matters.
In the past year Bitcoin has experienced first an impressive appreciation (1 Bitcoin was worth 10 Dollars in January and 1300 Dollars in November) followed by a large depreciation (1 Bitcoin was worth 900 Dollars in December). Moreover, enormous daily fluctuations of up to 50% suggest that it is more of a speculative asset than an instrument of commerce. Indeed, the usage of Bitcoins to buy goods or services is still rare, and, even in the few cases where it takes place, it is not clear if it is done for its distinctive technical properties or for recreational purposes.
In this context it is important to point out that prices denominated in Bitcoins are not lower than those in dollars because of the missing commission fees paid to the bank. Quite the opposite, given its fast appreciation as a currency, a Bitcoin amount paid in January for a sandwich would have bought two computing tablets in November.
Throughout history the currencies that have been most used are those that were able to guarantee price stability. As is well known, both inflation and deflation affect growth and development negatively by adding uncertainty to economic activity. At the time of the Great Depression , for example, the necessity to counteract the steep decline in prices led the US to abandon the Gold Standard. And essential to price stability is the ability to run flexible monetary policies when needed. Because Bitcoin was created to be a currency with both a flexible exchange rate and an inflexible monetary policy, it has exhibited fluctuations much larger than those controlled by a central bank, as in the case of the US dollar.
It is this volatility that will undermine the practical implementation of the use-cases listed by Andreessen. Just to focus on one of his examples, that of remittances, the fear of depreciation of Bitcoin could quickly overcome the appeal of avoiding transfer fees in the mind of an immigrant worker who is offered the option to convert his savings to Bitcoins before transferring them to his family back home.
Ultimately the fate of Bitcoin will depend on its ability to compete with other currencies. Regardless of the outcome, it is important to stress that the technology underlying Bitcoins does not depend on Bitcoin’s success. Quite the contrary, other digital currencies tied to the same technology but with different rules of monetary policy (i.e. ways to manage the contraction/expansion of the monetary base) may emerge and successfully compete with Bitcoin. The ones that will be able to exhibit price stability over time will be the ones that will stay with us for the long-run.